Bankruptcy & Markets — Investor Amnesia

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Print shows a ship labeled “Wrecked Corporation” and “Insurance Co. Bankrupt” that has wrecked on rocks with a darkened lighthouse labeled “Trust” and “Justice” nearby; its light has been snuffed by “Judge” and “Corruption”. Victims of the wreck, some clinging to the ship, others in the water, are labeled “Policy Holder” and “Pillaged Policy Holder”. A rope from the ship to shore is held by a “Receiver”, a “Lawyer”, and a “Shore Shark”, and is coiled around a money bag labeled “Fee”. Another “Lawyer”, using a gaff, reaches for a barrel labeled “Fees” that bobs in the water near the ship. Standing near the lighthouse is a man labeled “Referee” who is holding a pan labeled “False Beacon” that spews illuminated smoke labeled “By Order of the Court”; he burns papers labeled “Waste, Outrageous Extravagance, Extortion, [and] Cost”.


Visualizing History 


From the Archives

Facts, Failures, and Frauds (1859)

Reposting this book because it remains very pertinent to today’s topic. A 19th century account of financial fraud and business failures that reads as relevant today as it did back then.

Consider the first page of Chapter 1:

“Without any great violence, all the incentives to commercial crime may be brought under the one common rubric — the desire to make money easily and in a hurry.

The apprentice-boy, who robs the till of a few shillings in order that he may enjoy himself on a particular evening; the gigantic forger or swindler, who absorbs thousands that he may outshine the people who live and breathe around him, are so far in the same predicament that they cannot endure any delay to the gratification of this common passion.

Apart from these, but still actuated by the same desire, is the reckless speculator, who would risk everything in the hope of a sudden gain, rather than toil safely and laboriously for a distant reward. The speculator may, of course, be a perfectly honourable man, who would instinctively shrink from any deed that would invoke the interference of the criminal law; but if for time is adverse, he is on the high road to wrong-doing, and, moreover, there are many crimes not enumerated in the statute-book that are still heavy sins against the dictates of morality.”


Sunday Reads

Two weeks ago we looked at the history of fraud and short selling. Today, however, we are going to focus on one of the primary knock-on effects of this global pandemic: Bankruptcy.

Broken Benches

The Original FinTech ‘Platform’: Banking “Benches”

Have you ever wondered where we got the term bankruptcy from? The word ‘bankruptcy’ is derived from the 14th century Italian phrase “banca rupta” -> “broken bench.” During the 14th century, Italian bankers conducted their business and public transactions on benches like the one depicted above. If a banker became insolvent and was no longer able to continue lending or meet their payment obligations, however, their bench was smashed in half as a sign of failure and public shaming. Thus, “banca rupta” -> “broken bench” -> “bankruptcy”.

Coronavirus has broken a lot of benches.

 

The WSJ reported:

Chapter 11 business bankruptcy filings increased 26% in the first half of this year as more companies sought protection from creditors during the coronavirus pandemic…Commercial chapter 11 filings were up 43% last month from June of last year.

The Bloomberg visual depicts just how devastating this string of bankruptcies has been:

In this analogy, the Federal Reserve is an overwhelmed carpenter trying to salvage a growing mountain of smashed-up benches with superglue and duct tape. However, everyone knows that these are only temporary fixes, and the cracks are starting to show. Many investors and economists have concerns that the worst is yet to come, as a recent WSJ article noted:

A bigger rise in bankruptcies is likely to be seen in the coming months as federal Paycheck Protection Program funds and other assistance programs run out for small and midsize businesses… We may be on borrowed time for job cuts in a number of industries…that were not necessarily distressed when we entered the pandemic”

The retail sector has been hit particularly hard, as foot traffic essentially stopped on a dime due to COVID-19. It feels like every week there is yet another major company filing for Chapter 11 bankruptcy. Whether it be J Crew, Neiman Marcus, or more recently Brooks Brothers, coronavirus has marked the demise of many household brands.

Those who have read my posts over the last few months will know that I try to focus on what the potential knock-on effects of of negative shocks and major events like COVID-19 may be. I wrote an article in June detailing the second-order consequences of the San Francisco Earthquake of 1906, and how this non-financial exogenous shock led to the Panic of 1907. In May, I covered the history of Minsky Moments, and how COVID-19 had the potential to become one such ‘moment’.

