Saturday, October 13, 2007

Will the Minimal Percentage of Defaults Continue?

While M-LEC may take some of the pressure off of credit markets, the overhang of leveraged loans and high-yield securities still looms.

According to Fitch Ratings, there are $577 billion in leveraged loans and high yield securities maturing between 2008 and 2010. There is an additional $283 billion coming due in 2011, and more after that.

Typically, companies try to roll over these loans. The existing loans, however, were issued in an unusually loose credit environment. Credit spreads were compressed in the market place (risk was priced at an unusually low level), Treasury securities were still at low yields, and then there were the covenant lite loans.

It is highly unlikely that these loans will be refinanced on terms similar to those of the original loans/bonds.

The question then becomes, how are the companies performing? Unlike structured securities, this will be relatively straightforward.

In all likelihood, unless the Fed drives rates down significantly below 4 percent, there will be a large number of defaults.

This situation only relates to the structured security mess in that losses in those markets could lead to distress sales of existing loans/bonds, and a lack of appetite for new loans.

Personally, I'm brushing up on my distressed securities skills. I'm reviewing notes from my bankruptcy class with Professor Ed Altman, looking over my notes from the bankruptcy seminars I took at NYU Law, reviewing the changes to the bankruptcy law, and studying current techniques for the valuation of distressed securities.

I was very involved in the restructuring market in the early 1990s (I was a founding member of the New Jersey Chapter of the Turnaround Management Association and the East Coast representative to the Deloitte & Touche Valuation Group Restructuring Committee).

Interestingly, the skill sets employed in understanding a distressed company are not terribly different to understanding early stage companies. In both cases it is imperative to monitor cash, assess existing operations and make changes, and position the business for the future. The major differences are that early stage companies tend to not have the legacy issues associated with bankrupt companies, and their capital structures tend to be more straightforward (although I have seen some very strange structuring of early stage financing).

With these experiences (and some other related work), I feel that I can add significant value to this process as it progresses.

Bottom line, I personally expect a reversion to the mean. By this, I mean that default rates cannot continue at such low levels, particularly given the excesses of the last few years.

I have heard conflicting reports about how active the distressed market is at this point, but I do expect a significant increase in activity.

Here is an article from The Lawyer discussing the current situation from a legal professional's point of view:

From The Lawyer, 1 October (Vol 21, Issue 38)

Credit crunch casts NY shadow

Forget corporate - it's so last season. In New York, the field to be in if you want to get hired is bankruptcy. Now you won't sense this from walking around Manhattan. The US may be on the brink of financial meltdown, but there's no sign of that in the streets below Central Park.

Although the fallout from the credit crisis continues to make headlines - along with the indictment of Milberg Weiss class action stalwart Melvyn Weiss, the big legal market news in the city this month - around town the usual New York business of making as much money as possible continued non-stop.

In Bryant Park, the site of one of New York Fashion Week's big shows last week, the construction of the $1bn (£496.13m) Bank of America Tower slowed not one jot because of the summer's hysteria in the debt markets. When the building is completed in 2009, expect some of the city's leading law firms to move in.

For now, however, all there is to see by the freshly laid turf squeezed between the
towers is ranks of men and women bashing their laptops and barking into phones. Slowdown? Not here.

But first impressions can be misleading. None of New York's top lawyers are going to admit it, of course, but there's a nervousness here. Major M&A is on hold. The promised restructuring wave hasn't arrived.

What happens next is, according to Weil Gotshal & Manges restructuring partner Harvey Miller, "the sixty million-dollar question".

"Three months ago, if you asked someone what the effect of the sub-prime crisis would be, they'd probably say, very contained and limited, no leakage," says Miller. "The fact that it spread so international, that BNP closed two funds in Paris, and the problems at Northern Rock, was a shock. The ability to contain the credit crunch wasn't as strong as those so-called knowledgeable people thought."

So New York's law firms, like everybody else, are waiting to see whether the events of the summer will hit the real economy. Will there be a deeper recession that hits at the bricks and mortar underpinning the confidence not just of the markets, but of the consumer? And if so, shouldn't they be hiring to reflect the market change?And as Miller says: "It seems to me the situation is less under control than anyone thought."

But in New York the firms with the big litigation and bankruptcy groups, firms such as Milbank Tweed Hadley & McCloy, Paul Weiss Rifkind Wharton & Garrison, O'Melveny & Myers and Weil, are gearing up already. That could be via lateral hires (such as Vinson & Elkins' hire of New York bankruptcy boutique Cronin & Vris last month), or it could be at the bottom. The September crop of associates may just have discovered that their services are more in demand in restructuring than in corporate.

Lawyers might not move the market, but the canny ones will be ready to jump when their clients ask them.

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