Dr. Altman on the Mammoth Debt Problem

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1 WEBINAR Dr. Altman on the Mammoth Debt Problem Annotated Slides Latest Saved Version: 7/6/2018 HIGHLIGHTS EDITION Here s why this is a very bad time to let down your guard. - Jerry Flum

2 Dr. Edward Altman Named to the Max L. Heine endowed professorship at Stern in 1988 Previously chaired the Stern School s MBA Program for 12 years International reputation as an expert on corporate bankruptcy, high yield bonds, distressed debt and credit risk analysis Primary areas of research include bankruptcy analysis and prediction, credit and lending policies, risk management and regulation in banking, corporate finance and capital markets Max L. Heine Professor of Finance at the Stern School of Business, New York University Received a MBA and PhD in Finance from the University of California, Los Angeles CreditRiskMonitor. All rights reserved. CreditRiskMonitor Webinar: Dr. Altman on the Mammoth Debt Problem 2

Jerry Flum Hedge fund manager CEO of CreditRiskMonitor since 1999 Held a series of investment leadership roles, including as an institutional security analyst, research and sales partner at an

3 Jerry Flum Hedge fund manager CEO of CreditRiskMonitor since 1999 Held a series of investment leadership roles, including as an institutional security analyst, research and sales partner at an investment firm and founder and general partner of a private investment pool Has been a guest lecturer at MIT/Sloan School of Management CEO and Chairman CreditRiskMonitor Served in the USMCR Received a BS in Business Administration from Babson College and a JD degree from Georgetown University Law School 2017 CreditRiskMonitor. All rights reserved. CreditRiskMonitor Webinar: Dr. Altman on the Mammoth Debt Problem 3

4 The Debt/GDP Problem in the U.S. is HUGE 1. Debt is 3.5x GDP If debt of $67T goes down 10%, then about $7T of wealth is lost. Compare this with the $19T GDP 3. Debt is an asset held by investors 4. The drop in wealth people will spend less 5. Over capacity 2017 CreditRiskMonitor. All rights reserved. CreditRiskMonitor Webinar: Dr. Altman on the Mammoth Debt Problem 4

Diminishing returns from Debt-Financing by Decade 12/31/1949 3/31/2017 Date Range Decade Change in Debt (billions $) Decade Change in GDP (billions $) Debt/GDP 12/31/1949 12/31/1959 353.6 258.3 1.

5 Diminishing returns from Debt-Financing by Decade 12/31/1949 3/31/2017 Date Range Decade Change in Debt (billions $) Decade Change in GDP (billions $) Debt/GDP 12/31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ A huge amount of incremental debt is now required for a small increase in GDP. * Most recent data available T_621 6/08/ CreditRiskMonitor. All rights reserved. CreditRiskMonitor Webinar: Dr. Altman on the Mammoth Debt Problem 5

6 High Debt/GDP is a Global Problem, Even Worse in Other Countries Debt levels worldwide create unprecedented risk, never seen before. There is nowhere to hide. U.S. A possible prelude to currency wars, tariffs CreditRiskMonitor. All rights reserved. CreditRiskMonitor Webinar: Dr. Altman on the Mammoth Debt Problem 6

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

7 $ (Billions) Size of the U.S. High-Yield Bond Market $1,800 $1,600 $1,400 $1, (Mid-year US$ billions) $1,622 Junk debt has grown dramatically. $1,000 $800 $600 $400 $200 Junk loans ( leveraged loans ) add $900B, to make a total of $2.5T 13% of $19T GDP. $- Source: NYU Salomon Center estimates using Credit Suisse, S&P and Citi data CreditRiskMonitor. All rights reserved. CreditRiskMonitor Webinar: Dr. Altman on the Mammoth Debt Problem 7

8 Jan-87 Jan-88 Jan-89 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 U.S. Non-financial Corporate Debt to GDP: Comparison to 4-Quarter Moving Average Default Rate January 1, 1987 June 30, % 46% 45% 44% 43% 42% 41% 40% 39% 38% 37% % NFCD to GDP (Quarterly) 4-Quarter Moving Average Default Rate 16% 14% 12% 10% 8% 6% 4% 2% 0% Every peak in the ratio of debt/gdp is followed by a peak in defaults. Default rates could spike to over 12%. Time bomb for the $2.5T on the prior chart, getting close to exploding. Sources: FRED, Federal Reserve Bank of St. Louis and Altman/Kuehne High-Yield Default Rate data CreditRiskMonitor. All rights reserved. CreditRiskMonitor Webinar: Dr. Altman on the Mammoth Debt Problem 8

