The Everything Bubble Bust Pt. 2: Zombie Apocalypse
My first article in the “The Everything Bubble Bust” series focused on the bursting of the stock-market bubble, which is already reached minimum bear-market stage, because that is the most obvious area of everyone’s concern, and it is something with which we are all familiar. In my second article, I was going to focus on the bursting bond bubble, but I found that one part of the bond bubble is sooo big it may be a bubble within a bubble. I decided it needed to be an article of its own because central banks debate its size, significance, and whether or not they created it in the same manner they talk about bubbles. I’m calling it the “zombie bubble” and giving it an article of its own even though it is the biggest part of the bond bubble.
The bursting bond bubble may include a zombie apocalypse
The Federal Reserve defines zombie corporations as follows and talks about their existence as if they are a bubble the Fed may have created with its years of loose monetary policy:
The unprecedented fiscal and monetary policy support in the wake of the COVID-19 pandemic has brought to the fore concerns that cheap credit could fuel the financing of zombie firms—that is, firms that are unable to generate enough profits to cover debt-servicing costs and that need to borrow to stay alive.
The Federal Reserve
The number of zombie firms in a nation rises as a “share” (or percentage) of total corporations whenever credit grows cheap. Zombies, of course, tend to fall into the “junk bond” category of credit. When interest rises, some of these firms die off because they cannot afford to refinance their debt when their bonds mature, while they have made little to no progress at paying it down because all their income can cover is the interest on their debt. As to whether or not the existence of zombie corporations has blown up into a financial bubble in its own right, the Fed claims,
Our main finding is that zombie firms are not a prominent feature of the U.S. economy. Among both private and publicly listed firms, zombie firms are few in number and generally small; they are mostly concentrated in the manufacturing and retail sectors and account for a small share of total credit to nonfinancial firms.
The Fed, of course, studied whether they are a “prominent feature of the U.S. economy” because many economists and even other central banks believe they are! If the Fed’s conclusion is right, zombies may not present a big threat, but the organizations disagreeing with the Fed on the significance of zombie corporations within the economy have just as much clout in this world as the Fed, maybe more. I’m talking particularly about the Bank for International Settlements (BIS), which did a lengthy study of its own.
It may be the Fed is playing the same game it did when convincing itself and the nation that inflation was not a prominent feature of the new U.S. economy that they were responsible for or had to deal with. Perhaps they would like to dodge the responsibility for setting up a zombie apocalypse like they tried to dodge the inflation inferno they helped set up.
While the Fed brought up the concern that their cheap finance may cause a rise in zombie firms, the number of zombie firms has also been found to rise during periods of high inflation because businesses with tight margins struggle more to survive. And inflation is certainly something for which the Fed is responsible. That is why one of the Fed’s two legal mandates is to keep inflation in check — something they’re not doing very well at right now.
During high inflation, most businesses try to absorb some of the producer costs of inflation and not pass them on in order to maintain market share. Zombie companies, because they have razor-thin profit margins (if any at all), are the least able to do this and so are more likely to lose market share by having to raise their prices above their competitors. Similarly, zombie corporations are more likely to go bankrupt during times of declining GDP.
We all know by now that we have’t seen inflation this hot or this persistent since the early eighties, and I’ve pointed out recently that US GDP is falling seriously close to recession. Janet Yellen and Ben Bernanke both confessed the Fed is responsible for creating most recessions. So, the Fed’s cheap finance drives the forces — recessionary GDP and high inflation — that help turn weak corporations into dying corporations. Then the Fed breathes in artificial life support with its cheap corporate credit by directly buying up failing corporate bonds in its QE program and in general by lowering all bond interest rates and by financing government bailouts to keep the dead alive. That sounds like creating zombies to me — the walking dead, kept alive solely by Fed artificial life support.
Here is a graph provided by the Fed showing the percentage of corporations in the US they classify as zombies: (Note that each rise begins during a time when the Fed was lowering interest rates to get us out of the recessions their headmasters admit the Fed helped create, and then those zombie corporations fail, taking us into the next recession.)
The following graph shows where the Fed began lowering interest rates right at the start of a recession or just before because it can see its high interest rates are creating a recession, and notice that the zombies in the graph above start to rise at about that same point because lower credit costs are the oxygen they need in order simply to survive: (During other times, they would die natural deaths and never accumulate.)
