Outlook 2008: Distressed debt players expect higher default rates, continued market correction

By Stephanie N. Rotondo

Portland, Ore., Dec. 31 - Investor uncertainty in the distressed market resulted in a seller-heavy 2007 - and going into 2008 it is not clear whether that uncertainty will linger or clear.

The past year was fraught with anxious investors: turbulence in the housing and financial sectors, and fallout from one too many so-called "bad deals" weighed heavily on the general marketplace.

The desire to take on any risk associated with distressed debt was therefore dampened.

"Going into 2007, everything was priced to perfection," said Robert Grimm of JGiordano Securities Group. "That is difficult to sustain."

In fact, the perfect-priced market was hard to maintain. More names, especially those linked to LBOs, started showing up on the distressed radar - some not long after their original bond deals went through.

However, default rates remained at record lows, giving distressed players few new ideas.

But with 2008 on the horizon, the possibility of a recession looms - which could have a positive effect in the distressed arena.

The upside to a recession for distressed investors is an increased default rate, which might help to correct the market.

True, the market was expecting 2007 to be the year where defaults gained ground, but the economy at that time was in a period of growth and prosperity. As the year wound down, however, the economy began to crumble, priming 2008 for an influx of defaults.

Adding to the pressure on credit quality, more turmoil in the housing and financial sectors is anticipated in the months ahead - though some expect conditions to stabilize toward the latter part of the year.

Still, Grimm expects that 2008 will bring a continuation of what began in 2007: hesitant investors who have developed a more passive wait-and-see train of thought.

With that, the junk market will be looking to certain sectors, particularly housing, financial and retail/restaurant/entertainment, to see where the ax will fall.

2007: A tale of woe

The past year might have started off solid, but it ended with its proverbial tail between its legs.

The beginning of 2007 began with money freely flowing in all directions. Deals were getting done left and right - some with negative consequences.

One of the biggest negatives in the distressed arena was the onslaught of LBOs. Looking back, many market players agree that a good portion of those transactions should never have been done in the first place.

"The LBO, from the first, cooked everybody," one unnamed trader said. "I can't stand the LBO business. It was stupid [to do in the first place], but the market was willing to do it."

"There were too many bad deals," said Grimm. Now, he added, the market is paying for them.

In addition to the "bad deals," the housing sector took a turn for the worse. Housing prices, which had hit record levels, started to decline as buyers began to back away. A glut of inventory - and no way to unload it - put homebuilders on the ropes.

But both of those issues could have been considered positive for distressed debt players, had it not been for the subprime mortgage meltdown that occurred in the summer. The uncertainty took hold and investors all but backed away from the distressed arena, unwilling to take any risk.

Housing foreclosures began to climb, hitting levels never before seen. That stress took its toll on the broader market - along with the housing sector, other cyclical industries, such as retailers, also began to flounder - but no one was prepared for the pressure it put on the financial sector.

"I think it took everyone by surprise," said Garry Hindes, a portfolio manager at Deltec Assets. He said that while some people were talking about the subprime problem, it was only part of the larger issue.

"What people did not see was the extensive, excessive leverage that was put on," he said. When portfolios are leveraged 15 to 1, "that's when people get wiped out," he said.

Another problem that took the financial sector by surprise was the bank SIVs - structured investment vehicles.

"I had never heard of this before," Hindes said.

But several major banks set up these programs, using them to borrow short and lend long by issuing commercial paper and investing in other securities.

"There are two cardinal rules that you don't have to go to Harvard business school to learn," Hindes said. "Number one, if you are leveraged 15 to 1, it is going to blow up in your face. Number two, you don't borrow short and lend long."

"None of this is rocket science," he added.

And, as financial institutions started to pile on the losses, it seems that he was right.

Troubles spread

The turmoil in the financial sector leaked out into the general market as well. Struggling companies looking to get any type of financing were either slapped with more stringent deal terms, or were unable to find the cash altogether. With that, investors - some who were already trying to sort out what all of this meant - became even more hesitant to jump in to anything.

And the housing troubles also began to show signs of spreading to the broader economy.

This was seen clearly in the retail/restaurant/entertainment sector, which depends heavily on consumer spending. But as worries of a recession loomed, consumer spending started to weaken, causing an already troubled industry to struggle even more.

"Clearly retailers are under stress," said Diane Vazza, managing director global fixed income research at Standard & Poor's. "We are being couponed to death, or pre-discounted to death. You never saw that before," she said - especially before the holiday season.

For the distressed market all those problems had added on top the historically low default rates - as of November, the default rate had hit an all-time record low of 0.98%, with just 14 defaults in the year - and 2007 was a year for the record books.

"The distressed inventory has been delayed," Vazza said. "We had expected to see a build up of [default rates] in 2007."

"This was the worst year since 1990," Hindes said. "Every 15 to 20 years, you get one of these years."

But Grimm was slightly more optimistic.

"I think what we started to see is some of the correction that I have been looking for in the market," he said.

More uncertainty in 2008?

Junk market players have been varied on their predictions for 2008, but there is one thing they can agree on: it will be a better year than 2007.

Troubles in the housing sector, along with the financial market, are not expected to ease up - at least not right away. But investors could begin to get more involved.

"Time heals all wounds," Hindes said, opining that investor uncertainty will dissipate in 2008.

The influx of private equity firms swooping in to save the day that was seen in 2007 will likely not repeat in 2008, as cash flows continue to be tight.

"You may see some [private equity deals] on an isolated level," Vazza speculated, adding that the deals will be better evaluated than they were in 2007.

"It is a much more sound evaluation game now," she said.

And the recession risk and continued declines in consumer spending are likely to give the default rate a boost in 2008.

