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Higher Interest Rates and Ballooning Consumer Debt Will Trigger the Next Bankruptcy Wave


These are strange economic times. The Great Recession in 2008 was followed by a remarkable period of steady growth fueled by historically low interest rates. While the pandemic shutdown in 2020 was briefly cataclysmic, it spawned frenzied growth in real estate and other sectors, with seemingly insatiable pent-up demand fed by even lower interest rates and massive government stimulus. Is this the new normal we’ve been hearing about?


Hardly. My crystal ball is no less fuzzy than the next prognosticator’s, but it seems clear that a reckoning is coming, most likely by the second half of 2023. Whether it hits earlier or later than that, the next bankruptcy wave will be triggered by higher interest rates and ballooning consumer debt.


Higher Interest Rates Mean More Expensive Debt, Less Economic Activity, and More Bankruptcy Filings

The ability of businesses, investors, and consumers to borrow money cheaply fuels economic activity. Interest rates have been remarkably low for remarkably long. The average prime rate from 1947 to present was 6.8%, which includes the whopping 20% rates of the early 1980s (topping out at 21.5% in December 1980) and the rock bottom 3.25% rates from 2008 to 2015 and again from 2020 to 2022.


Prime is 7% in November of 2022 – not far off from the historical average – but shockingly high in relation to the last 14 years. Higher rates mean that every capital-intensive endeavor is more expensive, with a corresponding decrease in projected ROI. The result will be fewer projects and investments, which will inevitably lead to a softening of the labor market.


To further complicate things, interest rates did not increase gradually, in a way that would give developers, investors, entrepreneurs, and home buyers time to adjust. Instead, prime jumped in 2022 alone from 3.25% to the current 7%.


By rapidly increasing the federal funds rate (to which prime is tied) the Federal Reserve is seeking to forcefully slow economic activity as a means of arresting inflation before it gets out of control. Whether inflation can be tamed, and the dreaded “stagflation” avoided, remains to be seen. But dramatically higher borrower costs will certainly slow economic activity and the results will become evident as soon as the current momentum runs out and pre-existing liquidity is used up. Bottom line: whether you agree or disagree with the Fed’s timing and approach, you can’t fight it, and a slowdown is coming.


Ballooning Consumer Debt Means Less Consumer Spending

The government’s reaction to the pandemic was to unleash massive amounts of stimulus in 2020 and 2021. It was directed at businesses in the form of PPP loans, EIDL loans, employee retention credits, and other programs. Many small businesses were saved as a result, but there are also plenty of “zombie” enterprises that are now shuttering as the excess liquidity runs out.


Massive government stimulus was also directed at individuals in the form of earned income tax credits, advance child tax credits, and both federal and state unemployment compensation. The historic levels of government transfers boosted household income while household spending was severely curtailed by social distancing. Counter-intuitively and unintentionally, this led the personal savings rate to soar. The Federal Reserve estimates that U.S. households accumulated about $2.3 trillion more in savings than they would have but for the pandemic and resulting stimulus.


At the height of the pandemic, American households began spending like never before to improve their existing homes, or buying new homes, to cope with the realities of lock-down-life and work-from-home. As restrictions on travel and gathering eased, Americans deployed their savings with a YOLO fervor on shopping, dining, travel, and experiences. Only recently have we seen the frenzy wane due to a combination of exhausting pent-up demand, price inflation, and savings depletion.


As of Q3 2022, not only has the savings rate plummeted, but consumer debt has ballooned. A recent report from the New York Fed shows total household debt now stands at $16.51 trillion, which is $1 trillion higher than the prior year, and $2.36 trillion higher than at the end of 2019, before the pandemic recession. It doesn’t take an economist to recognize that absent additional and massive government intervention the pendulum will soon swing violently away from frenzied consumer spending.


Conclusion

Even bankruptcy lawyers don’t hope for dire economic times, and there is always hope that the Fed’s actions and the resilience of America’s businesses and consumers will make any downturn shallow and short. But the pendulum always swings, and the historically low bankruptcy rate of the past few years will not last. Higher borrowing costs, lower savings rates, ballooning consumer debt, and inflation will likely result in a wave of bankruptcy filings in 2023.

 

Robert Gonzales - Nashville Chapter 11 Attorney

Robert Gonzales is a partner with EmergeLaw, PLC in Nashville, Tennessee. He guides smaller and middle market companies through financial restructurings utilizing out-of-court workouts when possible and Chapter 11 when necessary.


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