The Fed claims that its graph of zombies shows a cyclical pattern that simply rises with recessions and falls with times of economic expansion (because maybe those companies during good times come fully back to life and are zombies no more):
Furthermore, the share of listed firms that we identify as zombies displays a cyclical pattern, rising in recessions and falling during expansions, likely reflecting a mix of aggregate and industry-specific shocks.
The Fed would like to believe it is not responsible for fostering zombies, and would have you believe they simply rise and fall with the business cycle. I’ll note, however, that the zombies rise and fall inversely with Fed interest rates. Besides, the Fed is largely responsible for creating these “business cycles” anyway by raising rates until it creates a recession, then lowering them throughout the recession until it helps foster a recovery to the recession it created (by its own admission from those at the top).
Other institutions present a much sicker zombie picture than the Fed
The Fed’s graph of the rise and fall of zombies doesn’t look too terrible because it shows a slight downward trend over a long period of time, so the problem is just cyclical and not generally getting worse as the Fed’s financial easing has gotten bigger and bigger. However, here is a set of similar graphs by the Bank for International Settlements (BIS) from its zombie study that shows a broad swath of nations, including the US. See how different the BIS graph of zombies in the US (final graph in the set) looks from the Fed’s:
In the data compiled by the BIS, every nation shows a clear trend upward over the years, with many of the nations, including the US, Great Britain, Canada, and France now at their highest peaks ever. This is a global problem caused by the US Federal Reserve, the Bank of England, the Bank of Japan, the People’s Bank of China, and the European Central Bank (for the European nations shown). There is an upward trend almost across the entire board with each new cycle of zombies getting worse as each new QE/bailout cycle by central banks has gotten bigger!
None of the graphs, however, show what has happened during the COVID years. At most they show the first year. We’re going to have to guess what the last year hath wrought (or rot). Yet another serious bunch or researches shows the same extraordinary high peak for the US near 20% that the BIS shows but strangely doesn’t show any ups and downs along the journey:
All agencies profess to be measuring and graphing the same thing but their graphs look very different! The main reason for the difference comes down in good part to how broadly you define “zombie” — how distressed and ready to collapse a company has to be to fit in this genera taxonomically because it is not a precise scientific classification. It turns out you can cherry-pick your zombies. In defining a “zombie,” you might include, for example, how much of an interest rise would it take to club them over the head and kill them off. It also depends on what sources of information the study uses and what kinds of data the studiers choose to include.
For example, the Fed states,
There is no formal definition of a zombie firm, but it is generally agreed that these firms are economically unviable and manage to survive by tapping banks and capital markets (Caballero, Hoshi, and Kashyap 2008). Accordingly, we identify zombie firms in U.S. data by requiring that they are highly leveraged and unprofitable. More precisely, we require that zombie firms have leverage above the sample annual median, interest coverage ratio (ICR) below one, and negative real sales growth over the preceding three years. High leverage and low ICR help identify firms that cannot cover their debt-servicing costs, while negative sales growth identifies firms with low growth prospects, as sales growth is a good predictor of firms’ future performance.
The Federal Reserve
Whereas, the BIS notes,
Given the novelty of our zombie definition, we assess the robustness of our results with respect to variations in the specification of our zombie definition and with respect to alternative zombie definitions used in the literature, specifically definitions based on old age and subsidised credit…. We define a zombie company based on a persistent lack of profitability and low stock market valuation. The rationale for this definition is that firms which cannot generate profits over an extended period and whose stock market valuation suggests that they will also not do so in the future should normally exit the market.
BIS
(The BIS also applies some of the Fed’s credit worthiness measures to its definition.)
Based on its “novel” definition of a zombie, the BIS says,
We find that the number of zombie firms has on average risen significantly since the 1980s across the 14 advanced economies covered by our analysis.
Even the Fed notes a difference in its text between “broadly” defined zombies and “narrowly” defined. They also note that the financial press usually finds about twice as many zombies as the Fed does because of what they look at, while university studies tend to fall in the middle between the financial press and the Fed when listing zombie corporations but on the high side when listing private zombie firms. Regardless, the Fed’s numbers are consistently the most conservative zombie numbers, to which the Fed, itself, agrees.
