This note is by guest author Suresh Sankaran of Kamakura Corporation.
The objective of this note is to showcase how the Kamakura Risk Information Services ("KRIS") default probabilities subscription service assists users to manage exposure entry and exit based on Kamakura Default Probability ("KDP") movements.
On September 29, 2016, the five firms bidding to rescue Japan's ailing Takata Corporation (NIKKEI: 7312.t) ("Takata") recommended that Takata file for bankruptcy protection as a necessary first step in their restructuring plans. Takata faces huge costs related to the global recall of millions of potentially faulty air bag inflators, and it is seeking an outside white knight. The company received proposals from five bidders in the week of September 22, 2016. Reuters reported on that day that
"Filing for bankruptcy protection is Takata's only option to retain the bidders' interest because a filing will reveal the extent of its liabilities, one of the people involved in the restructuring proposals said. Takata faces about 1 trillion yen ($10 billion) in recall costs, according to market estimates. There is also the prospect of legal liabilities related to the inflators, which can explode with too much force and which have been linked to at least 15 deaths, mainly in the United States. It is therefore, understandable that any potential white knights would want to reset Takata's 1 trillion yen in debt through bankruptcy."
The default probabilities produced by the KRIS service include both the best practice reduced form default probabilities and the older and less accurate Merton model default probabilities. In this note, we use the KRIS version 6.0 reduced form default probabilities, the newest and most accurate model in the KRIS default models framework.
The chart below shows the history of the 1-month (in red), 1-year (in blue), 5-year (in orange), and 10-year (in green) default probabilities for Takata:
In Kamakura Corporation's popular troubled company index, a firm is considered "troubled" if its default probability exceeds one percent. The graph above shows that the 1-year default probability of Takata exceeded 15.00% in July 2016, consequent to the airbag recall story hitting the news. However, it is illuminating to note that a full 10 months before this event, Takata was showing a deterioration in its creditworthiness, starting September 2015, where all four term structure points on the default curve moved up from 2-3% to well over 6%. For a fixed income investor, this is tremendous early warning, and highlights exit options well before a default event. This makes for particularly interesting reading in conjunction with the airbags recall event, as it is evident that even before the troubling news on the airbags were aired, the organization was in troubled waters. While the recall story outlined a specific problem with the company, the Kamakura Default Probabilities showcased the increasing risk on account of the changing market landscape. It is debatable whether the organization would have had such a surge in its default probabilities had it not been for the unfortunate news relating to its airbags, but it cannot be disputed that Takata's troubles pre-dated this problem.
Another important metric in KRIS is the cumulative default probability for the issuer. On September 30, 2015, the cumulative 10-year default probability for Takata was a high 3%. This metric was a warning signal provided by KRIS a full twelve months before its troubles.
A third analytic in the KRIS portfolio of outputs is the impact of macro factors on the company's creditworthiness, and this represents a statistical relationship between key risk and macro factors and the performance of the company. It can be clearly seen from the graph below that the macroeconomic factors influencing Japan plays a major role in explaining the probability of default movements of Takata, and has an accuracy of close to 92%. Furthermore, it can be seen clearly from the graphic that both oil prices and the USD JPY exchange rates are negatively correlated with the probability of default.
Another indicator that is very valuable as an early warning signal is a comparison to the industry peer group, which in the case of Takata is the autos & components peer group. It can be seen clearly in the graph below that Takata's one-year default probability moved to well above the median, and indeed higher than 2 standard deviations above the median, in late 2015. This is another warning, more than a year before default, to exit from any holdings of Takata.
Postscript: Consequent to the first version of this blog post on 3 October 2016, it has been reported that Takata hired law firm Weil Gotshal & Manges LLP to help it weigh options that could include bankruptcy or a sale, according to people with knowledge of the matter. The Japanese manufacturer might choose to seek court protection just for its U.S. unit, but nothing has been finalized yet.
Furthermore, it has been reported that Takata pleaded guilty on February 27, 2017 to a criminal charge on the airbag scandal, and has agreed to pay U.S. dollar 1 billion in restitution. This guilty plea sets the stage for the sale of the beleaguered airbag maker.
As early warning indicators go, it does not get any clearer than this, where a full 6 months before this predicament came to pass, information in KRIS clearly outlined an exit strategy.
The KRIS default probability models are benchmarked on more than two million observations of firms of all types. The total number of defaults used in the current version 6.0 models is more than 2,600. The unparalleled volume of data and the research insights of Kamakura's Managing Director Prof. Robert Jarrow make the KRIS default probability service the most accurate early warning credit risk assessment indicator framework available. That is one of the reasons why Credit Magazine named both KRIS and the Kamakura Risk Manager Software package "Innovations of the Year". For more information about KRIS default probabilities, please contact your Kamakura representative or e-mail Kamakura's credit experts at info@KamakuraCo.com.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.