The Covid-19 debt crisis is now baked in. When do we eat it?

Is Covid-19 a buying opportunity for investors? Should you buy stocks at peak fear?

That’s our question for this week in Fortune & Freedom.

Yesterday kicked things off with a reminder that stockmarkets don’t care about the present. They care about the future. That’s where they derive their prices from.

So, as miserable as the lockdown may be, that’s not enough information for investors. We need to consider the shape of the recovery.

But doesn’t the word “recovery” tell you what’ll happen? Maybe…

Today I give the pessimist’s case. And their favourite topic is simple – debt.

The argument is simple too. We’ve added so much debt that, at some point, there will be a debt crisis. Much like 2009’s.

There are already some signals this is likely to happen.

Prices tell you about the future

Just as you need to figure out the future to predict financial market prices, those prices can tell you about the future which financial markets expect.

Financial news website Bloomberg reports “Bond Defaults Deliver 99% Losses in New Era of U.S. Bankruptcies”. That’s a forecast, based on market prices.

But I better explain the basics first.

Bonds are loans which investors can make to earn interest. What makes them interesting is that they can be bought and sold for a market price, a bit like stocks. When defaults are likely, the price falls. Which is bad for investors, of course.

When a company goes bust and is wound up, its creditors, including bond holders, usually get some of their money back. Unlike the owners of the business, the shareholders, who typically get nothing.

This is one reason bonds are a safer bet than stocks. Even if the company goes bust, your bond investment should get some money back.

Unfortunately, the current wave of bankruptcies in the US is leaving more of a mark than usual according to the Bloomberg article:

Bankruptcy filings are surging due to the economic fallout of Covid-19, and many lenders are coming to the realization that their claims are almost completely worthless.

Instead of recouping, say, 40 cents for every dollar owed, as has been the norm for years, unsecured creditors now face the unenviable prospect of walking away with just pennies — if that.

How do we know this is likely to happen? The prices of credit default swaps, which are a bit like insurance you can buy on a bond going bust, suggest that defaulting bonds will pay out even lower amounts than in 2009 – when the financial crisis’ fallout played out in debt markets.

In other words, the markets are anticipating companies that go bust will do so in far worse shape than before. In other words, it’s a more severe crisis for those companies in too much debt.

The problem is of course that many lenders are also in debt. Can they weather such losses.

This chain reaction is what makes debt so dangerous. It’s why a debt crisis is contagious and the word contagion is used to describe it. One default can trigger many more.

But that’s in the US. We began our story there because US financial markets are developed enough to have a lot of bonds and credit default swaps which reveal the distress to come in their market prices. They reveal what the market expects is coming for investors.

In Europe, banks and bank lending are a bigger topic when it comes to debt. Which means we know less about what’s going on. The banks don’t have market prices on their loans like American bonds do.

Still, we can guess what’s going on behind the scenes in the world of debt here too. And it’s not pretty.

Bouncing back into lockdown

In Britain, the Treasury’s Bounce Back Loan Scheme (BBLS) has so far dished out £40 billion to 1.3 million small- and medium-sized firms.

Impressive… or impressively bad, depending on your point of view about the lockdown and what happens after.

But, as we’ll get to below, the worry about a debt crisis is that, if you fail to save just a few debt sufferers, it can be enough to kick off the contagion for everyone else. Only one domino must fall to kick off a broader chain reaction.

How might this happen? I can think of a few not-so-hypothetical ways.

Under the BBLS extension for the new lockdown, businesses which maxed out on the BBLS first time around can’t go on to borrow more. That’s a third of BBLS borrowers according to information released by the British Business Bank after a freedom of information request.

Companies not tied to one of the accredited lenders of the Bounce Back Loan programme initially fell through the cracks too. The Guardian reports that “an all-party parliamentary group… found that around 250,000 small and medium-sized businesses could have been locked out of the first scheme because they do not bank with any of the 28 accredited lenders.”

The non-bank lender Tide was struggling at the start of November to secure further funds, leaving its customers dry on BBLS too.

And now the UK government’s Bounce Back Loan borrowers are bouncing back into a second lockdown. They face much the same situation, only with more debt than before. Great help that was.

Back in October, Meg Hillier of the Public Accounts Committee told the Independent that “The government estimates that up to 60 per cent of the loans could turn bad.” A large proportion of that is likely to down to fraudulent applications and minimal credit checks. But still…Yikes.

Where are all these figures going to be at the end of lockdown 2?

But it’s not all about businesses.

Debt deferrals are accruing defaults

As of the 23 October, UK Finance summed up the state of mortgage deferrals in the UK:

UK Finance has confirmed that there are now 162,000 mortgage deferrals in place, down significantly from the 1.8m in place in June.