Well it is pretty clear that an acceleration of bankruptcy filings is another knock-on effect of COVID-19. Fragile balance sheets and struggling industries don’t tend to thrive in economic downturns, and 2020 is no different. For the retail sector, people have been talking for years about the decline of brick and mortar retail due to eCommerce giants like Amazon, and that trend has only accelerated in recent months. Amazon may have had the retail sector in its cross-hairs, but COVID-19 is pulling the trigger.

Spanish Flu and Bankruptcies

The immediate question in all this is what did bankruptcies look like during the Spanish Flu? Well, interestingly there was not a spike in what contemporary writers labeled “business failures”. Although there a significant differences in the two forms of stimulus, the government played an important role in staving off (at least partially) a boom in bankruptcies by stimulating the economies. Today, this came in the form of literal stimulus bills and financing programs like the Payment Protection Program (PPP), but in 1918 this government stimulus manifested itself in increased demand for war-time supplies due to World War I. This government demand was so stimulative before the Spanish Flu truly ravaged the United States that most businesses were able to weather the pandemic. An article on this topic from 1919 states:

Failure returns for 1918 reflected unprecedented prosperity of a vast proportion of the country’s inhabitants, due mainly to the stimulus of a highly successful war conducted at a distance, so that few unfavorable effects were to be seen or felt. The results were total business casualties below any thing witnessed for a third of a century, liabilities that compared favorably with any but the best of years, an unprecedentedly small number of banking casualties, and a smaller proportion of failures to those engaged in business than ever before recorded since Bradstreet’s records of Business Mortality were first made up. . . .

There were some unfavorable features met with in the year, notably extremes of cold and heat in winter and summer, a severe drought causing partial failures of corn and cotton, an unprecedentedly fatal epidemic, government interdiction ending in partial paralysis of a number of important industries, notably building, brewing, distilling and automobile manufacturing, and accompanying restriction of all but most essential operations in other lines. On the other hand, there was first and foremost a hothouse stimulation of all lines aiding in war operations, immense demand from government sources for all kinds of materials and products that could be used in war, active employment at high wages for all who could work with their hands, and a vastly enlarged purchasing power of the mass of the people… It is an additionally interesting feature that, not withstanding the slowing down in business that followed fast upon the signing of the armistice and the interruption to trade at many centers by the influenza, so great was the momentum in business and so profitable had been the previous months’ trade, that the lowest monthly totals of casualties ever recorded were reached in the closing quarter of the year.”

Now let’s dive in!

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Business in a Time of Spanish Influenza

The most important and heated debate in the United States currently revolves around the tradeoff between preventing the spread of COVID-19 through continued lockdown restrictions, and re-opening the economic in efforts to avoid further economic disaster. This timely post helps offer insights on this debate from the American experience with Spanish Influenza in 1918. The author studies how the lockdowns and restrictions in 1918 impacted business activity / bankruptcies.

The evidence brings into sharp relief one feature of the tradeoff between public health and a healthy economy. The COVID-19 debate focuses on the economic costs of mandatory lockdowns and shelter-in-place orders. Less discussion has focused on the economic costs of the counterfactual of not locking down and not sheltering. History offers an object lesson. Any comparison between 1918 and 2020 must be drawn carefully given advances in medical practice, changes in the structure of the economy, and the inherent differences between countries at war and peace. But wartime demands militated against mandatory lockdowns and sheltering orders.

One consequence was that the Spanish flu virus was passed among workers and several industries experienced epidemic outbreaks in their workplaces. Productivity declined. Some of the South’s principal industries witnessed 25 to 50% worker absenteeism rates that reduced output by 10 to 20% for periods between one and four weeks. Had it not been for federal administrators pressuring these industries to maintain production in support of the war effort, it is likely that the output declines would have been even larger. America’s experience with the Spanish flu shows that any debate about health benefits and economic costs of lockdowns and shelter-in-place orders must be compared to a reasonable counterfactual in which more people die and the economy still contracts.”

The primary conclusions from his research are threefold:

  1. Retail sales declined during the three waves of the pandemic; manufacturing activity slowed, but by less than retail.
  2. Worker absenteeism due to either sickness or fear of contracting the flu reduced output in several key sectors and industries that were not ordered closed by as much as 10 to 20% in weeks of high excess mortality. Output declines were the result of labor-supply rather than demand shocks.
  3. Mandated closures are not associated with increases in the number or aggregate dollar value of business failures, but the number and aggregate dollar value of business failures increased modestly in weeks of high excess mortality.

