Here Comes a Bankruptcy Boom

Ailing companies could lay off 3 million more Americans.

Broken Circuit: Circuit City Stores Inc. filed for bankruptcy protection Monday and is slated to close 20 percent of its stores and cut more jobs.

If you've been saving your cash for fire sales at bankrupt retailers, don't blow it all at Circuit City. Many other companies are likely to end up in even worse shape over the next year.

So far in 2008, there have been a few name-brand bankruptcies—like the recent Circuit City filing, Linens-n-Things, Frontier Airlines, and Mrs. Fields Cookies—plus the colossal liquidation of Lehman Brothers. But believe it or not, it has been a fairly calm year for bankruptcy judges, by one important measure: the corporate default rate. The share of corporate bonds in default over the past 12 months, which goes hand in hand with bankruptcies, has been about 3 percent, according to data compiled by Prof. Edward Altman of New York University's Stern School of Business. That's near the historical average. So, the vast majority of corporations have been paying their debts during the early part of this recession.

But like many good things of the past few years, that's about to end. The latest data from Altman suggest that by this time next year, the corporate default rate will be somewhere between 8.5 percent and 11.1 percent. That means there could be three to four times the number of corporate bankruptcies we've seen over the past year. And each one of those will probably involve layoffs.

As a result, Altman predicts, the unemployment rate could peak as high as 9.5 percent, which would represent a net loss of jobs for 3 million people beyond those who are already unemployed today. "It could hit autos, builders, retail, a lot of areas with a lot of employees," Altman says. "It's going to be rough."

Altman's unemployment prediction is on the gloomy side—Goldman Sachs, for instance, forecasts a peak unemployment rate of 8.5 percent next year. But there certainly seems to be plenty of bad news around the corner. General Motors is one teetering giant. The big automaker says it could run out of cash within a few months, which could prompt one of the biggest bankruptcy filings in U.S. history. That would affect dozens of suppliers, hundreds of car dealerships, and the banks that finance GM's cars. Chrysler could follow suit, and Ford isn't in much better shape. Overall, estimates for job losses in the auto industry range from 30,000 to as many as 100,000.

And that's just one industry. As unemployment worsens and the recession deepens, consumers could rein in spending even more than they already have, leaving an impact on everything that has to do with consumer sales. And Altman says he has already seen a dramatic increase in bankruptcies among small and midsize companies.

Declaring bankruptcy, however, isn't always as dire as some people believe. Most companies that file for Chapter 11 protection don't go out of business. Instead, they shed debt, reorganize, and emerge as healthier companies. That's what United Airlines and Delta Airlines have done and Circuit City is planning to do.

A successful reorganization, however, requires a special kind of financing to help the ailing company get back on its feet, called debtor-in-possession financing, or DIP. This is usually a lucrative business for banks and financing companies, since the DIP lender gets paid back before most other creditors. Except that right now, banks don't want to lend to anybody. "The problem is the DIP market is all but closed," Altman says. If lenders don't loosen up, add one more item to the government's to-do list.