9 The Amount of Debt Used to Buy Equity is Staggering This Can t Be a Sustainable Trend Exhibit 12: Massive Debt for Equity Swap Debt goes up. Cash comes in and goes to investors, not for plant and equipment to help pay back the debt. As of Jan 2017 Source: Federal Reserve Not good for credit and purchasing managers. p CreditRiskMonitor. All rights reserved. CreditRiskMonitor Webinar: Dr. Altman on the Mammoth Debt Problem 9

10 Euro Junk-bond Investors Go Crazy % Same rate for Euro Junk as US Treasuries? Investors in Europe are Risk On A perfect picture of a MANIA. Source: Board of Governors of the Federal Reserve System (US), 10-Year Treasury Constant Maturity Rate [DGS10], retrieved from FRED, Federal Reserve Bank of St. Louis; September 12, CreditRiskMonitor. All rights reserved. CreditRiskMonitor Webinar: Dr. Altman on the Mammoth Debt Problem 10

11 Stocks are Over-valued (Total Stock Market Capitalization vs. GDP) High stock values create an equity cushion that makes junk debt look less risky right now. Market value to GDP is Warren Buffett s favorite indicator of overvaluation. Market value of $27T can easily come down 20% = $5T or 25% of the $19T GDP. Whether GDP is forecasted at 2% or 3% isn t the main issue to focus on any more CreditRiskMonitor. All rights reserved. CreditRiskMonitor Webinar: Dr. Altman on the Mammoth Debt Problem 11

12 Equity (Market Value)/Total Liabilities Ratios (H.Y. Companies, ) Average Market Equity/Total Liabilities* MV/TL is a key ratio, a risk indicator signaling that companies are now in worse shape than they were in 2007 just before the Great Recession. *X 4 in Z-Score Model Source: S&P Capital IQ CreditRiskMonitor. All rights reserved. CreditRiskMonitor Webinar: Dr. Altman on the Mammoth Debt Problem 12

13 Correlations Between Various Asset Class Stock & Bond Index Returns Over Time ( ) Stressed Cycle I 01/ /1991 (24 obs.) Stressed Cycle II 01/ /2002 (24 obs.) Stressed Cycle III 01/ /2009 (15 obs.) Full Sample Period 01/ /2017 (367 obs.) Most Recent Period 01/2010 7/2017 (91 obs.) Citi HY Index Defaulted Bond Index 68% S&P 500 Stock Index 48% Defaulted Bond and Bank Loan Index 76% S&P 500 Stock Index 54% Defaulted Bond and Bank Loan Index 80% S&P 500 Stock Index 73% Defaulted Bond and Bank Loan Index c 62% S&P 500 Stock Index 59% Defaulted Bond and Bank Loan Index 52% S&P 500 Stock Index 72% A big change since 2008 which few have noted: stocks and bond prices are now highly correlated for the first time. This reduces companies flexibility to switch from debt financing to equity, by selling stock. Source: E. Altman & B. Kuehne, NYU Salomon Center 2017 CreditRiskMonitor. All rights reserved. CreditRiskMonitor Webinar: Dr. Altman on the Mammoth Debt Problem 13

14 Benign Credit Cycle? Is It Over? Length of Benign Credit Cycles: Is the Current Cycle Over? No. Default Rates (no) Default Forecast (no) Recovery Rates (no) Yields (no) Liquidity (no) We are now in the 8 th year of what is usually a 4-7 year cycle of benign credit. Risk On causes people to forget history CreditRiskMonitor. All rights reserved. CreditRiskMonitor Webinar: Dr. Altman on the Mammoth Debt Problem 14

