A vintage year for failures

Speaking at the FinanceAsia and AsianInvestor distressed investing conference, the Patron Saint of Bankruptcy, Professor Ed Altman, believes that we are entering a golden age of corporate default.

NYU Stern Professor Ed Altman loves bankruptcies so much that he uncorks a bottle of vintage claret and shares it with Mrs Altman whenever a big bankruptcy occurs. That being the case, the Altman house could be permanently sozzled in the next couple of years.
He loves bankruptcies because they give more ammo to his Z score, a linear bankruptcy predictor that he pioneered decades ago. When this correspondent heard Professor Altman speaking in New York more than 10 years ago, he mentioned then that he was stymied by the lack of defaults with which to prove his theories. Since then, bankruptcies have increased, and he believes we are now in a purple patch, a glorious age of failure.
"Deleveraging is difficult when a government is trying to stimulate growth, for example by slashing interest rates," he says. "Yet the quickest way to deleverage is to go bankrupt."
We arrive in a distressed position after several years of unprecedented liquidity; years in which distressed debt funds had so few distressed opportunities that they resorted to direct lending to corporates -- and fuelled the credit fire. In recent years even CCC-rated companies could get capital markets financing. That, of course, has now changed and spreads between high-yield markets and 10-year Treasury notes have shot up, and now stand at 1,400 basis points. Professor Altman thinks that while that ratio looks fairly priced at present, as further hurdles cause slip ups, spreads could rise further.
"Liquidity nowadays is when you wet your pants after you look at your portfolio," he observes. "Default rates peak at the end of a recession, or just after the end. So to judge when maximum defaults will take place, start by trying to figure out when you think growth will return to zero."
The Altman bankruptcy models used to be published infrequently. This took the form of a mortality rate indicator, an actuarial-style technique that looked at the credit quality of a company at birth, then tried to work out how long it would exist before conking out. Nowadays that model is complemented by market-based models that churn out different predictions of default every day.
For the 1997 Asian crisis, his models -- that look at micro levels of potential individual corporate delinquency -- tagged South Korean companies, followed by Thai and Indonesian firms as being the most likely renegades. Illustrating just how macro and micro issues are intertwined, those countries did suffer worst.

So which Asian countries show up worst in his models today? Unfortunately he didn't specify, though he did say that defaults in Asia are a lot less than elsewhere in the world. This makes reliable modelling harder, but he does expect to have a prognostication soon on likely Chinese corporate default.
He observes that decoupling has been proven to be a false theory, and thinks that Asia is going to face a significant increase in distressed situations. He now looks across a debt landscape that includes $1.1 trillion in high-yield debt and $1.6 trillion in leveraged loans, and seeing that just over a quarter of this is of the lowest credit quality -- CCC grade -- he anticipates that 35% to 40% of those loans could get into difficulties in the next 12 months.
Professor Altman has been in the limelight recently because of his testimonies to US government committees regarding their beleaguered carmakers. He is pragmatic on this issue and would like to see GM crossing the Rubicon into bankruptcy (which coincidentally would give more data points for his model).
"Anyone like to guess what percentage of distressed exchanges eventually go bankrupt?," he asked the audience. "It's about 50%. Half don't work out and that's because with the debt swap they still didn't fix the underlying operations properly."
Statistically, 2008 was a monster year in notional size for bankruptcies, because of the liability figures being blown out by Lehman's crash. So far, this time around, Professor Altman has recorded 20 companies entering bankruptcy with liabilities of over $1 billion, and expects this cycle to out-do previous records.
2008 was a sticky time for distressed funds, he notes. Down on average 26% and with 30% redemptions. If a distressed investor now buys a bond at 25 cents on the dollar, that might seem cheap, but it won't be cheap if default rates go up, meaning that even those 25 cents can drop to zero. Professor Altman advocates restraint on going long in distressed debt, and that the opportunities will still be there in six months.

"For now," he says. "It is still too early to pile in." Until then, the Altman wine cellar risks depletion.

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