Defaults & Recoveries - Fitch

This is a synopsis of a free report available through Fitch. I put together this deck to summarize what the credit markets are doing these days. All of the data and charts come from Fitch. The wise-crack remarks are of course, my own.

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It should be obvious why this matters: we find ourselves in a credit crisis that for many, has morphed into either a liquidity crisis (balance sheet can‟t be monetized fast enough for the right amount of cash) or a solvency crisis (liquidity crisis + time constraint – as in pay me right now or you‟re done). Default rates are the obvious metric to look at, but recovery rates, while not as obvious, is more important (IMHO). Why? If recovery rates are high, even illiquid loans and collateral are still in demand and that means you as a lender can get a nice chunk of change back post-default. The gold bars tell you that isn‟t happening right now.

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Here, we can compare the recovery rates on leveraged loans to their bond counterparts in the previous slide. Note the relative outperformance of loans vs. bonds in recovery rates.

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What they‟re talking about here is the explosion in the underwriting of covenant-lite and PIK loans/bonds. Covenant-lite, or “cov-lite” deals, were named that for two reasons: First, the number of covenant tests a borrower had to meet were reduced. Where in previous years you may have had to pass a Fixed Charge covenant, a Leverage covenant, and possibly a Liquidity covenant, now you may only have 2 of those or even just 1. Second, you may not have to test the covenants as frequently. Back in the day, a covenant was tested for compliance pretty much each quarter. In „05-‟07 there was a shift to only do tests in the case corporate events occurred (LBO, stock buy-back, etc.). So company performance could deteriorate before you could recognize it and mitigate your risks. Why did this happen? This is simply a symptom of a market that had grown to believe market liquidity was their birthright. It didn‟t matter who ensured it, they just believed it was theirs and nobody would take it away. They never thought a day would come when the liquidity spigot would be turned off, or worse, was tapped out and dried out.

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Note: emergence is defined by Fitch as “time after the plan has been confirmed by the court (once all the requisite creditors have voted to approve the plan), but before the pre-petition instruments are cancelled and replaced with new debt and equity.” Because the new debt and equity will be re-set @ par, you need to look at the value of the old debt & equity before that new issuance occurs, but after the bankruptcy plan has been approved. The 30-day post-default price is the measure used most frequently. It‟s simple, transparent, and Fitch has found it is a very good indicator of the recovery of the debt.

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This just lists the ways recoveries can occur. But you need to know how recoveries occur to understand why they are what they are. That‟s in the next slide.

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Note that in the senior unsecured and subordinated debt, recoveries tend to be in the form of equity – not cash. 67% of the recoveries in sub debt were in equity and warrant form, while 78% of the senior secured was either cash or new debt postdefault. As Fitch says ”it is not surprising that at emergence the value of pre-petition instruments might deviate from the firm value established by the court ⎯ the market‟s view of the reorganized company‟s prospects (reflected in any equity stake) may at that point be different from the court‟s assessment.” That‟s a fancy way of saying the value of the equity can change – usually it‟s lower. Note what is happening here, though. It‟s a debt-for-equity swap. Leverage in the firm pre-bankruptcy was too high and so the junior debt holders usually end up taking an equity position and bringing down debt levels in the firm when you look at leverage ratios and the like. But you don‟t need to be in bankruptcy to effect this change in the capital structure of a company. Ford (F) wasn‟t when they did it several years ago and look where they are now compared to GM and Chrysler. All it took was a recognition of the issues by management, the equity & debt holders, not some cataclysmic event.

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This is a distribution of recovery rates broken out by % of the bankruptcy plan enterprise value to the pre-bankruptcy asset value of a company (Total Assets prebankruptcy). In a bankruptcy, the liabilities & equity side of the balance sheet is affected, since Enterprise Value is Evf = MVd + MVe - Cash & Cash Equivalents where MVd is the market value of the firm‟s debt and MVe is the market value of the equity (including preferreds & minority interests). So in this chart, the lower the ratio between the firm‟s plan EV and the firm‟s prebankruptcy asset value, the more the value of the firm is essentially “written down” in bankruptcy. Write down too much, everyone assumes the business was a fraud and you, Mr./Ms. Debt Holder, get nothing. Write down too little and you get nothing as well. It‟s best to find a happy medium as these recovery rates show.

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Things to note: Most of these firms were excessively levered (Total Debt on average was 86% of Total Assets), points to Debt/Equity of 6X. Note the next two items. This points to exactly how much balance sheet destruction these companies undergo as part of their restructuring.

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