One of the items we are asked most frequently is “how does the economy impact bankruptcies,” both in terms of volume, as well as in terms of liquidation.  I wanted to share a few of the trends and observations we are seeing and communicating to our partners.

In terms of volume, bankruptcies are a lagging indicator on the economy.  The thought process is really two-fold: 

• First, folks will see a decrease in income or job loss, etc.  They will then work hard looking for a solution to their problems, like another job or financial restructuring through debt settlement, refinance, or a myriad of other possibilities. In the mean time, the lack of health insurance or other factors causes their out of pocket non-discretionary spending to rise. Bankruptcy tends to be a last resort on the part of most debtors, so by the time they are filing, they just can’t hold it together any longer. However, the economic cycle that led to the start of the debtor’s financial crisis probably started months ago, since the bankruptcy lags the economic cycle by some months.  This is very much the case in the macro-economy.

• Debtors won’t file bankruptcy unless they have something to protect; be it wages, a house, or business assets.  Thus, the unemployed renter with no real assets is not likely to file for bankruptcy. However, once he or she gets a job where wages can be garnished, they certainly may have to file at that point.  Thus, we will likely see another wave of bankruptcies as job losses stop and the unemployed enter the workforce again.

In terms of liquidation, debtors who are making less have lower disposable incomes, and thus lower plan payments in bankruptcy – particularly to unsecured creditors.  If a debtor loses their job, or has a major financial setback, this will also cause an increase in conversions to Chapter 7, plan amendments to lower payouts, or dismissals of the bankruptcy account.

What we are sharing with our partners is that based on what we are seeing, the bankruptcy volume is likely to continue upward for several more quarters, and that assumes that the economy is stabilizing and begins to slowly improve.  The liquidations for unsecured creditors are likely to remain lower than we have seen historically, as consumers restructure their debts in bankruptcy while struggling with a sluggish economy, lack of real wage growth, underemployment and a very tough family balance sheet.

Longer term, the future is very difficult to predict.  The consumer and financial institutions have presumably learned a valuable lesson about the dangers of debt, and it is likely that financial institutions will tighten underwriting, and the average consumer will be more prudent managing their assets and liabilities.  That prudence likely will lead to sluggish growth because of lower demand for assets, and lower supplies of debt.  Coupled with what our economic team is predicting as a relatively high interest rate environment in the next couple of years, that is a recipe for fewer bankruptcies, but lower payouts for those that do file.  Additionally, there is likely to be a bias toward Chapter 7 as incomes fall and the means test becomes less of an issue, and more of the value of business and real estate assets fall under state exemptions due to recent deflation.

As we learned over the last several years, the one thing that economists can do very well is get things wrong.  We’ve been advising some of our partners to consider looking at servicing options if their risk tolerance is relatively high – as the uncertainty is being reflected in the asset prices traditional debt buyers are willing to place on flow deals.

Bankruptcies are a lagging indicator of the health of the economy, and the health of the debtor.  Once you see bankruptcy liquidations and volumes turn, the end of the recession is past for certain.  The historical lag may not be a good predictor due to the severity of the current economic downturn, but we are forecasting a 2 to 4 quarter lag – so there is still a pretty long bankruptcy runway ahead in 2009-2010.     

Edward J. Barton is Chief Executive Officer of B-Line, LLC. Ed joined B-Line as Controller in 2001 and was appointed Chief Financial Officer in 2002 before being promoted to Chief Executive Officer in 2008. Ed, a CPA and CFA, received an MBA from Syracuse University and a BBA (magna cum laude) from the University of Notre Dame. He then went on to become the Director of Finance (Western Region) for Luminant Worldwide Corporation. He has been vital in the development of cash and recovery models, policies and procedures, financing, financial statement preparation and review, human resources, client audits and investor relations.