Outlook 2009: Year to bring more corporate defaults, more distressed opportunities

By Stephanie N. Rotondo

Portland, Ore., Dec. 31 - The distressed bond market got off to a rocky start in 2008 - and, by all accounts, 2009 is not looking much better.

Going into 2008, the market was grappling with the subprime mortgage blowout of 2007 and what it meant for the market as a whole. Troubles in the financial sector were just starting to gain momentum and retail and home sales had begun to decline.

As recessionary pressures continued to weigh heavily, the fallout was broader than expected. Seemingly stable financial institutions crumbled, retailers and homebuilders began filing for bankruptcy left and right and the automotive sector seemed doomed. Even casinos, historically considered "recession-proof," began buckling under the weight.

At the end of 2007, default rates were at all-time lows. By the end of November 2008, that number had more than tripled and was expected to increase three-fold again in 2009.

With the market in turmoil, the U.S. government stepped in, taking measures to ensure economic stability. But its efforts were ultimately seen as focused only on symptoms, and failing to cure the problem. As a result, consumer confidence - a key indicator of economic health - tanked. Investors, having already lost a good portion of their portfolio, shied away from the distressed world, even as opportunities in that area increased dramatically.

Looking to 2009, the questions on everyone's minds are "Where is the bottom?" and "Will there be some sort of recovery in 2009?" But so far, the answers to those questions are elusive.

"I think folks are going to be happy to turn the page on this year," said an analyst, who asked not to be named.

What went wrong?

The financial instability of 2007 continued well into 2008. As a result, everyone - including consumers, investors and even banks and other credit providers - began tightening their belts.

"That really infiltrated access to credit and capital markets," said Diane Vazza, managing director and head of global fixed-income research at Standard & Poor's. "Particularly for companies that are the lowest rated. Those companies are vulnerable. They were already highly leveraged."

As of December 2007, the default rate was at a record low of 0.97%, according to Vazza. Nearly a year later, the default rate jumped to 3.2%.

"We're going through a year like we've never seen before," said Neal Schweitzer, senior vice president of Moody's Investors Service and an expert in bank loans. "So a lot of the benchmarks used to define a distressed company are less than useful and may be misleading."

Certainly, many companies that were considered distressed in 2007 were even more firmly planted in that arena in 2008. But then companies not even on the radar, such as Washington Mutual Inc. or Pilgrim's Pride Corp., took up camp in that world.

With financial instability came a sharp decline in consumer confidence. Retailers, homebuilders and automakers began to rack up losses and consumer spending decreased. In turn, anything remotely connected to those sectors - trucking companies, building product manufacturers and automotive parts suppliers - suffered as well.

"We are in a consumer-led recession," Schweitzer explained. "And by definition, that is very difficult to control."

Take, for example, the $700 billion bailout for financial institutions. "It is hard to get your mind wrapped around that as a consumer," Schweitzer said.

Still, the government's attempts to "regain control or assert some sort of stability" continued. As such, Wall Street began looking to Main Street for the answers.

"We have been watching Washington, D.C., for the last three to four months," said an analyst who asked not to be identified. "Funds and analysts and brokerage houses are all taking their cues from what is going on in D.C."

Unfortunately, just as consumers are unable to comprehend what all the bailouts meant for them, market players also realized the government might not be able to provide those answers.

"You can't always count on the government to act rationally in regards to financial stuff," the analyst said.

Default rates and the absence of private equity

Coming out of 2007, default rates were at record lows. Through the year that followed, the market indicator began to show marked increases. But S&P and Moody's see that rate increasing even further into 2009.

S&P has forecast a default rate of 7.6% through September 2009, while Moody's sees the rate moving up to 10.6% though November - up from a November 2008 rate of 3.1%

"In medical terms, the default cycle in not acute but chronic," said Schweitzer, speculating that the current cycle could be a "long drawn out bloodletting."

Schweitzer adds that it is important to consider what the shape of the default curve will look like. Typically, the default curve will peak and then drop.

"We might not see a peak and quick drop off," he opined. "We might see a prolongation of defaults over a longer period of time." This, he said, will have a "significant draining impact on the economy and consumer confidence."

"Default rates have been artificially low for three years now because private equity firms were stepping in before covenants kicked in and put companies into Chapter 11," said a distressed trader. "Now that the private equity firms have to deleverage, we will indeed see a large increase in filings."

Private equity players were big through 2007. Come 2008, there was little to no involvement from that area. According to market sources, there will be even less in 2009.

More filings, more opportunities

But the news is not all bad. More bankruptcy filings mean more opportunities for distressed investors.

"I expect a lot of new players to the arena," a trader said. "I think distressed will be the 'it' place to invest in 2009 and 2010.