The full abstract is provided below:

This paper documents the shortrun effects of shutdowns during the Spanish flu pandemic of 1918, which provides a useful counterpoint to choices made in 2020. The 1918 closures were shorter and less sweeping, in part because the US was at war and the Wilson administration was unwilling to let public safety jeopardize the war’s prosecution.

The result was widespread sickness, which pushed some businesses to shutdown voluntarily; others operated shorthanded. Using hand-coded, high-frequency data (mostly weekly) this study reports three principal results. First, retail sales declined during the three waves of the pandemic; manufacturing activity slowed, but by less than retail. Second, worker absenteeism due to either sickness or fear of contracting the flu  reduced output in several key sectors and industries that were not ordered closed by as much as 10 to 20% in weeks of high excess mortality. Output declines were the result of labor-supply rather than demand shocks. And, third, mandated closures are not associated with increases in the number or aggregate dollar value of business failures, but the number and aggregate dollar value of business failures increased modestly in weeks of high excess mortality.

The results highlight that the tradeoff between mandated closures and economic activity is not the only relevant tradeoff facing public health authorities. Economic activity also declines, sometimes sharply, during periods of unusually high influenza-related illness and excess mortality even absent mandated business closures.”

A Bankruptcy History of Manias & Panics

This is a super post on the history of bankruptcy, manias, and panics. The author covers FIFTY case studies from 1575 to 2008. Rather than trying to read all the way through, I’d pick a few case studies and read them individually. However, if you have the time, obviously read the entire post. It is fascinating.

This incredible article is best described by the author himself, so I’ve provided the introduction to his piece below:

Fraud and irrationality are often blamed for financial manias and panics. Investor euphoria can unleash social and technological breakthroughs, but the subsequent collapse can destroy value and radicalize the political sphere. Are these events random, idiosyncratic, or driven by some force? The ex-post answers—be they monetary, criminal, or international contagion—have a profound impact on the role of government in society, but have questionable predictive power. The historical narrative in this article does not argue that overvaluation, changes in money market rates, and fraud play no part in financial panics. However, the instigating events that lead creditors to become sensitive to information which might impair contractual protections suggests that financial panics are reactive to changes in jurisdictional bankruptcy processes. The history of bankruptcy law is intertwined with that of crises and banking law, and—as argued using over 50 case studies spanning the Dutch Tulipomania of 1637 to the Great Recession of 2008—consistently causes and accelerates financial manias and panics. In addition to credit collection and borrower relief, the English word ‘bankruptcy’ has specific legal and social connotations that differ across time and jurisdiction. In the United States, for example, it is a strictly federal process for the impairment of contracts. Separate State insolvency laws developed to favor local creditors —or a ‘race of diligence’ as the courts referred to it— over the 19th century before the enactment of federal bankruptcy law. On the other hand, the States of the German federation signed treaties for cross-border liquidation using the konkurs process—which can be translated as both equity and competition. Although creditors could collectively form compositions to reorganize a going concern, few jurisdictions empowered their courts to force holdout to accept restructuring terms outside of public works, fostering uncertainty. Grounds for filing are another variable. English law defined specific acts and traders eligible for involuntary bankruptcy proceedings that only creditors could raise against them. While action could be brought against dealers of linen and money, defaults by the Crown or central bank were protected —enabling them to loot as well as serve as lenders of last resort in times of crisis. French law asked the courts to decide whether overindebtedness was due to fraud, carelessness, or unfortunate illiquidity due to (temporary) prevailing economic conditions.

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In England, only investors in a few corporate enterprises —including the East India Co. and the Bank of England— were immune from bankruptcy, while only investors in small ventures had limited liability in France. The goals and effects of these policies manipulate the flow of liquidity to where it is most remunerative and likely to be collected. Finally, the legality of provision of liquidity is itself variable. Under free banking regimes in Scotland and the United States, private banks issued notes —subject to immediate convertibility into real money, specie— as a circulating medium of exchange. As the government granted successive monopolies to bankruptcy remote institutions —first for note issuance and then general ‘banking’— intermediaries outside of this periphery devised regulatory —arbitrage negotiable deposit accounts (e.g., checks) and then traded derivatives— but were themselves subject to bankruptcy liquidation.

While too much liquidity causes inflation —allowing debtors to pay off loans through less work— too little may create deflation —compelling default as the burden of repayment grows. In addition to the permissibility of brokering transactions, the liquidity of the underlying asset depends on the availability of central clearing— which reduce counterparty default risk by netting trades. This holds as much for specie as it does for real estate. Changes in any of these factors may incite creditors to increase or refuse to renew lending. To the extent that each is controlled by legislation or the judiciary —and not an individual private actor— they are  collectively grouped under ‘bankruptcy’ law.

