Cruel winter ahead for Wall Street as pandemic debt matures

A banker told me recently that CEOs “have to do something pretty special to go bankrupt” in the last couple of years when the government pumped massive liquidity into the market, at the height of the pandemics.

That is now changing, possibly quickly, with the Fed raising interest rates and reducing the size of its balance sheet.

A brutal winter is likely for Wall Street as markets remain choppy and their biggest clients scale back. Traditional deal-making such as IPOs has declined significantly. At every major investment house, management is quietly planning layoffs (and some, like Goldman Sachs, not so quietly).

One area of ​​potential growth: Wall Street’s restructuring departments. They are looking to expand to advise companies so burdened with high debt that they need to sell things or “restructure” in Chapter 11 bankruptcy.

Recession looms

Sources tell me that investment banking firm Morgan Stanley is considering a major expansion of its restructuring team (Morgan Stanley would not deny the matter). Other banks will likely follow suit because none of this is really rocket science.

Other major firms are likely to follow Morgan Stanley's move.
Morgan Stanley CEO and Chairman James Gorman is reportedly weighing a major expansion of the restructuring team.

If you think the Fed needs to raise interest rates a lot (which, given the latest inflation numbers, it does), the economy will suffer. Recession looms. The likelihood is that some segments of corporate America are loaded up with cheap debt and will need help avoiding bankruptcy — or finding a way out of it. It will be a big business for Wall Street.

The unwinding of the credit cycle to tighter lending standards is always pretty tough on corporate balance sheets, but it could be particularly brutal this time given the monetary policy experiments — and corporate debt binge — of the past two-plus years, bankers tell me.

Since the pandemic, even the most troubled companies have had access to credit. So-called leveraged deal-making exploded. M&A often relied on loans because the Fed provided so much easy money that the banks practically gave away loans.

What goes up eventually comes down on Wall Street. The easy money of the early 2000s paved the way for the financial crisis of 2007-2008 with mortgage debt at the center of the reduction.

The easy money of pandemic economics has led to similar risk-taking among companies and investors. A relaxation is guaranteed although it is still unclear whether it will reach such catastrophic levels.

Share prices have continued to fall in recent months.
In previous years, the state pumped massive liquidity into the market.
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Consider the $1.4 trillion plus loan market, which includes loans from the most indebted companies. Such debt has doubled in just seven years. More worryingly, the largest share of the market compromises loans to the most risky credits. “Junk” loans now make up more than 28% of such loans, according to data trackers at Morningstar.

You see where I’m going with this: As interest rates continue to rise, these borrowers will find it harder—perhaps impossible—to refinance debt. Profit margins (if the companies are profitable) are squeezed as the economy slows. This Gordian knot leads to lower stock prices, layoffs, etc. Companies dump assets and file Chapter 11. Bondholders will be owners of parts of corporate America because they have first liens on impaired assets, meaning losses for big money managers and pensions.

In the middle of this mess, the restructuring departments of the big banks will stand for advice and earn fees for their time.

The good news

Some caveats to doom and gloom. Restructurings are starting to pick up (see Revlon and Bad Bath & Beyond), but they are not dominating the headlines because default rates remain low. The St. Louis Fed’s index of all commercial bank loan defaults is well off the peaks reached shortly after the banking crisis.

But bankers say that the problems arise when the loan terms reach the final phase and so-called balloon installments fall due. The big numbers begin next year when more than $200 billion in leveraged loans will need refinancing, and will rise annually by multiples until about $1 trillion matures in 2028, says one banker.

There is a lot of debt to refinance in the face of tighter credit conditions. It is a recipe for recession, but also for money to be made from restructuring shops on Wall Street.

Inflationary spiral

As bad as inflation is, there’s a good chance it’s going to get a lot worse. A serious nightmare scenario is beginning to circulate among top Wall Street investors.

It began with BlackRock CEO Larry Fink’s grim assessment, explained in this column last week, that the Biden administration was creating significant inflation through reckless spending. It is now nearly impossible for the Fed to engineer a “soft landing” of the economy with 8.3% inflation.

Still, it could be worse. Global drought and the continuing war in Ukraine are leading to declining harvests and higher food prices. Gas prices may be coming down, but the administration seems intent on keeping them high by canceling drilling permits. As workers demand higher wages (and railroad workers got one last week by threatening to strike), Fed Chair Jerome Powell is raising interest rates until the economy crashes.

Dark stuff that some experts dispute, many of the same geniuses who said inflation was “passing.”

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