"I would say it is very safe to say that everyone will enter the [distressed] market," he continued. "The only new funds coming to market now have been 'distressed' funds. Like everything else there will be a huge disconnect between the true practitioners and the coattail funds. Either way, it will be a free for all for 2009 and the start of 2010."

"There should be decent activity in January," said an analyst. "A lot of folks took a fairly extended vacation in the second half of [2008]."

"Most institutional investors told me in late September, 'I'm done, I'm out of the market'," Schweitzer said. Having been burned several times over the last year, they chose instead to close out their books to avoid losing more value.

Still, the prospects in distressed remain positive.

"Versus a year ago, there are better risk-reward opportunities," the analyst said. "Some of the smarter funds are getting back into buyer mode."

But evaluating the risk versus value in the current market is the tricky part, opined Moody's Schweitzer.

"A lot of things need to be evaluated to determine value versus risk," he said. "There are more moving parts now than we have ever had."

One of the biggest factors, he said, was companies' "exposure to the degree of spending pullback." That is, how consumer confidence would affect a company's livelihood.

The role of consumer confidence

As of November 2008, the Conference Board Consumer Confidence Index had improved slightly from its 38.8 all-time low in October to 44.9. The Expectations Index also improved to 46.7 from 35.7 the month before. However, the Present Situation Index continued to decline, falling to 42.2 from 43.5.

"The persistent declines in the Present Situation Index suggest that the economy has weakened further in the final months of this year," said Lynn Franco, the Board's director, in a press release. "Inflation expectations, which have been at historically high levels in recent months, subsided considerably as a result of falling gas prices. But, despite the improvement in the Expectations Index this month, consumers remain extremely pessimistic and the possibility that economic growth will improve in the first half of 2009 remains highly unlikely."

"We have a classically different environment in which central authorities have trouble fine-tuning or discerning likely outcomes," said Schweitzer. "If consumers aren't spending, the next shoe to drop will be levered corporate defaults.

"Right now, it's clear that those purses are increasingly closed," he continued. "People just have a lack of confidence in what they are being told."

"A lot of stuff is going on right now and it is very difficult to know how to place your bets," said an analyst. "You never know where the sky is falling next."

That said, once consumer confidence picks up, or at least the "issues are defined," he added, there could be some positive momentum, though the worst will not be over.

"But that doesn't happen until inauguration day, at least," he predicted.

Sectors to watch

Much like the beginning of 2008, the sectors to watch remain anything even remotely connected to consumers, like retailers, autos, homebuilders and the like. But market players also expect second-tier financials to continue to play a role.

In the case of the automotive sector, the market will continue to keep an eye on the Big Three and their parts suppliers as the questions surrounding the Detroit automakers' fate persist.

"Automakers have asked for $34 billion in bridge loans," said an analyst. "But what is it a bridge to?

"This won't be the last time they are on the Hill," he added.

The Big Three tried in vain to get lawmakers to approve some form of a bailout plan - the companies were originally seeking $25 billion, which was then inflated to $34 billion, though the final bill that went through Congress called for only $14 billion. Even as the Treasury Department said it was willing to step up to help out, time was quickly running out for General Motors Corp. and Chrysler LLC. Eventually a $17.4 billion rescue was put together.

The picture for the sector was definitely grim toward the end of 2008 and Fitch Ratings does not see how 2009 will be much better.

"The combination of a deepening U.S. recession and the effects of the credit crisis are expected to produce a further decline in 2009 automotive industry sales volumes from already-depressed 2008 levels," the agency said in a statement published in early December. "Fitch Ratings projects that industry sales volumes will decline approximately 10.7% in 2009 to 11.6 million light vehicles, from an estimated 13 million units in 2008.

"Although it appears that temporary government aid will be forthcoming for the Detroit Three, there remains much uncertainty regarding the amount, structure, timing and other terms of this assistance."

Furthermore, should the auto makers tank, they will bring down with them the parts suppliers - several of which exited bankruptcy in late-2007 and early-2008. Delphi Corp., which planned to exit bankruptcy in the first half of 2008, is still waiting to emerge from under Chapter 11 protection.

Retail, financials facing challenges

But the auto arena is not the only industry facing another year of struggles.

"Any retail company is up against the wall because they are just trying to maintain and get through," said Schweitzer, pointing to another area of interest.

According to S&P's Vazza, the standout sectors will be anything consumer discretionary and cyclical.

"It will be mostly negative in terms of credit quality," she said.

But the most pervasive, at least in Vazza's opinion, will be the financial sector.

"It is unprecedented in terms of the depth and pervasiveness of it," she said of the troubles in the financial arena.

"There is going to be more consolidation there," said an analyst. "Maybe at the insurance level, maybe banks. Goldman [Sachs] will be swallowed by someone. The question is who?"

The analyst noted that it will be important to watch how banks use TARP funds.

