Sunday, December 07, 2008

Default Rates & Static Analysis

As recently as a early 2007 ago there was very little "risk premium" between debt of varying quality. The risk premium is usually measured against US Government debt (Treasuries) of equivalent duration (i.e. a 5 year bond compared to a 5 year security). For instance, if the Treasuries were yielding 5%, then high-quality (at the time) corporate debt might be issued at 6%, with riskier debt as high as 9% (a premium of 4%).

At the time I wrote that this absence of a risk premium was unusual and meant that buyers of debt were being paid very little (beyond what they'd get for a risk-free government issue) for taking on the business risk tied to these often highly leveraged, cyclical businesses. As it would later turn out, these yields were far too low, and since have widened to historically high levels. For example, while Treasuries are around 5% now, "junk" bond yields for new issues are near 20%, which is an amazing premium of 15% or so.

Some analysts are saying that these yields are TOO high (i.e. the market is demanding too much for the level of risk that you are taking on). By their reckoning, companies would have to default at a rate that they didn't even approach during the great depression in order to justify these yield levels. Others are recommending that this might be a good time to jump in at these levels.

While their calculations of required failures do indeed seem high, the analysts have failed to take one CRITICAL variable into account - the absence of liquidity - essentially they are only modeling the risk of default in isolation.

The REAL cause of disruption in business today is something else - the complete seizing up of the market and closing of the door to companies seeking additional funding. For example, the risks in these two models are completely different:

1) what is the required return for a basket of "junk" credit quality companies assuming that they have access to additional funding (at that same high premium above Treasuries)

2) what is the required return for a basket of "junk" credit quality companies assuming that the market for high-yield debt has completely shut down and there is NO access to additional funding?

The analysts, looking at historical data (even comparing to dire scenarios, like the depression) are assuming a static market where companies can go back and raise more money, albeit at a high rate. However, in November 2008, there was only ONE (small) "junk" bond debt issue - the markets are frozen, per this article.

Companies that are have debt at "junk" credit levels are HIGHLY correlated with companies that NEED new funding to keep functioning (i.e. they are burning cash). Until recently there wasn't the prospect that markets would freeze and whatever cash was on hand would be pretty much all that was available for the intermediate term.

I am not saying that something IS or IS NOT a good investment- I am only pointing out that a static analysis of default rates that utilizes historical data needs to take into account the complete freeze in the credit markets and absence of new funding, at almost any rate.

This is an example of "negative correlation", or the old-wives tale of "when it rains, it pours". Lousy business conditions are tied with high interest rates and an absence of debt buyers at almost any price.

If these conditions aren't loosened up and access to new cash provided expect to see default rates that blow away historical levels, because today's companies are leveraged beyond the historic levels, and are required to continue to go back to the public markets for new funding.

The only slight silver lining is that many of these companies won't be able to get debtor-in-possession financing which is necessary to emerge from bankruptcy, meaning that they will be liquidated (like Linens & Things, Bennigans, Mervyns, etc...). The liquidation of competitors will give their slightly stronger competitors a chance to survive, since companies in bankruptcy operate at a distinct advantage (they can break contracts, for example). This logic is why Ford can't survive if GM and Chrysler go into bankruptcy (assuming they aren't liquidated immediately) - because then GM and Chrysler will have a big cost advantage that will overwhelm Ford immediately. In the past (when markets were liquid) entire industries such as airlines languished in bankruptcy seemingly indefinitely.

Cross posted at Chicago Boyz

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