This narrative can be illustrated by the most recent case study in this article: The Great Recession of 2008. Following the earlier Asian Financial Crisis, international investors demanded safe debt. Whereas home mortgages were sensitive to information regarding borrower bankruptcy, these mortgages could become safe debt if default risk were reduced. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”) restricted access to bankruptcy in favor of insolvency debt management plans and gave home mortgage lenders priority over other creditors. BAPCPA—along with the Bankruptcy Amendments and Federal Judgeship Act of 1984’s safe harbor around negotiable derivatives, which gave counterparties priority over other creditors—purposely reduced incentives to monitor counterparties and gave markets a (false) sense of security about the mortgages underlying the repo market. The low default risk increased liquidity and allowed lenders to remove risky assets from their balance sheet and expand mortgage financing.

While it’s not possible to quantify the effect of the bankruptcy process relative to all of the other effects, the case studies in this article hope to illustrate how these mechanisms operate to develop more resilient economies. Without appropriate legal technology to solve collective action problems in the presence of asymmetric information, market failures arise in the form of systemic runs on credit extended to banks and other intermediaries. In the wake of financial panics, these technologies are developed by the government, courts, and the private market to improve access to financing, alleviate failures, and reset the cycle.”

The Financial Crisis of 1825 and the Restructuring of the British Financial System

I’ve written and spoken about the Panic of 1825 on multiple occasions, but it is worth revisiting once again. Among other things, this article looks at the role of the Bank of England in the panic of 1825, and the policies (or lack thereof) it implemented.

“The argument developed in this paper is that the common element in all the problems of Britain’s first return to gold arose from the pressures of coping with vastly increased informational uncertainties within the existing structure of English institutions. These problems started with the Treasury itself, confronted by the difficulties of servicing the huge government debt accumulated during the Napoleonic Wars and deprived of its primary source of revenue, the income tax. They continued within the Bank of England, forced now to take on new responsibilities while searching for new sources of revenue to replace its wartime profits. They were compounded by the response of the London capital market, which produced a bewildering array of new financial assets to its customers to replace the high-yielding government debt now being retired. All this left the London private banks and their corresponding country banks—as well as their customers in agriculture, trade, and manufacturing—floundering in the resulting confusion.

The government’s piecemeal reforms, introduced during the crisis of 1825 and its immediate aftermath, provided smoother patterns of tax collections and interest disbursements, established Bank of England branches throughout England, stimulated country bank competition with joint-stock companies outside of London, and eliminated the Bubble Act of 1720. Even the bankruptcy laws began to be rewritten in 1831.”

Most relevant to today’s post, however, is the section on the wave of bankruptcies following the financial panic:

The 1825 spike is all the more anomalous for coming at the end of a period of declining numbers of bankruptcies, with no major changes in trade direction or policy evident, much less any sign of renewed warfare. From 1794 on, Silberling constructed quarterly totals of the advances made by the Bank of England to its private customers and the government. From his comparison of the pattern of advances with that of banknote issue, prices, and bankruptcies, he concluded that advances were a much better barometer of prices and business conditions than banknote issues and, moreover, that in general the claim of the Bank’s officers that they followed a real-bills doctrine—responding passively to the demands of business for credit on realized trade contracts—was justified.

The exceptional decrease in advances after 1819, driven by the Bank’s determination to accumulate sufficient bullion to validate the resumption of convertibility of its banknotes into specie at the pre-war par in terms of gold, did not show up in bankruptcies. Closer examination of the relationship between advances and bankruptcies from 1819 through 1830, shown in Figure 11, shows possible encouragement of speculative movements in 1823 and 1824 but moderation in 1825 until the Bank responded to the crisis at the end of the year by increasing the total of advances enormously in the first quarter of 1826. Afterwards, Silberling’s figures show a distinctive inverse pattern, which is so short in duration that it could again be consistent with the real-bills story, especially if we allow a lag of six months to a year from the actual credit restriction to the recorded opening of a bankruptcy commission.

Parliament collected evidence in the years afterward to determine the pattern of bankruptcies… These bankruptcy records indicate further that the financial panic was transmitted through the credit channels of Great Britain, radiating out from the London capital market, and had its final impact in the trade and industry of the countryside through the liquidity crunch exerted upon the country banks.

