Corporate Default Alert

By Heide B. Malhotra
Heide B. Malhotra
Heide B. Malhotra
June 22, 2011 Updated: June 22, 2011

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.

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