Losing by Default

After the immeasurable human tragedy triggered by the attack in lower Manhattan on Tuesday, September 11, a lot of corporate managers and investors asked the question: What will the rest of the year bring? After all, there was still three and a half months left to the annum. Knowing that it would have to digest anywhere from US$15/$100 billion or more in claims from the terrorist attack, the insurance industry also worried about such things as hurricane season, which was far from over, plus the Euro-winter storm season, and asbestos liabilities.

Airlines, banks and the tourism industry, among many others, worried about a further downturn in their respective segments — areas that were not doing very well even before September 11. And all worried about the continuing downturn in the equity markets (the TSE 300 closed September down 560.66 points from August, the Nasdaq closed down 306.6 and the DJIA closed down 1102.2).

True to their collective fears, the hits came — once, twice, three times, four times — but not from where most had feared: “Enron Corp. Files Largest U.S. Claim for Bankruptcy,” from The New York Times – December 3, 2001; “Argentina Defaults,” from The New York Times – December 30, 2002; “Kmart Files Bankruptcy, Largest Ever For a Retailer,” in The New York Times – January 23, 2002; and “Global Crossing Files for Bankruptcy,” published in The Washington Post – January 28, 2002.

According to Standard & Poor’s, January 14 last year was the worst ever for corporate failures, as 211 companies worldwide defaulted on US$115.4 billion of debt. Both totals are records. (The old records were set in 2000, when 132 issuers defaulted on US$42.3 billion of debt.)

The default rate for “speculative-grade,” or junk-rated, issuers surged to 8.57% last year from 5.68% in 2000, the highest since the 10.87% record set in 1991. About 4% of all issuers — including those with “investment-grade” ratings — defaulted in 2001, matching the record set in 1991. Along with Enron, some of the other more high profile failures in 2001 included Converse Inc., Sunbeam Corp., Polaroid, Pacific Gas & Electric, Southern California Edison, Bethlehem Steel, Finova, At Home Corp., and Burlington Industries. There were nine failures in Canada last year including Laidlaw, Dylex, Canada 3000, 360Networks, Algoma Steel, and Country Style.

S&P expects the U.S. economy to bottom in the first quarter of this year, and that the default rate should peak near 11% by the beginning of summer, before “trailing off” by yearend. To be sure, the agency reported January 31 that the trend was, indeed, continuing after a record amount of corporate debt fell into default the first month of 2002. A total of 41 companies defaulted on US$31.3 billion of rated bonds, led by Kmart Corp. and Global Crossing Ltd. This is only US$11 billion of the then-record total for all of 2000. And at the writing of this piece in mid-February, Kaiser Aluminum Corp. filed for Chapter 11 bankruptcy protection (February 12) and the financial press was reporting strong rumors that a few more major corporations were on the brink, including WorldCom, Tyco and the German media firm Kirch Group.

September 11

Prior to the terrorist attack, there were already signs of weakening in many economies worldwide. The event of September 11 simply helped push the weaker ones into the abyss.

Moody’s reported in late December that 9/11 contributed to ratings downgrades on at least US$143 billion in debt and is likely to have “farther reaching, though difficult to quantify, credit implications.” Of the 212 Moody’s downgrade announcements since September 11, “…some 58, or 27% cited the terrorist attacks, their aftermath and fears about further incidents,” according to Moody’s chief economist. “It would be wrong to simply conclude that without the terrorist attacks these downgrades wouldn’t have occurred,” he said. “But they exacerbated the downturn in U.S. corporate credit worth and made a bad situation worse.”

Enron

Houston-based Enron filed for Chapter 11 bankruptcy protection on December 2. In its filing, Enron listed about US$24.7 billion in assets and US$13.1 billion in debts. Though widely speculated and anticipated, the impact of the filing was still sharp and far-reaching. The values of tens of millions in equities and billions in bonds became uncertain, as did the 401 (k) retirement plans of Enron employees. Corporations around the world (and their shareholders) became uneasy, as many companies got “painted with the Enron brush”.

An A.M. Best report released on February 4 said that “Enron Corp. has hit the portfolios of several insurers, which reported investment exposures totaling more than US$3 billion. Best said that the life and health industry holds the bulk of the exposures, with about US$2.8 billion, while property and casualty insurers held just over US$600 million, as measured by market value (this figure does not include the potential for tens of millions worth of surety and D&O claims).

Canadian companies of all kinds found they were not immune to the collapse of Enron. According to The Toronto Star of February 6, a handful of Toronto-area companies, much of Calgary’s oil patch and several leading Canadian banks, are among the creditors listed in the Enron collapse — about 60 in total, The Star claims. Among them are the likes of CIBC, Bank of Montreal, Toronto Dominion Bank, Royal Bank of Canada, PanCanadian Energy Services, Petro-Canada Inc., TransAlta Corp., Union Gas Ltd., TransCanada PipeLines Ltd., BP Canada Energy Co., Husky Gas Marketing Inc., Canadian Hunter Exploration Ltd., Renaissance Energy Ltd., Talisman Energy Inc., Consumers Gas Co. Ltd., Dynegy Canada Inc., Miller Waste Systems, Atlantic Packaging Products Ltd., Open Text Corp., and Direct Energy Marketing Ltd.

Kmart

Kmart filed a voluntary Chapter 11 bankruptcy petition on January 22, and said it would consolidate operations and close unprofitable stores as it reels from approximately US$11 billion in debt. The retailer has set a target of July 31, 2003 for emerging from bankruptcy protection.

