Monday, December 22, 2008
Debt Recovery Prospects Darken
--default recovery might be less than usual. --Higher use of senior loans pushed other creditors further down the pecking order in restrcuturing --Lack of DIP (debt in possession) reduced the attraction for restructuring since the path to outright liquidation is shorter. By LIAM DENNING Bankrupt debtors used to be thrown in jail. Do that now, and America's prison system would collapse. Rather than seek incarceration, today's creditors are focusing on extracting better recovery rates: the amount they get back on defaulted debt. Unfortunately, excessive leniency during the boom years means not only having to deal with more defaults, but also getting very little back when that happens. Professor Ed Altman of New York University's Stern School of Business expects 11% to 11.5% of U.S. high-yield bonds outstanding at the end of the third quarter to default within a year. His proprietary model suggests average recovery, given that default rate, of about 27 cents on the dollar. There is an established inverse relationship between default rates and recovery rates. Defaults tend to rise during economic slowdowns, which is also when asset prices drop. With the current recession drawing comparisons with the dark days of the early 1980s, and the S&P 500 down 45% since October 2007's peak, creditors can bank on a lot of collateral damage. Loose covenants and the use of payment-in-kind "toggles" exacerbate the problem. Giving creditors more breathing room helps avoid default, but also allows terminal cases to simply burn through more assets, leaving less to recover when the day of reckoning finally dawns. PIK-toggles, meanwhile, amount to extending more credit to a borrower even as ability to pay visibly deteriorates. Thankfully, issuance was small in the grand scheme of things. There are two bigger problems for creditors to contend with. One is the higher use recently of senior loans, fueled by demand for collateralized loan obligations. The proportion of U.S. speculative grade issuers with only outstanding loans and no bonds rated by Moody's Investors Service leapt from about a fifth at the start of the decade to 59% by June 2008. More use of loans pushes other creditors further down the pecking order in a restructuring, leaving them with less. But it also means that, with more lenders holding senior claims, they are also unlikely to be made whole. The second problem is scarce debtor-in-possession and exit financing: the credit extended to bankrupt firms to help them restructure and emerge from Chapter 11. Traditional financiers have withdrawn or, seeing rich yields in distressed bond markets, can divert their resources there. Without that support, banks will have a tough time syndicating DIP loans. In effect, this reduces the attraction of filing for bankruptcy protection, since the path to outright liquidation is much shorter. Little wonder that 2008's amount of U.S. distressed bond exchanges -- in effect, debt restructurings done out of court -- is bigger than every year since 1984 combined, according to Professor Altman. Expect more. Unless DIP financing frees up soon, however, creditors could end up taking savage haircuts as assets are offloaded in fire-sales, and restructuring efforts risk seizing up, delaying recovery for everybody.