"There is a 50/50 shot of a recession," Grimm noted. With that, he expects "big upticks in defaults" - even without a recession.

"2008 will be much more tied into the economy," Grimm said. "People are more aware because we are at a stretch point. A lot of credits are hanging by a thread."

All of these things could signal better times in the distressed market - if investors can shake off their risk aversion.

Default, default, default

Like 2007, default rates are expected to climb in 2008. But given the current market conditions, this time the prediction seems more likely to come true.

According to Vazza, Standard & Poor's is forecasting a 3.4% baseline default rate through the third quarter. However, for this to occur, 56 companies would need to default by that time.

There is also a "worst case scenario" rate of 4.4% - which is still under the long-term average of 4.5% - where 74 companies would need to default by the third quarter.

"Currently, in the U.S. right now, there are 71 companies that are 'weakest links'," Vazza said. All of those companies would need to miss payments in order to push the default figures close to the worst-case prediction. "You would have to have a recession scenario for that to occur."

There is also a best-case scenario rate of 2.3%, of just 39 defaults.

"In any of these scenarios, we are looking up from where we are right now," she added.

"The reality is there is a ton of potential companies that are in danger," Grimm said. While there are some all ready on the radar, Grimm speculated that there will "maybe be some from left field that we didn't expect."

The financial sector and the general market

"The market fell off a cliff in July [2007]," Vazza said, propelled by a subprime mortgage meltdown that infected the financial sector at large.

"It might have caught some people off guard," she continued.

The turbulence caused by the rockiness in the sector will continue to influence thinking into the New Year.

"A lot of concern remains. Certainly there is a headline risk," Vazza added,

And as the sector remains opaque, as Vazza puts it, "more transparency" is needed to alleviate the uncertainty.

"I don't think we have seen the end of that," Grimm notes. He speculated that there are "more losses to come," some that have not previously been disclosed.

But the Bush administration's mortgage bailout plan and continued rate cuts from the Federal Reserve could help the situation in 2008.

"There is a lot of hope that the bailout plan will help the housing market," Grimm said. While he personally does not see the connection, "people are trying to hang their hat on something."

And even as the market was generally dissatisfied with the Fed's end-of-year cut - a quarter point instead of the anticipated half - most do not see that as the end of the central bank's involvement.

"We are clearly heading into additional rate cuts," Vazza said.

"It probably should have been more," Hindes said of the most recent decrease. But he agrees that there will more cuts to come.

In the end, Hindes sees a lessening of the turmoil in the sector.

"We have seen the worst, but there is more to come," he said. He added that the overall situation, in a way, has been somewhat optimistic. Instead of banks failing, as was seen in the savings and loan crisis, there has been incoming capital to help stave off a total meltdown.

And while the credit crunch has affected outside sectors as well - companies like Delphi Corp. and Dura Automotive Systems Inc. had to delay their emergence from bankruptcy because they could not arrange exit financing on acceptable terms - freeing up the credit market will not only inspire investor confidence, but also allow companies to find financing.

Hope for homebuilders

The housing industry - and anything related to the sector, such as forest products - will continue to see some strife, at least through the end of 2008.

"Builders are on the ropes," Grimm said.

"We are not close to the bottom," he added. "There is more room on the downside as far as prices go.

"It's going to take a substantial amount of time before we hit bottom. Maybe the end of [2008]."

However, "it could very well be pushed out to 2009 or later," he said.

In new construction, Hindes said price levels should level out "probably [in 2008]," giving homebuilders a chance to clear out their inventory.

Recently restructuring specialists Alvarez & Marsal set up a homebuilders advisory group, and the heads of that area said they believe few builders are safe from the troubles facing the industry. They saw the second quarter of 2008 at key in forecasting the sector's future.

Consumer spending and the cyclical company

Pressure will continue on the retail/restaurant/entertainment sector through 2008, as consumers further cut back discretionary spending.

"We think consumer spending will decline into 2008," Vazza said, adding that rising oil prices will play a significant role, especially in colder climates.

"There's a strain out there," she said.

"In terms of credit, you have a high proportion of speculative grade ratings [in the retail/restaurant/entertainment sector]," Vazza said. Currently, over 80% of companies in that sector are speculative-grade rated.

According to Grimm, the cyclical sectors will be the most vulnerable in 2008.

"If we do see a worsening of the economy, those companies are going to be in real trouble," he said.

For example, a company like Linens n' Things, which has already been struggling to keep its head above water, could see even worse numbers than it did in 2007.

"The reality is their business has been troubled," Grimm said. Given that most - if not all - retailers are so dependent on the holiday shopping season, "if they have a bad Christmas, where do they go from there?"

Linens is one of several retailers that got involved in the LBO blowout. That company's deal is just over a year old - and its bonds are currently quoted in the low- to mid-50s.

But with consumers tightening their belts, Grimm adds that it not so much that they stop spending as much as they change where they spend. Discretionary spending will decrease, but spending on staple items will stay the same - sort of.

"You always need to buy stuff for the kids," he explains. "But instead of going to specialty stores, you go to stores like Target and Wal-Mart.

"[Consumers] don't stop spending per se. They just change their spending habits," he said.

And Grimm believes that the fundamental change in spending has all ready started to happen.

"Look at sales of specialty retailers," he said. "Their overall sales numbers are good, but it is being spent in different places."

Advice for 2008: Tread lightly

Going in to 2008, market players are hoping for increased default rates and a more free credit market to spur activity.

One trader, however, advises investors to "hold onto their cash.

"Find things you like with backbone - not poisonous stingers," he said.

He encourages investors to "buy very slowly.

"It's just going to be mayhem for a while," he said.

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