15 6/1/2007 9/14/ /31/2007 4/15/2008 7/29/ /11/2008 2/26/2009 6/11/2009 9/24/2009 1/11/2010 4/26/2010 8/9/ /22/2010 3/7/2011 6/20/ /3/2011 1/18/2012 5/2/2012 8/15/ /28/2012 3/15/2013 6/28/ /11/2013 1/28/2014 5/13/2014 8/26/ /9/2014 3/26/2015 7/9/ /22/2015 2/8/2016 5/23/2016 9/5/ /19/2016 4/5/2017 7/19/2017 YTM & Option-Adjusted Spreads Between High Yield Markets & U.S. Treasury Notes June 01, 2007 August 31, 2017 Yield Spread (YTMS) OAS Average YTMS ( ) Average OAS ( ) 2,200 12/16/08 (YTMS = 2,046bp, OAS = 2,144bp) 2,000 1,800 1,600 1,400 1,200 1, YTMS = 539bp, OAS = 544bp 6/12/07 (YTMS = 260bp, OAS = 249bp) 8/31/17 (YTMS = 412p, OAS = 385bp) Definition of a benign cycle: interest rate spreads are lower than normal, today. I would call this a Minsky Moment. Sources: Citigroup Yieldbook Index Data and Bank of America Merrill Lynch CreditRiskMonitor. All rights reserved. CreditRiskMonitor Webinar: Dr. Altman on the Mammoth Debt Problem 15

16 Historical H.Y. Bond Default Rates Straight Bonds Only Excluding Defaulted Issues From Par Value Outstanding, (US$ millions), (8/4) Year Par Value Outstanding a ($) Par Value Defaults ($) Default Rates (%) 2017 (8/4) 1,622,365 17, ,656,176 68, ,595,839 45, ,496,814 31, ,392,212 14, ,212,362 19, ,354,649 17, ,221,569 13, ,152, , ,091,000 50, ,075,400 5, ,600 7, ,073,000 36, ,100 11, ,000 38, ,000 96, ,000 63, ,200 30, ,400 23, ,500 7, ,400 4, ,000 3, ,000 4, ,000 3, ,907 2, ,000 5, ,600 18, ,000 18, Year a Weighted by par value of amount outstanding for each year. Par Value Outstanding* ($) Par Value Defaults ($) Default Rates (%) ,258 8, ,187 3, ,557 7, , , , , , , , , , , , , , , , , Arithmetic Average Default Rate (%) Standard Deviation (%) 1971 to to to Weighted Average Default Rate (%)* 1971 to to to Median Annual Default Rate (%) 1971 to Source: NYU Salomon Center and Citigroup/Credit Suisse estimates Benign cycle: the default rate is below normal. Investment can flow to less productive, inefficient uses. Somebody owns that debt. Because debt has grown, it has set up over $300 billion in potential defaults, in a normal correction. GDP is only $19 trillion. The lost wealth can trigger less spending, and excess capacity CreditRiskMonitor. All rights reserved. CreditRiskMonitor Webinar: Dr. Altman on the Mammoth Debt Problem 16

17 Default & Recovery Rates for High-Yield Bond Defaults, Q17 Default Rate Overall Recovery Rate Energy/Mining Recovery Rate All Other Recovery Rate % n/a % % Q % Weighted Average Default Rate ( ) Arithmetic Average Recovery Rate ( ) 3.49% Definition of a benign cycle: very high recoveries from defaulted bonds. More Minsky -- this can change quickly if we have a catalyst. Don t let down your guard CreditRiskMonitor. All rights reserved. CreditRiskMonitor Webinar: Dr. Altman on the Mammoth Debt Problem 17