Like Enron, the spin-off effect from a company the size of Kmart filing Chapter 11 is usually quite substantial. Again, millions are in danger of being wiped off the valuations of the company’s equities and bonds. People lose their jobs, pensions and 401 (k) plans get hit and other companies, such as suppliers, begin to feel the pain. For example, the day Kmart filed for creditor protection, S&P’s placed its ratings on Fleming Cos. Inc. on CreditWatch with negative implications. Fleming has a US$4.5 billion 10-year supply agreement with Kmart Corp.

According to an A.M. Best report released February 11, “The life/health industry reported a market value of US$332.8 million in Kmart securities, including common and preferred stock and corporate bonds, while the p&c market reported US$52.4 million”.

Global crossing

Global Crossing filed for bankruptcy on January 28 in the fourth-largest corporate insolvency in U.S. history. The move wiped out over US$40 billion in shareholders’ equity. Global Crossing had piled up debts of US$12.4 billion, against assets of US$22.4 billion. The largest unsecured creditor is Charles Schwab Corp.’s U.S. Trust Corp., which holds US$3.8 billion in bond debt, according to court filings detailing Global Crossing’s 50 largest unsecured creditors. The second largest, J.P. Morgan Chase & Co., holds US$120 million in bond debt. Other creditors include Morgan Stanley, Aegon USA Management Inc., the Bank of New York Co. Inc., DuPont Capital Management, Hartford Investment Management Co., Nationwide Mutual Insurance Co., Northwestern Mutual Life Insurance Co., PPM America Inc., and Teachers Insurance and Annuity Association.

Other creditors include Lucent Technologies (owed US$31,357,050 according to Global Crossing, but owed US$123 million according to Lucent), Alcatel (US$31,056,980), Tycom US (US$29,160,213), SBC Communications (US$26,840,151), Verizon (US$23,963,607), Nortel Networks (US$13,802,224), Cincinnati Bell (US$13,357,868), Cisco Systems (US$12,6
26,693), and Level 3 Communications (US$10,112,149).

Argentina

Argentina formally defaulted on part of its massive US$141 billion public debt January 3 and set the stage for a devaluation of its currency on January 4. The country missed a payment of US$28 million due on an Italian lira bond January 3. The default was expected to shut it out from new foreign credit.

According to a S&P’s analyst January 16, “we believe that most of the banks in Argentina, if you were really to take a sharp pencil to them are, in an economic sense, pretty much insolvent.” Analyst Tanya Azarchs observes, “for instance, government bonds on banks’ balance-sheets are worth maybe 10 to 20 on the dollar. The banks are carrying them at par for ‘Argentine accounting purposes,’ but you know and I know they’re not worth that much.”

Credit quality

S&P’s default studies have found a clear correlation between credit quality and default remoteness: the higher the rating, the lower the probability of default, and vice versa. Lower ratings always correspond to higher default rates. Furthermore, the lower an obligor’s original rating, the shorter the time it normally takes to default (see Figure 1). For instance, the mean life of defaulting ‘B’ rated companies was 3.8 years for the period under study, while those rated ‘AA’ that defaulted did so within an average of 11.9 years from the initial rating.

Diversification

Whether it is an investment book for a large global institution, a business of any size, or an individual’s personal portfolio or pension, one of the cornerstones of successful investing is ‘diversification’ — otherwise known as “not putting all your eggs in one basket”.

Diversification protects against a downturn in any one geographic market, business sector or for any one company. It usually begins with spreading one’s risk over fixed income instruments and equities. Then, spreading the risk further within each of these two main segments, by purchasing various bond and equity offerings at different risk tolerance levels. This guards against economic downturns, regional disparities, catastrophe, political unrest, etc. Most of the companies with exposures to some or all of the above defaults hold a wide range of investments. And while they will take a hit on certain things, all-in-all, diversification will protect them against wide-ranging devastating losses. However, individuals whose entire 401 (k) plans were vested in one stock (such as Enron) will not fare as well.

Credit structuring

The question remains of what effect the record default rates recorded in 2001 will have on creditors’ ability to recover their investments if and when the issuers emerge from bankruptcy.

According to S&P’s, “from 1987-1999, the recovery rate stood at 53.3% and has been slightly lower since then at 51.6%. While this suggests that recovery rates are falling, this is only true of poorly structured debt. Standard & Poor’s research indicates that debt cushion and collateral are the two most important elements in achieving better recovery rates and that recovery rates are remaining strong (well above the overall average) for well-structured debt.” S&P’s says that well-structured paper with collateral and greater than 50% debt cushion achieves recovery rates about three times higher (at 91.3%) than the cohort of instruments that are not backed by collateral and have a debt cushion of less than 50%.

Conclusion, not the end

The firestorm surrounding Enron’s Chapter 11, coupled with controversy surrounding the failures of Kmart, Global Crossing and others, have served to draw immense attention towards corporate governance including: the vigilance of senior management, the roll of the auditor, the part played by the board, as well as the duties of regulators.

These Chapter 11s have also triggered a major flight to quality, as investors looking to buy debt have deferred to highly-rated instruments, or have shed corporate paper altogether, moving capital to safer government bonds. Perhaps in the medium-term, such shakeups can be seen as good — as corporations and investors get an understanding of what went wrong and why, and how they can avoid such failures in the future. Going forward (at least for awhile) businesses may tend to tighten up their operations, auditors will be more careful, and investors become more conservative in their holdings.

But, in the meantime, it is difficult to make a silk purse from a sow’s ear, particularly when billions have been shaved off the asset side of many balance-sheets around the world, and thousands may be left without a nest egg.

Figure 1: Time to default by rating category (1987-2001)

* Or Jan. 1, 1981, whichever is later

N.A. = not applicable