I came across the following article (hat tip Calculated Risk) about analyst predictions for corporate defaults (see Citi and J.P. Morgan Predict a Buffet of Defaults). The author writes:

With credit flowing to practically any company in need of cash in recent years, the rate of defaults for U.S. high-yield companies fell to just 0.34% in December, according to a J.P. Morgan Chase analysis. The J.P. Morgan analyst, Peter Acciavatti, predicts that is about to rise drastically, to 4% by the end of 2009, and he isn’t alone. As BreakingViews points out today, Citigroup expects the default rate to surge to 5.5%, as easy credit becomes a distant memory.

It has been my expectation for several months now that defaults would tick up (see here and here and here for my explanations for why, and by how much). I find it interesting that the Morgan and Citi analysts predict an uptick of only 4-5.5%. I still find that a little on the optimistic side. As the full extent of the current credit crisis becomes clearer, I think these figures will represent more of a best case scenario.

I am expecting an increase in the default rate in the 10% range. How did I arrive at 10% you might ask?

1. The historical default rate is around 3%. We’ve been running at around 1% for the last few years. If we revert to the mean, we could plausibly expect somewhere in the 5% range for the next several years. However, business cycles don’t often work like that. We usually enjoy several good years punctuated by a more brief and intense bad period. Therefore, I would expect something greater than 5% for a shorter period (2 years or so rather than 3 years), maybe something like 7% one year and then 10% the following.

2. I used the 2000-2002 slowdown as a benchmark. If I remember correctly, following the doctom bust the default rate exceeded 12%. My expectation is that the current cycle won’t reach those extremes. The dotcom bust was more of a business, investment-led recession whereas the current slowdown (I hesitate to call it a recession, at least not officially yet, although I do believe that we currently are in one) represents a housing, consumer-led slowdown. The balance sheets of businesses are stronger now than they were in 2000.

3. Boy, haven’t the banks been uber-optimistic of late? It’s all contained, what credit crisis, we have ample reserves, the underlying assets still have substantial value, and so on. With the accuracy of analysts’ predictions in 2007, a higher number just seems like a lay-up.

So there you have it. My expectation is for an increase in defaults to 10%.

This is not to say I won’t be wrong. I could absolutely miss the mark on this one. And I’m not sure with what level of confidence I can conclude 10% (i.e., where the confidence intervals would lie around that mean). However, if anything, I would be more surprised to see my estimate miss to the upside than to the down.

Be Sociable, Share!

• 

This entry was posted on Wednesday, January 9th, 2008 at 5:52 pm and is filed under Corporate Strategy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.