The estimates reported in Figure 3 show that our filters identify a lower share of zombie firms than are generally reported by the financial press and the academic literature, both for private and publicly listed firms. One likely explanation is that we require firms to not only have limited debt-servicing capacity, but also bleak growth prospects.
The Federal Reserve
The last graph by an economics outfit is so broad it includes major corporations like Macy’s and Exxon that one mightn’t usually think of as being so bad off they will die if their bonds don’t stay at the zero bound. Either of those major, gentrified corporations may not fit the Fed’s subjective measure of having bleak growth prospects. The Fed, I think, is limiting its focus to the worst of the worst zombies and skewing toward smaller corporations that have fewer revenue chains for possible growth.
How disastrous a rise in bond interest will be depends on who is right in how narrowly to define a zombie corporation. Obviously the last graph presents a terrible danger where nearly 20% of US corporations would, by definition, cease to exist if credit costs rise as they are now. Let’s note that credit costs for corporate bonds have remained low for a long time, even when central banks raised their basement interest a little because there was no inflation for bonds to price in. Now, with sovereign debt interest rising due to inflation (such as seen in US treasury yields), there is far more inflation to price into all bonds as central banks back out of bond markets as some the largest CBs around the world are saying they are going to do almost in unison (to be covered in my more general bond-bubble Patron Post).
In fact, during none of the periods where zombie corporations came and then either went away because low credit costs after a recession enabled them to heal their wounds or because they went bankrupt … during none of those periods was there any inflation at all to speak of. So, this is the first time we are going to get to see how zombies do when their corporate bonds have to start pricing in inflation that investors and credit-rating agencies will likely be far less prone to ignore as inflation and zombie risk rise together.
One thing we can say for sure is that 2020 was not a good year for zombie corporations and other distressed companies. Whether enough of the remaining dead wood got burned out in 2021 to clear the forest floor of accumulated fire hazard, the following graph doesn’t show:
While the rise in zombie deaths in 2020 is more than obvious, 2020 didn’t have high inflation yet, and it had rock-bottom interest rates for most of the year and massive bailout programs. Still the lockdowns and other COVID-related business problems would have likely caused a shakeout of the weak, except that the bailouts may have helped sustain some of the weak. 2022 will be a much different kind of fire season for this tinder-filled forest with increasingly higher and drier winds financially. Moreover, we may have actually piled in new zombie corporations during 2021 that were carried along by all those central-bank relief programs and dirt-cheap credit. But there are no data for that, so it’s a guess for all of us as to what is out there.
The graph on the left also shows the survival rate for zombie companies is not long. The vast majority burn out within three years. Of course, the risk is not just what the loss of up to 20% of the companies in America and similar percentages in other nations would mean for employment and GDP, but what it would mean to the banks and other creditors who have gone long financing them. The knock-on effects could be significant, which may be why the BIS notes interest in the subject, as the number of zombies has likely been continuously climbing:
The BIS also notes that most zombies leave zombie status by recovering, not by death. So, they say, the threat posed by zombies may be an illusion. On the other hand, they note that those companies that recovered from their zombie status have a high relapse rate, and the rate of relapse has been growing worse. But, again, we haven’t seen how any zombies perform when inflation runs this hot and keeps climbing and bargain-basement interest rates rise quickly in a forced firefighting response to the inflation conflagration.
How bad can the zombie bust be?
The graph below on the left shows the number of zombies has been hugely rising, according to the BIS, as has the number of zombie deaths, and the graph on the right shows the percentage of zombies that return to zombie status is more than three times higher than the percentage of non-zombies that ever enter zombie status, meaning zombies tend to hang around as zombies do in fiction, creating a lot walking-dead weight that is a burden to society.
In conclusion, the BIS says,
Our analysis suggests that the share of zombie companies has increased considerably over the past three decades, rising from 4% in the late 1980s to 15% in 2017.… The zombie disease seems to cause long-term damage also on those that recover from it. The weakness and risks in advanced economy corporate sectors may therefore not be fully captured by headline figures…. With respect to the causes, our analysis suggests that zombies often emerge in the wake of business cycle downturns and financial crises…. At the same time, we find that financial pressure on zombies has dropped since the early 2000s, in part reflecting the easing effects of lower interest rates on financial conditions.
