Default rates to nudge higher in 2008; credit derivatives market to soar, Deutsche's Tierney says

By Evan Weinberger

New York, Dec. 12 - While 2008 brings more uncertainty than any time in the last seven to eight years, companies have gathered enough capital behind them to weather the storm for the next year or so, said John Tierney, the director of fixed income research at Deutsche Bank.

Because of that, Tierney told a press conference held by GFI Group Inc. in New York Wednesday, the surprise of 2008 will be that the number of corporate defaults will only nudge up slightly, rather than skyrocket as some other more dire predictions have called for. According to Deutsche Bank statistics, the default rate stood at under 2% heading into 2007.

"The public side of corporate America is as well positioned as could possibly be," he said. "Profits have been high, people have been building up equity and they've been very, very careful about adding on debt."

The average debt to EBITDA ratio stood at just over 1.25 heading into 2007, according to statistics provided by Deutsche Bank. By contrast, those levels were over 1.5 heading into the 1998 crisis.

At the same time, corporate leverage ratios are at their best level in the past decade, Tierney said. Heading into 2007, the average debt to equity ratio stood at around 0.5. The debt to market capitalization ratio stood at less than 0.25 at the same period.

In 1998, according to the Deutsche Bank statistics, the average debt to equity ratio stood at around 0.75. The debt to market capitalization stood at under 0.25.

The danger lurking, however, comes from the uncertainty in the air. "The outlook is as uncertain as it has been for the last seven, eight years," Tierney said.

He said that if the economy heads into a recession, rather than a protracted slowdown, the corporate default rate will spike, as is feared.

A rising default rate would have an impact on credit derivative spreads. If defaults rise to the nearly 4% that was seen in 2001 and 2002, then credit derivative spreads will widen significantly, Tierney said.

Volatility in the credit derivative market jumped as hedge funds entered in the first half of 2007, driving derivative indexes to significantly higher volatility than cash indexes. Volatility has come more in line with cash index volatility as the number of new players in the credit derivative market has flattened out.

Credit derivatives keep growing

Still, the credit derivatives market grew to a projected $50 trillion in 2007 from around $30 trillion in 2006. Tierney projects that it could grow to nearly $90 trillion by the end of 2008.

The credit derivative products available to investors and trading volume have risen significantly, with the single-name market in loans and PCDS (preferred credit default swaps) showing strong growth. Banks and hedge funds make up around 90% of participants in the credit derivative market. Pension funds, insurance companies and other "real money" investors only make up about 2% to 3% of the CDS market.

High yield credit spreads have widened significantly since the beginning of the credit crunch in August, they shouldn't spread much farther if the wider markets hold up. If not, high yield credit spreads could widen out a further 200 to 300 basis points. "As markets keep getting worse, high yield spreads widen," Tierney said.

Other markets are in for tougher sledding. The leveraged buyout boom is "not coming back" after the wave of problems in LBOs followed closely on the heels of a buying binge by private equity shops in the first half of 2007. Instead, Tierney expects to see more strategic mergers between well-positioned companies in 2008. Most of these deals will be under $1 billion, he said.

With the collapse of many asset-backed securities, particularly mortgage-backed securities, structured finance is "on life support."

The one characteristic that is constant across all markets, however, is uncertainty. It's still not entirely clear whether the current problems facing the market are concentrated in the financial sector or are economy-wide. "I don't think anyone can really know what the answer is," Tierney said.

While corporate credit remains strong and companies will probably be able to hold up if no major recession hits, Tierney said. But he added that if oil prices continue to rise and falling house prices scare consumers, along with inadequate Federal Reserve policy, the economy faces many pitfalls.

That could be a boon to the growth of the credit derivatives space, he said.

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