It confirmed that lenders have now provided a total of 2.5 million mortgage payment deferrals since the start of the pandemic.

Throw in other debt and that’s a total of 4.4 million deferrals across mortgage, credit card and loan accounts – of these, 323,700 are still in place.

But the period in which people can apply was extended to 31 January 2021 so the number could increase again.

Whether household or business, the level of deferred debt is now vast. And nobody really knows how much of that debt will go bad once it can do so. Deferred debt payments also defer defaults, but that in turn means the defaults are accruing, accumulating and growing in size.

How will this build-up be released? The BBLS loans are all government guaranteed so banks won’t suffer if those go bad. What will happen to the debts which companies already owed aside from their BBLS loans? The government didn’t guarantee that…

Borrowing to survive, not invest

What’s new about this crisis is that borrowers, including those deferring payment of debt, are borrowing to survive. To buy time.

That’s very different to borrowing in order to invest in an asset, for example. Debt must be repaid, so if you aren’t investing it in something that improves your ability to repay it, you’re eventually going to get into trouble. Unless of course you’re talking about the BBLS loans – borrowers might have a different view about those because they’re guaranteed by the government – but only time will tell.

My favourite gold miner was debt free going into the crisis. Not any more… and its share price has become incredibly volatile since it borrowed. That same phenomenon is playing out in many businesses.

The worry here isn’t just a broad based struggle of the economy under the added debt.  And it’s worth noting that interest can continue to accrue even when the debts are deferred.  Although the FCA’s research suggests a third of adults have lost income with an average household income loss of a quarter.

Still, the vast majority of those who got loan deferrals managed to begin repaying again….

The real fear is for those who can’t pay their debt. They will be a far smaller subset of those who needed help. But their impact could be far larger.

The crisis will not be dished out equally, in other words. But those who really take a hit put the rest of the economy at risk. Let’s explain how.

Contagion coming?

Debt’s ability to amplify both upside and downside risk is immense. A borrower who can’t afford their mortgage might become impressively rich by the time they foreclose thanks to rising house prices. Or they could end up in vast amounts of debt even after selling their home if prices head in the other direction.

The lockdown and the pandemic will hit some of us far worse than others. And almost all of us are in some form of debt. Most people can’t own a home without it, after all.

Debt turns the basic necessities of life like shelter and food into a high stakes game where losing can be very painful indeed.

And the losses can expand to others. Shareholders who lose their investment, lose an asset. That’s the end of the story. But a defaulted borrower (whose loan isn’t guaranteed by the government) can transfer their losses to the bank and to anyone else they owe money to. This creates the potential for the problem to spread beyond the business or household which borrowed money.

The striking consequence is that the impact of debt defaults isn’t on the broad economy at first, but on how very severe it is for a small subset of the population. Those who have to dip into life savings, or who lose businesses and homes. They are hit so badly that, even if the rest of us come out of the crisis fine, it can trigger a broader crisis.

The impact of a default is so large that a small number of defaults can begin the crash. It spreads from there.

That is the nature of debt.

The debt defaults are yet to come

But here’s the real message for today. If the lockdown and pandemic are going to lead to problems in debt markets, then those problems are yet to play out.

Not just because of the deferrals. But because these problems take time to unfold. The initial term of the Bounce Back Loans is six years. And before the end of the first year borrowers have the option to extend the term to ten years (and there’s no interest to pay in the first year, and they can opt to take interest and payment holidays of up to 18 months too…).

It took US sub-prime years to hammer markets around the globe. That’s because it wasn’t clear how far the defaults would spread. It’s the same this time. We don’t know who’s on the list. Bond holders? Banks? Small businesses?

Ironically, the debt problems are only likely to become evident once the world thinks it has a recovery underway. That’s true for several reasons.

It’s when governments will reduce support for the economy and debt markets.

Central banks will begin to worry about inflation and wonder if they should raise rates.

Banks will to make money and end their deferral and assistance policies.

At this point, the fallout of the past year will become evident. And a debt crisis, if it does happen, will strike.

Risk gets shifted, not reduced

When financial markets and economies panic, governments step into the chasm with more spending. Sometimes they even do some bailing out.

Either way, private debt that would’ve gone bust morphs into government debt instead (the BBL guarantees we’ve been talking about). The burden is shifted to government budgets.

The worry is that, if you keep doing this, government debt eventually gets problematic too.

We’re already there. In fact, we’re already in the next phase. When government debt is so large that it can only be maintained with money printing.

That leads to inflation, as we delved into last week.

Tomorrow we consider the path for government debt.

Can the economy and stockmarkets go up when government spending is cut from its current levels back to more normal amounts? Will the economy survive de-stimulus?

Nick Hubble
Editor, Fortune & Freedom