The latter point, of course, means that, in this unusual environment of significantly rising credit costs that are pinned to inflation, which the Fed and other CBs cannot kill off without putting their economies into recession, the risk to economies because of their zombies is substantially higher. CBs also cannot easily lower credit costs again when this possible cascade starts to emerge from the tightening effects of rising interest rates on financial conditions. If they do, the continuing rise in inflation is something zombies are especially vulnerable to, as well, so they may die off anyway.
But, according to the BIS, there is an additional risk from the detritus of past years that they say is now laid up in the zombie forest:
With respect to the wider consequences of zombie firms, our findings point to a growing army of enfeebled recovered zombies who underperform compared to healthy firms as a so far unrecognised consequence of the rise of zombie firms over the past three decades.
In other words, the whole economy is weakened because so many of the zombies that came and went are at a higher risk of re-zombification. They are weak, dry wood in the zombie forest that will more easily combust when times get seriously difficult and credit seriously dries up compared to what the zombies have gotten used to. This is one of the reasons I said last month that our economy is not strong as many claim but is badly weakened. (One of many deeply structural reasons I didn’t even go into because one can only cover so much in one article.)
To give a sense of the worst potential scale of the problem in the US, the third report with the highest graph above notes,
In the US zombie companies are estimated to control 2.2 million jobs and have built up $2 trillion of debt over the pandemic, nearly $500 billion higher than the peak of the Great Recession. These are not just small firms either, with an analysis by Deutsche Bank Securities identifying nearly one in every five publicly traded U.S. companies as a zombie, double the number in 2013. They include iconic brands such as Macy’s, Boeing, Carnival, Delta Air Lines, Exxon Mobil and Marriott International.
GDP Live
A failure on that scale would be cataclysmic even if nothing else went down in the bond bubble bust, which is why I made zombies a bubble of their own, even though they are a sub-bubble of bonds. Obviously, credit costs cannot rise much if these companies are already considered, by definition, barely able to hang on by just paying their financing costs. Yet, corporate bond rates are likely to, in the very least, double once bonds are pricing in 7% inflation after years when inflation was below 2%. So, if even just half of those zombies were to burn up in the conflagration of corporate bond rates, the impact of losing a million jobs and having potentially a trillion dollars in debt defaults would be quite damaging to the whole economy with knock-on effects of its own.
On a global scale, the International Monetary Fund, another institution of equal clout to the Fed, estimates $19 trillion in zombie debt, which they say is about 40% of all corporate debt that could collapse.
It is quite possible that the pandemic kept the undead alive and breathing, allowing their numbers to grow unseen, possibly higher than any time, depending on whose methods you use, because interest rates went as low or lower than they’ve ever been over the last two years of the pandemic while government rescue plans came on the scene as life support to businesses that would have died in the pandemic. At the same time, the pandemic depleted many businesses of a major portion of their income streams, likely putting even more in a zombie state if those incomes don’t recover after the government rescues fade. (Leave it to a pandemic to be the cause of a zombie apocalypse.) Those programs have ended, and now the zombies are all being taken off the life support of ultra-low interest, too.
Over the past year, economists have grown increasingly alarmed about the rise of so-called zombie companies. Although not yet insolvent, these businesses are left to shamble along aimlessly, not earning enough to reinvest in the business but still turning over a sufficient amount to pay off debts. Now, as COVID restrictions lift and economies reopen, these undead firms could prove to be a curse for hopes of a strong economic recovery…. Government support schemes, low interest rates and access to cheap credit has helped to keep many of these companies in a state of suspended animation. It has also caused the number of these zombie businesses to soar.
Raconteur
And that was written almost a year ago.
Bloomberg has estimated that a quarter of all the companies in the Russell 3000 are barely able to pay the interest on their debts at last year’s rates. Another company paints a picture of the stacking up of zombies in the UK like this:
Those are each quarterly increases, potentially adding up to a 42% increase in the zombie horde year on year (depending on how many might have recovered or gone bankrupt during that time). The number is likely higher still a year later. As the tide now goes out, we are about to find out how many zombies have been swimming naked.
How does the zombie apocalypse likely end?
