Corporations in the 21st century business environment require short-, medium-, or long-term funds to support ongoing operations. Some funds are used for day-to-day working capital needs and others for investing in the growth and expansion of the firm.
To finance operations or expansion, a firm may procure funds from a lending institution, issue convertible bonds, or issue stocks, allowing the public to hold an ownership position and share in the firm’s profits. Before a lender or the public invests in the company, the credit risk is assessed through analyzing the financial condition of the company.
Lenders, to mitigate the risk of the company defaulting on the loan, have resorted to adding a number of caveats, also called covenants. The financing industry calls loans with limited or no special conditions covenant-lite loans. Covenant-strong loans generally require a firm to maintain a certain debt to earnings or debt to net worth ratio.
Risk analysis of the financial condition of major firms, even when rather thorough, didn’t forecast for the recent economic downturn, and credit agencies and others that should be in the know were somehow blindsided.
The latest financial crisis brought about not only mortgage loan defaults by individuals, but also small-, medium-, or large-sized firms either defaulted and restructured loans or filed for bankruptcy. Bankruptcy filings are generally triggered by an insurmountable debt burden and the inability to pay one’s obligations to creditors, mainly by defaulting on one’s loans.
Business Loan Default History
The good news is that business bankruptcy filings fell by 15 percent during the first quarter of 2011, when compared to the same period in 2010.
“The drop in bankruptcy filings demonstrates the continued effort of both consumers and businesses to decrease their debt loads and shore up their finances,” said Samuel J. Gerdano, executive director at the American Bankruptcy Institute (ABI), in its latest press release.
In 2007, the year the credit meltdown hit the United States and the international community, fewer companies that were granted a credit rating by the major credit companies defaulted on their bank loans than in 2006, despite liquidity problems. Rated companies recorded a total amount of $8.2 billion in defaulted debt in 2007, the lowest recorded since 1996, according to 2008 research by Standard & Poor’s (S&P).
In 2008, rated corporations reversed the trend with a corporate default rate of 2.41 percent and $429.6 billion of defaulted debt. Leading the pack of defaulters was Lehman Brothers, defaulting on $144 billion of debt. Rated corporations are those that are traded on the stock exchanges and given a numerical rating by one of the major credit ratings companies, such as S&P, Moody’s, Fitch Ratings, and Egan-Jones Ratings Company.
“The rise in corporate casualties is not surprising, as it comes on the heels of many consecutive years of heady growth. … We expect the current wave of defaults will restore a greater sense of equilibrium,” said S&P in its 2008 Annual Global Corporate Default Study and Rating Transitions.
After a two-year upsurge in loan defaults, U.S. corporate defaults by rated distressed firms dropped 70 percent from a high of 191 in 2009 to a total of 58 in 2010.
“The economic recovery and fresh injections of liquidity from central banks and yield-seeking investors were the main reasons for the decline,” according to S&P’s 2010 Annual U.S. Corporate Default Study and Rating Transitions report published in March.
A 2011 S&P study predicted that the default rate by rated U.S. corporations would decline to 1.6 percent by March 2012 with 24 companies defaulting.
S&P’s optimistic outlook predicts that in the coming 12-month period, even fewer firms would default on their loan obligations, suggesting a decline to 1.2 percent, while the pessimistic outlook, which would arise from a worsening U.S. economic condition, suggests an increase to a 3.3 percent default rate.
“A key mitigating factor for default risk has been improved funding conditions. Many low-rated highly leveraged companies have been able to tap the market for financing, enabling them to extend maturities and lower their debt costs and net debt,” according to S&P’s latest research report.
A major factor in increased borrowing activities and fewer defaults is that investors’ willingness to assume corporate debt has returned and maturing debt is easier to restructure than just a few months ago.
Next:America’s Most Distressed Sectors
America’s Most Distressed Sectors
S&P suggested in a May research release that “in light of sluggish consumer demand and some uncertainty about economic and credit market conditions, the media and entertainment, oil and gas, and retail/restaurants sectors were … the most troubled sectors as of April 30, 2011.”
In a research note published in the beginning of 2011, S&P stated that media and entertainment (M&E) companies accounted for a little under one third of all defaulted companies. Out of 53 rated companies that defaulted on their loan obligations, 13 were from the M&E sector.
S&P spotted 83 distressed companies in the M&E, oil and gas, and retail/restaurants sectors that were exhibiting risk factors, conceivably resulting in default in the near future.
During the past year, 60 percent of all companies in the retail/restaurant sector were downgraded by S&P. The M&E sector didn’t fare much better, as 42.4 percent of M&E companies were downgraded. In the oil and gas sector, 38.5 percent of all companies experienced a downgrade.
“Downgrade ratios have fallen precipitously for all three industries since the third quarter of 2009, which is indicative of a protracted period of improving credit conditions. The total nonfinancial downgrade ratio has declined in a similar fashion since the third quarter of 2009,” according to the latest S&P research report.
Scrutinizing Default Factors
“Permissive bankruptcy laws, not bad business downturns, seem to be the greatest cause of corporate bond defaults,” said Ilya Strebulaev, associate professor of finance at Stanford University, in a press release.
Strebulaev and fellow researchers studied corporate defaults over a 150-year period and found that when no bankruptcy code existed in the United States, there were very few corporate bond defaults.
“What happened in the case of defaults looked similar to what happens with Chapter 11 today—debtors were treated in a more friendly way, while creditors were treated in a less friendly way,” Strebulaev said.
Bankruptcy laws were developed in the early 1940s, after the end of the Great Depression, which reversed the trend the courts had taken. The bankruptcy laws were unsympathetic toward the debtor and favored the creditor. Again, during that time, there were very few defaults.
In 1978, bankruptcy laws changed, giving the corporate debtor more leeway in case of default, resulting in a significant increase of corporate defaults.
“If you measure financial constraints as the incidence of corporate defaults, there is not much of a link to the economy as a whole. Such defaults are more closely tied to the laws and institutional environment of the day,” Strebulaev suggests.
