Why I'm Keeping an Eye on Corporate Defaults

All eyes are on the recession these days, and rightly so. I'm definitely watching it closely...and I'll be the first to admit that I want this thing over and done with and behind us for good. However, the realist in me knows that a problem that took 25-30 years to create probably isn't going to be solved in a year or two. This is why I try to not get caught up in the daily headlines. For the most part, the media's point-of-view is extremely myopic, but it has to be because the public wants an answer for why the market moves on a daily basis. We know that fundamentals don't really change on a daily basis. However, that doesn't satisfy us. We need to know why the Dow was up or down 100 points today. So the media feeds us an answer everyday...and lately its been the same one. If the market is up...recession fears are easing...if the market is down...recession fears are growing...

Thanks for the insight!

If you really want to track this recession, you have to look deeper than the headlines. One of the indicators that I am currently following to track this recession is the Corporate Default Rate. Since this debacle was created by the great debt explosion (public, private, and consumer) over the past 25-30 years, wouldn't it make sense to track the deleveraging process?

High-yield bond defaults increased significantly in the first quarter of 2009 to $39.5 billion, resulting in a default rate of 3.65%. The first-quarter rate is the highest quarterly rate since the third quarter of 2002. According to NYU Salomon Center, the US and Canadian dollar-denominated default rate for the last 12 months rose to 7.98% from 4.65% at the end of 2008.

As you can see from the graph above, the current four-quarter moving average default rate (~8.0%) is nowhere near the peak of the past two recessions (13-15%). And taking into account the reckless lending standards of 2006 and 2007, I think default rates could peak out around 20% this time around. Which means we are still only in the 3rd or 4th inning of this game...

The bottom line is that I'm not falling for this "recession is over" nonsense until I know the final score of the corporate default game...which probably won't be for a few more years. I'll make sure to keep you posted...

Disclosure: Long GLD, SDS

Comments

[Mr. Yukos:]

You are wise with your comments about the media saying those exact quotes. It never fails - especially on Yahoo's homepage. I recently read some startling pieces of data in one of my Capital Economics reports: Over the last ten years, the US consumer has piled on $3.4T in debt. If we consistently save at the annualized rate of April's 5.7%, throughout the year, spending every cent of that to pay down debt, it will take us 6 years to deleverage. If our saving rate increases another 2%, to say, 8%, it will take us 4 years.

The beat down equity and crude oil markets were ready for a small rebound, but I believe long term players (who probably aren't even back into the market) are forgetting some things. Even when the unemployment rate starts to decrease and GDP starts to increase, we STILL have to deleverage. A similar idea can be addressed in housing: Even when consumers have the money to spend on real estate and go back into the market, prices will see another jolt down because of the inventory and negotiating power of buyers.

Jun 26 08:40 AM

[Relative Le...:]

Mr. Yukos - Great stats on the savings and deleveraging process. In reality we might use a quarter of our savings to pay down debt...which means we will delever in about 24 years! That's assuming we don't add any new debt (yeah, right!)...

Here's another stat for you. Okun's law suggests that a 1% improvement or decline in GDP corresponds to a 0.4% decrease or increase in unemployment. According to JPMorgan, if unemployment peaks at 11%, it would take 20 quarters of 5.0% growth to return to a 6% unemployment rate.

Jun 26 10:03 AM

[ozzy43:]

I think the author is overly optimistic. The 'problem' didn't take 25-30 years - it's taken almost 100. Fiat currency and fractional reserve banking began a lot longer than a couple of decades ago. Since 1913 (and central banking as we know it didn't really come together as a consolidated whole in this country until FDR in the 30s), the dollar has lost 95% of its purchasing power. We grew up in this era, and take it for 'normal' - it's not. Current policies cannot but accelerate that ongoing loss. The difference between 'nominal' and 'real' will inevitably become apparent, and sooner rather than latter, it seems likely.

This is not a recession, cooked government figures notwithstanding. It's a depression. A fundamental restructuring of the economy is underway, masked by government bailouts of zombie companies and cooked up figures for economic indicators on all fronts. But the toxicity remains. The 'real' unemployment rate is north of 15% already - what's the 'real' GDP? The 'real' inflation rate? Who knows? I do know it is far, far worse than these metrics reveal - and that this is not an accident.

So does it really tell us anything to look at corporate defaults when you have so many sectors being artificially propped up by so many market-distorting forces? I don't know, but I think, like so many other metrics that would yield useful information in a free market, the answers from reading such tea leaves are likely to mislead.

Jun 26 11:33 AM

[Relative Le...:]

Great comment, ozzy43. I can't tell you the last time someone called me optimistic about the economy... :)

I agree that this "problem" began much longer ago, however, the velocity of the problem has increased exponentially since the U.S. abandoned the gold standard in the early 70's....this is when the fiat currency really got out of control.

Also, I agree with you 100% that the government has "cooked" all of the key metrics. Which is why I think the only metrics that matter right now are the ones that track the deleveraging process (e.g., corporate defaults, mortgage defaults, credit card defaults, etc.). I realize that defaulting isn't the only method of delevering, but let's be honest, even an optimist would have a tough time convincing himself that the "pay down" method is even a remote possibility.

I suppose that the government can try to inflate these debts away (which I am sure they will try eventually), but that is an entirely different conversation all together...

Thanks again for the comment, good stuff.

Jun 26 12:48 PM

[user396040:]

I agree that the corporate default rate is a very important metric. I am not sure exactly how these percentages are calculated and what counts as a "default" (is a covenant breach counted as a default even though the debt continues to be service?). Publicly traded corporations entered this downturn with relatively strong balance sheets. On the other hand, many companies that had been taken "private" with LBOs, etc., were loaded up with debt. I review the Yahoo bond screener periodically to identify corporate debt with a YTM of more than 12% and the list is always loaded with companies which have been taken private.

Jun 26 01:07 PM

[Barry Robbins:]

If you are interested in investing in Gold, you might want to look at CEF or GTU, which both hold physical gold. Some of the Gold investors I have read recently have expressed doubts about GLD, and whether GLD actually has the assets it claims, or just claims on those assets.

Jun 26 04:17 PM

[Relative Le...:]

I hear you, Barry. There are alot of rumors floating around about physical Gold.

Check out this article...there are rumors circulating that COMEX may not have the physical inventory that they are reporting they do...

www.huffingtonpost.com...

Jun 26 04:47 PM

[Gregman2:]

Very nice work. The past two recessions...weren't they for the most part inventory recessions? If we look at the detailed nature of those past recessions--and those companies that did default, is it a true apples to apples with this downturn? In some respect, isn't this downturn more related to the Asian meltdown of '97 than to the prior two recessions you note?

Jun 27 11:14 AM

[BrentB:]

The numbers on increased debt are way low - they might be just the increase in credit card debt. The total of all residential mortgages in the US went from about $7 trillion in 2000 to over $14 trillion in 2008 - wikipedia. All that money bought bigscreen TVs and iPhones. Essentials, I know, but the money is gone and the houses have lost 30% of their value.

The consumers won't be back big time for many years. Only the banks that can fiddle their debt portfolios will be making any money, assuming something prevents foreclosures from snowballing.

Jun 27 03:40 PM