Of course, with numbers too big to fail, politicians will be attempted to rescue as many zombies as they can, but what good will that do? They are zombies who have already been through a rescue and are still zombies. What is the point of keeping the zombie horde alive by handing out respirators once again? It just leaves us with a self-replicating problem of zombies getting back up after being knocked down and weighing the whole economy down with their continued presence.
There is a cost in keeping them alive for the whole economy. They compete against the living for available food:
Speaking on the BIS podcast, its senior economist Ryan Banerjee says: “We’ve seen fewer bankruptcies, which means there have been fewer new entrants in the market, as there has been no space for them to occupy. That means there is potentially less chance for one or two of those new fast-growing firms, which have an outsized impact on productivity growth, to enter the market.“
They’re taking up space. They are soaking up available finance just to run non-viable firms. They are soaking up market share. That leads to a slower recovery for the more viable firms. It’s socialism that doesn’t let capitalism ever do its dirty work because we are afraid of the pain. Thus, the pain society has to absorb has gotten bigger with each passing zombie cycle.
Julie Palmer, partner at corporate restructuring specialists Begbies Traynor, explains: “A zombie business is one which is hanging on for grim life but isn’t really prospering and can do little more than just survive…. The combination of the long-term build up of these zombies and the turning off of support measures, which is going to have to happen, will finally mean that we start seeing a number of these businesses begin to fail, and in quite significant numbers…. If better businesses are able to come into the spaces they [zombie businesses] occupied and do things more imaginatively and flexibly, they will not only survive but adapt and prosper going forward…. Although it means a bit of pain in the short term, it’s the price to be paid for a more efficient economy and a sharper recovery curve going forward.â€
But we have to be willing to bare the pain, and our politicians and banksters repeatedly have not been willing to bare that pain. Put another way, the dinosaurs need to get their lazy, fat butts out of the way of the incoming mammals in an extinction-level event to make room for the new life to thrive. However, will our lame politicians ever be smart enough to let that happen, or will they succumb to the screams of the masses because having all the dead dinosaurs or stinking zombies pile up around you is an ugly event to have to go through?
The burials and cleanup though bankruptcies will take years and overrun courts and take out a number of financiers that may fall over into other financiers. But that is the situation we’ve already created for ourselves by carrying the dinosaur zombies through the last COVID extinction event and through the other extinction events that came before. Now we have an extinction time bomb on our hands.
If the Fed is right and the BIS and others are wrong about the size of the zombie horde, maybe it won’t be so bad. However, bankruptcies during bond defaults have become much worse for investors holding bonds in recent years than they ever used to be as bonds and leveraged loans have largely become “covenant lite,” making the current zombie problem far worse to bear when it does blow up:
Bankruptcy filings are surging due to the economic fallout from 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.…
InvestmentNews
Desperate to generate higher returns during a decade of rock-bottom interest rates, money managers bargained away legal protections, accepted ever-widening loopholes, and turned a blind eye to questionable earnings projections. Corporations, for their part, took full advantage and gorged on astronomical amounts of debt that many now cannot repay or refinance….
Ultra-low rates helped risky companies sell bonds with fewer safeguards, which creditors seeking higher returns were happy to accept. Now, amid a new bout of economic pain, the effects of those policies are coming to bear….
Debt issued by the owner of Men’s Wearhouse, which filed for court protection in August, traded this month for less than 2 cents on the dollar. When J.C. Penney Co. went bankrupt, an auction held for holders of default protection found the retailer’s lowest-priced debt was worth just 0.125 cents on the dollar. For Neiman Marcus Group Inc., that figure was 3 cents….
“There’s just going to be way more downside….â€
Now companies have more leeway to seek extra financing when they’re in trouble and to give lenders providing additional funds the right to jump to the front of the line if the company does go bankrupt.
“Covenant-lite paper usually means by the time you get back to the table with the borrower, the house is on fire.â€
So, will we let the huge zombie forest burn to the ground? I doubt it. We haven’t had the courage to be true capitalists so far. Thus, the problem is worse than ever. But, if we don’t have the courage to go through all the pain that we have now lain in for ourselves by keeping zombies alive on artificial life support cycle after cycle, then we get to live with a zombie economy full of even more dead weight that walks aimlessly among us as if it is alive for years to come.
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