Business Failures by Industry in the United States, 1895 to 1939

“Business failures have long been recognized as indicators of economic trends. Failures rise during recessions. Failures fall during expansions. Knowledge of these trends enables businessmen to make better decisions. So, business-information agencies began publishing data on the issue in the middle of the nineteenth century. The United States Commerce Department began publishing a series soon thereafter. The principal source for information about business failures during the late 19th and early 20th centuries was R. G. Dun and Company, which gathered the information from court filings nationwide. From the 1850s to the 1890s, Dun published information about bankruptcies in various venues and forms.

In 1896, Dun began publishing monthly data on business failures cross tabulated by branch of business, which the company asserted, was obviously “of the highest interest and importance to the business world” because the data showed in what directions misfortune had occurred in and which direction “misfortune was to be expected.” Dun was the first firm to do so. Dun continued publishing this series until the 1930s. The series has, however, lain dormant since Dun discontinued it in 1936. This article resurrects that series, entitled “Business Failures by Branch of Business.” The authors reconstruct it by examining every issue of Dun’s Review (plus related and successor publications) published between 1895 and 1940. The reconstruction requires the authors to fill gaps in the series and link the series to its successor, “Business Failures by Division of Industry.” 

Corporate Bond Default Risk: A 150-Year Perspective

I realize that I have shared this article a few times in the past, but I believe it’s such a good piece that it has to be re-shared in times like this when it is particularly relevant. As the uptick in bankruptcies is likely to persist, it is worth looking at the 150-year history of corporate bond default risk.

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“We study corporate bond default rates using an extensive new data set spanning the 1866–2008 period. We find that the corporate bond market has repeatedly suffered clustered default events much worse than those experienced during the Great Depression. For example, during the railroad crisis of 1873–1875, total defaults amounted to 36 percent of the par value of the entire corporate bond market. We examine whether corporate default rates are best forecast by structural, reduced-form, or macroeconomic credit models and find that variables suggested by structural models outperform the others. Default events are only weakly correlated with business downturns. We find that over the long term, credit spreads are roughly twice as large as default losses, resulting in an average credit risk premium of about 80 basis points. We also find that credit spreads do not adjust in response to realized default rates.”

In this article, there is a section on the Panic of 1873 that offers interesting parallels with markets today. The 1870s were highlighted by the exciting and rapid growth of new technology: railroads. With this exciting technology came booming debt markets:

‘The growth in economic activity was accompanied by a rapid expansion in the corporate bond market. For example, the number of bond issuers listed in the Commercial and Financial Chronicle was 158 in 1866, but quickly reached 421 by 1872. The Commercial and Financial Chronicle from this period is often filled with enthusiastic accounts about the promise of new technology:

‘Every well-built railroad if suitably located becomes a productive machine which adds to the wealth of the whole country… Our new railroads increase the value of farms and open new markets for their products. They lessen the time and cost of travel. They give a value to commodities otherwise almost worthless. They concentrate population, stimulate production and raise wages by making labor more efficient. Our existing railroads are computed to create more wealth every year than is absorbed for the construction of new railroads.” (January 11, 1873).’

Yet, eventually, this exuberance must face reality.

‘However, later in the same year there was a major panic which led to a default rate of 14.3 percent in 1873. Contrast the buoyant spirit reflected in the previous quote with that evidenced by the following quote from the Commercial and Financial Chronicle exactly one year later.

“After such a panic as has, the past year, swept over the country, it becomes a kind of melancholy pleasure to look over the field and find that there are not quite so many dead and wounded lying about as was anticipated. It was a fearful storm while it lasted, and although every one of course can say now that he knew it was coming, yet the real truth is, its breaking was terribly sudden and unexpected… There are few people who allow themselves to remember long the lessons experience would teach them. If this were not so, there would be many less failures in the world… Almost all felt they were carrying too much debt; they would henceforth be out of it. There are now, however, very evident signs that these resolutions have been mostly forgotten. Over-trading, as it is called, is an evil that has ever existed, and pretty much the same epitaph can be written above each business prostration—here lies the result of an attempt to do too much with too little capital. Must history necessarily repeat itself?” (January 10, 1874).”‘

 

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Jamie Catherwood
My name is Jamie Catherwood, and I’m a Client Portfolio Associate at O’Shaughnessy Asset Management. Get your financial history fix through reading my articles, or those that I link to in my weekly “Financial History: Sunday Reads”.
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