A hole in the middle

Buttonwood

Oct 18th 2005
From The Economist Global Agenda

Most financial assets have become “priced for perfection” during an extraordinarily benign period for credit. Late-breaking news: imperfection is at the gates

A POPULAR weekend destination for those members of the Family Buttonwood (all recovered, thanks) who are not obsessed with their weight is Harrods Food Hall, and most particularly the Krispy Kreme doughnut concession there. Some argue that doughnuts are a touch déclassé next to the caviar and exotic cheeses that Harrods more famously stocks. But KK’s glazed darlings, hot off the press, go down a treat with us proles, queuing in the bustling marble emporium.

So it was with a sense of dread that Buttonwood learnt of Freedom Rings’ filing for Chapter 11 protection from its creditors on Sunday. The little firm is owned by Krispy Kreme, which faces much bigger fall-out from an official investigation into alleged accounting fiddles. Freedom Rings was one of the last of a flood of companies and indebted individuals to file for bankruptcy before America’s rules became less accommodating to debtors on October 17th.

It is tempting to dismiss this Gadarene rush to bankruptcy as opportunistic, and much of it undoubtedly is. There are signs nonetheless that the underlying credit picture has darkened, and not just because of high-profile collapses in cars, airlines and financial- futures firms. During the past three years of global economic growth and corporate repair, investors have come to take for granted strong cashflows, record profitability, robust balance sheets and cheap money.
Their tolerance for risk has increased accordingly and so has their willingness to buy assets at prices that offer little protection in the event of any downturn. Most would agree that credit quality has now ceased to improve; with defaults broadly at their lowest in a decade, it is hard to see how it could. But is the credit cycle actually turning?

This is tougher to call than it sounds. It depends, in part, on whether you are looking at people or companies, in America or elsewhere, and just how you define the cycle (ie, actual defaults, widening spreads, worsening aggregate numbers?).

But consider the following straws in the wind, starting with defaults and ratings. Global default rates on high-yield bonds ticked up in the third quarter to 2%, from 1.8% in the previous three months, says Moody’s Investors Service. The amount involved—$14 billion— was actually ten times more than before. The rate had until now been declining, from 10.7% at its recent peak in 2002.

Another measure: in September the number of companies on watch for a downgrade was higher than those awaiting an upgrade, again according to Moody's. In previous cycles, a rise in the ratio of downgrades to total ratings changes has been a good predictor of rising default rates.

Standard & Poor’s reports 36 fallen angels (bond issuers that fall from investment-grade to junk ratings) so far this year—15 more than in the same period a year earlier. The amount involved is $507.4 billion, thanks to whoppers such as General Motors and Ford, and that is 12 times more than last year’s Lucifers.

Then take other kinds of lending. The Federal Reserve surveys officers at commercial banks each quarter. Its most recent figures, released in August, show that though the number of banks easing lending standards and terms is still greater than the number tightening them, the gap between them is narrowing. Defaults remain very low, but a number of banks are beginning to increase their provisions against loan losses. And many mortgage lenders have taken on board the Federal Reserve’s jawboning, it seems, and have reduced or stopped offering enticing interest-only and negative amortisation loans for fear that their customers will start missing payments when these rise later on.

In the leveraged loan market, where private-equity groups and others raise money, loan-covenant waivers and amendments to loan agreements have become more common in recent months, as companies in some sectors struggle to meet their numbers, according to Standard & Poor’s Leveraged Commentary and Data. Steve Miller, who writes it, points out that the market is still very strong. He does not see the increase in amendments as “some sort of huge signal of a default spike coming up, but the market is more fragile than it used to be”. Defaults bottomed out last year, and are expected to be higher 12 months from now.

Then there are credit cards, used by millions of people for household necessities, not just for that spur-of-the-moment Whistles pencil skirt or slimline iPod. Credit-card delinquency in America rose to a record high in the second quarter of 2005, according to the American Bankers Association. Late payment also rose on other types of borrowing, such as car loans and lines of credit secured on owned homes. A couple of British banks, too, have reported problems with credit-card receivables. By the end of the year in America most people will have to pay at least 4% of their balances each month, up from a typical 2% now; and, of course, will find it much harder to shed their debt by filing for “fresh start” bankruptcy.

There are slight signs of decay in corporate balance sheets, too, suggesting that the credit cycle is becoming less benign. The de-leveraging of the past three years—as companies cut costs, restored profits and paid down debt—may have drawn to a close in Europe, and in America it has given way to a mild net increase in borrowing to finance more capital spending and share buybacks. Philip Isherwood, a strategist at Dresdner Kleinwort Wasserstein, points out that the de-leveraging story was anyway a mixed one in America, where many companies merely amassed cash and left gross borrowing intact, while others in troubled sectors did not even do that.

Market jitters

And finally the markets themselves are suggesting that all’s not for the best in this best of possible worlds. In the past few weeks, equity and bond markets have sold off, emerging markets ditto, high yield bonds’ spreads over Treasuries have widened a bit and equity volatility has finally stirred from its lengthy snooze. There is typically some correlation between higher volatility and wider bond spreads, and between spreads and default rates, though it is unclear what leads what. So are we now heading definitely for the door?

It would be “premature” to assert that the credit cycle has definitely peaked, says John Lonski, chief economist at Moody’s, though he says he is surprised that corporate credit ratings aren’t going up, and share prices too. Matt King, head of quantitative credit strategy at Citigroup, reckons we are at the peak but it doesn’t feel that way yet because corporate cash and profits are still buoyant. “People think that companies have only to stop spending and acquiring and go back to their old ways. But history seems to show that once they start, they can’t stop.”

For what it’s worth, Buttonwood reckons that the credit cycle has turned, and that from here on there will be more bad news than good. The elements are already in place, beginning with a lot of junk bond issuance since 2003. That is a recipe for higher defaults, given the smallest push.
And that push is waiting in the wings: a hawkish Fed, perhaps even a new chairman determined to show that Alan Greenspan is not the only tough cop on the beat; slowing world economic growth; slowing corporate profits; consumers finally hobbled as house prices stagnate and interest rates keep rising. With all this in store, it is perhaps no surprise that the latest investor-confidence index released by State Street Global Markets, an investment firm, on October 18th, showed the steepest fall on record.

At the end of the day, the sharpest shock may come from the bankruptcy courts after all. Delphi was known to be a vulnerable firm in a troubled industry. Refco, America’s biggest independent-commission futures broker, caught the markets by surprise when it filed for protection this week. If the next couple of such surprises lead to a reduction in the supply of capital—either because investors take fright and bond spreads balloon or because banks turn stingy—that will make the cycle turn faster. Until then, all one can say is that credit quality, like Krispy Kreme’s finest product, has a hole in it.

Send comments on this article to Buttonwood (Please state whether you are happy for your comments to be published)

Read more Buttonwood columns at www.economist.com/buttonwood

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.