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Analysis / Research - Fall 2009

The Next Wave

“Debts are fun when you are acquiring them, but none are fun when you set about retiring them.” So said Ogden Nash, the late American poet and humorist. What then for companies that racked up billions of dollars of cheap debt during the go-go years of the credit boom? How will they cope now, faced with rather more sober refinancing conditions as maturity dates move into view?

As economic historians debate whether or not Lehman Brothers could have been saved, it’s clear that the global financial markets crisis of 2008 was entirely a self-inflicted wound, which had been years in the making. There were no external factors or shocks to blame. Quite simply, investors collectively lost confidence in the decision-making and risk-taking practices of large financial institutions, private investment capital and large swathes of Corporate America – arguably with good reason.

In the corporate sector, credit quality had never been so poor going into a recession. As we entered the maelstrom a little over a year ago, some 62% of rated U.S. non-financial corporate issuers were considered speculative-grade by Standard & Poor’s (S&P), of which over two-thirds were considered “deeper junk” (B+ or worse) – a significant deterioration in the distribution of credit ratings compared to a decade earlier. The leveraged buyout (LBO) craze of mid-decade contributed greatly to this phenomenon, with some $400 billion of LBO-related loans made in the U.S. between 2005 and 2007, according to Reuters LPC. European borrowers got in on the act too, with the equivalent of some $580 billion of leveraged M&A loans made during this same period, over half of them earmarked for LBO transactions. Already that fallout has begun; S&P recently noted that 42 of 46 European debt defaults of credit-rated or credit-estimated issuers that occurred in the first half of 2009 were LBO deals gone sour.

Today, even after cleansing the pool of rated issuers of hundreds of defaults that have occurred since early 2008, corporate credit quality remains exceptionally weak. Operating and financial challenges for high-risk borrowers still abound. The damage inflicted on a fragile global financial system from the combination of excessive risk-taking, high leverage and sharp economic contraction cannot be repaired in haste, notwithstanding the impressive rally in global credit markets since March 2009. This article will explore how risky borrowers have responded to largely inaccessible credit markets since late 2008 and the challenges that remain firmly in place even as the global economy seems poised for recovery in 2010. 

How are Financial Markets Faring?

Following the near-death experience in capital markets last fall and the precipitous price declines that continued into early 2009, the recovery in global financial markets has been striking. Conversations have moved on from open-ended bailouts, the nationalization of troubled industries and other dire rescue plans to, ultimately, the realization that the collective commitments and bold actions of policymakers in the developed world appear to have prevented the Depression-like scenario that seemed plausible last December. Yet this is no guarantee of smooth sailing in the months and years ahead, and it is certainly not a harbinger of borrower-friendly credit markets. Capital markets have opened up again to investment-grade and near investment-grade corporate issuers, but global fixed-income investors remain highly selective (and demanding) for riskier issuers.

One striking feature of the environment today is the growing divide that has opened up between investment banks and their corporate and retail counterparts. Investment banks – particularly in more traditional business areas such as foreign exchange – are delivering exceptionally good results. This is because a lot of capacity and capital has been withdrawn from the wholesale markets. By contrast, retail and corporate banking continues to struggle with asset quality and a lack of attractive new business.

As might have been expected, the first beneficiaries of government intervention programs have been financial markets. Equities, in particular, have rallied globally, while corporate credit markets have returned to pre-Lehman levels.

What’s Happening on Main Street?

The recession, which officially began in December 2007, is both a by-product of credit tightening and a contributor to its perpetuation; and this recession has been particularly brutal in terms of its impact on U.S. employment and economic activity and the destruction of personal wealth. Real U.S. gross domestic product (GDP) contracted by nearly 6% in the six-month period ended March 2009: its worst two-quarter slump since 1958. Real median household income declined 3.6% in 2008 – erasing gains of the past three years; and household net worth has fallen by 22% from its peak in mid-2007. Consequently, consumers and businesses alike have become exceedingly cautious in their spending and finance decisions of late – largely by choice, but also driven by market-imposed discipline.

Consumer spending, the main driver of U.S. economic activity, remains in deep doldrums. This is hardly surprising, given that three pillars of consumer confidence have crumbled: house prices (down nationally by nearly one-third), the unemployment rate (more than doubling to 9.8% – its highest level in 26 years) and the value of financial assets such as savings accounts and 401(k)s (down by more than 20% since the peak).

There are clear signs that many consumers have downshifted to survival mode. Monthly discretionary spending totals by U.S. consumers have been consistently lower by near double-digit rates or worse (year-on-year) in most product categories outside of consumables.
Despite talk of early recovery, there is virtually no evidence that consumers are willing to open their wallets without steep incentives, such as the ‘Cash for Clunkers’ program. Survey data consistently shows that about three-quarters of all Americans have cut back on personal spending. Credit-card debt outstanding has contracted at a record rate so far in 2009, while the personal savings rate has moved from nearly zero to its highest level in more than two decades – distinct signs that behavioral changes afoot may be more than just temporary adjustments. 

This state of high anxiety within the private sector is not just an American storyline. Consumer-driven demand in much of Continental Europe remains in contraction and massive government intervention has been required to prop up economies in most Western European nations. Despite recent indications that the recession may have ended in Germany and France, the outlook for private consumption in Europe remains poor in 2010.

Clouds are mostly gray in the corporate sector. Operating earnings for the S&P 500 Index have declined 53% from their peak in 2007, considerably worse than the 32% peak-to-trough decline in the 2001 recession and the 25% decline in the 1990-91 recession. Most companies that are meeting or exceeding earnings estimates in 2009 are doing so as a result of aggressive cost-cutting rather than generating top-line growth.

These tough measures are driving employers to shed staff in record numbers, blunting consumer confidence and reinforcing their reluctance to spend. Until there is discernible improvement in consumer sentiment, it is difficult to foresee any meaningful growth in their current timid spending patterns. Yes, a Depression-like scenario may have been avoided, but a period of prolonged economic weakness or anemic growth remains a distinct possibility.

We should remember that while equities are in recovery mode, the default and employment cycles are lagging indicators, which will continue to generate bad news for many months to come.

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