Yesterday, I looked at household debt where it is clear that households took on too much debt. What about corporations? Credit was readily available and there was a lot of private equity activity. It is well-known that the net result was a big upswing in corporate debt starting in 2002. Again we can take a look at the Flow of Funds data from the Federal Reserve to see this. The following chart is in current dollars (so not adjusted for inflation) and shows corporate debt and profit before taxes.
The 2002-2007 debt increase stands out clearly, as does a previous increase from 1992 to 2000. It is instructive to look at what happened during that previous increase. From about 1992 to 1999 profits grew and then leveled off, but starting in 2000 profits fell and really took a dip in 2001 and 2002 as the economy was coping with the twin shocks of the dotcom implosion and 9/11. Given the increased debt levels companies had a much harder time dealing with that downturn. In fact, debt-to-profit went from roughly 7x in 1996 to a historic high of 15x in 2001. Now lets look at how we are entering the current downturn. In 2007 debt-to-profit was below 7x, but that is largely due to an monsterous 3x increase in corporate profits from 2002 to 2007. If we assume for a moment that the current crisis will result in a drop of corproate profits simply back to 2001 levels, the debt-to-profit ratio will balloon to 22x. The following chart shows the ratio, with the dotted line indicating how the ratio would look at 2001 profit levels.
Now if we combine this with the finding from yesterday that much of the economic growth in the 2002-2007 interval was due to unsustainable household spending that is now evaporating, this is a rather scary picture for the likelihood of significant corporate defaults in the years ahead.
Some of the worst hit companies will be the ones that took on huge debts as part of the buyouts. Interestingly, many of the biggest deals were done with a debt feature called a PIK toggle. The PIK toggle allows the borrower to turn off paying interest in cash in return for even higher payments down the line. The feature was invented by Texas Pacific Group as a way to let a deal weather a downturn from a cash flow perspective. But that really only works for a minor hiccup. For a major downturn all it does is postpone the day of reckoning. I don’t know how many buyouts with that feature have already switched the PIK toggle, but there may well be a bunch of walking dead already: companies that have not defaulted on their interest payments but are accumulating extra debt that they will never be able to repay.