18 Mortality Rates by Original Rating All Rated Corporate Bonds* Years After Issuance AAA Marginal 0.00% 0.00% 0.00% 0.00% 0.01% 0.02% 0.01% 0.00% 0.00% 0.00% Cumulative 0.00% 0.00% 0.00% 0.00% 0.01% 0.03% 0.04% 0.04% 0.04% 0.04% AA Marginal 0.00% 0.00% 0.20% 0.06% 0.02% 0.01% 0.01% 0.01% 0.02% 0.01% Cumulative 0.00% 0.00% 0.20% 0.26% 0.28% 0.29% 0.30% 0.31% 0.33% 0.34% A Marginal 0.01% 0.03% 0.11% 0.12% 0.09% 0.05% 0.02% 0.24% 0.07% 0.04% Cumulative 0.01% 0.04% 0.15% 0.27% 0.36% 0.41% 0.43% 0.67% 0.74% 0.78% BBB Marginal 0.32% 2.34% 1.24% 0.98% 0.49% 0.22% 0.25% 0.16% 0.17% 0.33% Cumulative 0.32% 2.65% 3.86% 4.80% 5.27% 5.48% 5.71% 5.86% 6.02% 6.33% BB Marginal 0.92% 2.04% 3.85% 1.95% 2.42% 1.56% 1.44% 1.10% 1.41% 3.11% Cumulative 0.92% 2.94% 6.68% 8.50% 10.71% 12.11% 13.37% 14.32% 15.53% 18.16% We may exceed the normal default rates for junk bonds. B Marginal 2.86% 7.67% 7.78% 7.75% 5.74% 4.46% 3.60% 2.05% 1.73% 0.75% Cumulative 2.86% 10.31% 17.29% 23.70% 28.08% 31.29% 33.76% 35.12% 36.24% 36.72% CCC Marginal 8.11% 12.40% 17.75% 16.25% 4.90% 11.62% 5.40% 4.75% 0.64% 4.26% Cumulative 8.11% 19.50% 33.79% 44.55% 47.27% 53.40% 55.91% 58.01% 58.28% 60.05% *Rated by S&P at Issuance Based on 3,280 issues Source: Standard & Poor s (New York) and Author s 2017 CreditRiskMonitor. All rights reserved. CreditRiskMonitor Webinar: Dr. Altman on the Mammoth Debt Problem 18

19 Default and Recovery Forecasts: Summary of Forecast Models Model 2016 (12/31) Default Rate Forecast as of 12/31/ (12/31) Default Rate Forecast as of 12/31/ (8/04) Default Rate Forecast as of 8/04/2017 Mortality Rate 4.50% 4.20% 4.20% Yield-Spread 6.00% a 2.18% c 1.85% e Distress Ratio 4.38% b 1.94% d 1.68% f Average of Models Recovery Rates* 4.96% 37.5% 2.77% 43.8% 2.58% 44.6% * Recovery rate based on the log Linear equation between default and recovery rates, see Altman, et al (2005) Journal of Business, November and Slide 45. a Based on Dec. 31, 2015 yield-spread of 699.8bp. b Based on Dec. 31, 2015 Distress Ratio of 24.7%. c Based on Dec. 31, 2016 yield-spread of d Based on Dec. 31, 2016 Distress Ratio of 7.4%. e Based on Aug. 04, 2017 yield-spread of 385.9bp. f Based on Jul. 31, 2017 Distress Ratio of 5.51%. With the investment market (stocks + bonds) a huge 4.5x GDP, investors are likely to anticipate the difficulty of a narrow exit door. Investors could move sooner and faster than anyone expects. Source: All Corporate Bond Issuance and Authors Estimates of Market Size in 2016 & CreditRiskMonitor. All rights reserved. CreditRiskMonitor Webinar: Dr. Altman on the Mammoth Debt Problem 19

20 Companies are Leveraged, and Shareholders Have Leveraged Their Stock Holdings Could This Accelerate a Correction? Anyone heard of margin calls? 2017 CreditRiskMonitor. All rights reserved. CreditRiskMonitor Webinar: Dr. Altman on the Mammoth Debt Problem 20

What to Do: Get Ahead of it Now Pay special attention to public companies, because public companies can leverage up to a greater degree than private firms, and so they have leveraged up Build a

21 What to Do: Get Ahead of it Now Pay special attention to public companies, because public companies can leverage up to a greater degree than private firms, and so they have leveraged up Build a process your management can trust for public companies Watch out for falling stocks of junk-bond companies Stay alert for the next major market correction: o o The downturn could happen faster than usual It could be ugly Public companies are 40% - 50% of all corporate revenue. Half of the A/R Trade data we collect represents debt owed by public companies. They are bigger than you think. Don t let down your credit culture CreditRiskMonitor. All rights reserved. CreditRiskMonitor Webinar: Dr. Altman on the Mammoth Debt Problem 21

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Are You Prepared for a Credit Downturn? A Conversation with Dr. Edward Altman

Are You Prepared for a Credit Downturn? A Conversation with Dr. Edward Altman Agenda Introduction & Housekeeping Keynote: Are We in a Credit Bubble? Q&A 2 Welcome! Dr. Edward Altman Professor of Finance