"Will they use it on mergers?" he asked. "Or will they put it back into the economy as promised?"

As for the latter, the analyst noted that banks have yet to open up the credit lines as they deal with liquidity and asset value concerns.

How the government factors in

The U.S. government spent a good portion of 2008 trying to figure out how to put a stopper in the recession. The Federal Reserve cut interest rates several times over the year and the government has funded numerous bailouts, on top of the $700 billion financial market rescue fund.

But given that many believe the current economic conditions are unprecedented, some wonder if the government's involvement in the crisis was really a good idea.

"In no way should government have any involvement in a capitalist system," said a trader. "And true markets should be left to fend for themselves.

"But clearly America is no longer a capitalist society and the next six months will greatly resemble a cross between socialism and communism," he continued. "We have already greatly undermined the entire financial system by doing sporadic and partial interventions. The problem now is we are too far in to stop and not anywhere close enough to justify keeping going."

Though 2009, the trader speculates that the government will continue to pump more money into the system - which an analyst says is an attempt to stop deflation, at the expense of possible inflation. He also foresees more stimulus packages in 2009.

"And when all else fails, buy (read nationalize) the failing industries that are deemed too important to fail," he added.

Still, others are looking to president-elect Barack Obama's inauguration on Jan. 20 as a key moment in terms of the economy's future.

"We are getting a sense of what [the Obama] Administration is going to do, but he is not putting his policies out there just yet," said an analyst, pointing to Obama's efforts not to usurp power from the current president. "His policies are going to become more important and the change of power will have more impact than folks anticipate."

But not everyone agrees.

"The inauguration is more symbolic," said Vazza. "We have already seen the president-elect get involved and make appointments."

Policy initiatives are also already in place, which, to Vazza, is the important part.

"To me, it's more the policy initiatives," she said. "I think that these interventions are coming at the problem from all kinds of different ways."

And, she adds, the "interventions" will continue through 2009 and will be seen as a positive move for the economy.

Recovery and the distressed investor

Market players see the economy recovering some in 2009, but many are quick to point out that recovery will not be a fast process.

When asked if he saw a bottom in 2009, Schweitzer replied simply, "I hope so."

"We are faced with a new set of factors," he explained. "And the severity of these factors when combined, we don't have a blueprint for this.

"I think the answer is going to be that institutional investors and credit providers will be a reasonably good indicator," he added, pointing to their "re-entrance" in the market.

"We need renewed confidence, in a substantive way, across the board," he said. "That will indicate a return of confidence in the fundamentals of the marketplace."

Currently, market players have relied on both the fundamentals of the market and the technicals, an analyst explained. But as both of those factors have been hurt - redemptions and liquidations in the market have skewed those benchmarks - they have proven unreliable indicators. Still, the analyst expects that at least the fundamental side of things should clear up in the next few quarters, giving "better clarity on the economy."

"Distressed investors need to know where the entry point is and if there is value," said S&P's Vazza. So far, would-be investors have felt that it was too early to jump in the game, she noted.

What investors need to consider, she said, is a company's overall credit status. In doing your "credit homework," investors can find the distressed opportunities in companies where potential value outweighs the risk.

"Eventually, good companies will get access to credit," said an analyst - though he warned it would not be "the level of access we have seen over the last five years."

The analyst points to the "good company/bad balance sheet" model, which he believes has been "missing for years."

"Most distressed companies have been frauds or other types of bad companies with bad balance sheets," he said, citing cases such as Enron or Le-Nature's. Over the next year or so, however, he sees so-called "good companies" being forced into Chapter 11 - and that's where distressed investors should take advantage.

Moving forward

The last year was anything but good for the distressed arena, at least in the sense that investors were too concerned with risk versus value. But 2009 is expected to bring more distressed opportunities, some of which might be worth the risk involved.

"The pendulum now may have swung so far where there is more reward than risk," an analyst said. "There are a lot of places in this market where folks are running for the hills and that creates opportunity."

"We have all heard the prognosticators calling for a tripling of the default levels a year out from now," Schweitzer said. "Once we begin to see that, the question has to be asked: 'What happens to market prices, to credit supply?'"

When the "second shoe drops" - that is, a significant rise in corporate defaults - Schweitzer believes it will be "frightening" to see what impact there will be on already "significantly depressed security prices."

"Then we are all going to take a powder and go to Argentina," he quipped.

Others say that the collapse of several hedge funds - not to mention the closing of a few distressed desks - has resulted in a change of power. That is, the sellside is now in control.

"The sellside has the ball, to some degree," a trader said. As hedge funds exited the market, "momentum traders" entered, and they are the ones "willing to ride it out."

In the end, 2009 might be somewhat better than 2008, but it might be beyond that when the market finally stabilizes.

"I think 2009 will be better than 2008," a trader said. "But I think 2010 will be absolutely huge in our business."

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