Default rates double; set to escalate further

15 May 2009

Tweet
Facebook
LinkedIn
Google plus
Send to

For years bearish professionals have been warning of imminent and widespread defaults. Now it seems they are upon us, with double-digit default rates expected within the year. Kimberly Romaine reports

The long-awaited wave of defaults is starting to take shape, with levels doubling in Q1 to 3.8% for European leveraged loans by number of borrowers. The figure stood at 1.8% for Q4, according to Fitch Ratings.

The figure is likely to creep much higher, according to anecdotal evidence, which suggests many sponsors are currently negotiating with banks over the state of certain portfolio companies as banks use fine-tooth combs to weed out "problems" in their own portfolios.

Fitch backs up this notion, citing loose covenants on loans issued in 2007 as a sure sign that more defaults are on the way, but they are just harder to predict since the "early warning system" of a covenant breach is lacking. Thus Fitch estimates future default rates by setting the highest-risk borrowers (rated "B-" with negative outlook; comprising EUR54bn) against the agency's total debt outstanding of EUR250bn (across 288 ratings). This suggests a far more worrying default rate of 10-15% in the next 12-18 months.

Much of the trouble is likely to come from "recycled deals" - those passed between sponsors (secondary, tertiary, etc buyouts (SBOs/TBOs)) - and recapitalisations. Both types of deal were rampant during the boom years of 2005-H1 2008 and involved aggressive growth forecasts, which are increasingly difficult to attain. According to Fitch, in a sample of 29 dividend recaps and 40 SBOs/TBOs, after two years on average into the deal, most performance metrics have been missed meaning long term refinancing risks loom (see table).

A DOZEN DEFAULTS IN DETAIL

Fitch registered 12 defaults for European leveraged credits on a loan-to-maturity basis as of March 2009:

DURATION - on average, deals took 26 months to default

SECTORS - Problem sectors are unsurprising (though retail is conspicuous by its absence): five in auto; three in buildings and materials; two in gaming.

COVENANTS - not a big problem, since few deals leveraged in the heyday were very restricted. Only two of the 12 were in breach.

EQUITY CURE - just one deal benefited from a sponsor-provided equity cure before default

DEBT-FOR-EQUITY SWAP - six of 12 experienced this; another five sought creditor protection.