Not only are corporate defaults expected to increase later this year in some sectors, but corporate bankruptcies are projected to rise as well. The Euler Hermes Business Failures Index predicts a 12 percent increase in corporate bankruptcies, says chief economist Dan North. The firm insures firms' accounts receivables.
Corporate bankruptcies are a function of the overall economy, and GDP is expected to be weak for at least the rest of 2007, North says. That is compounded by the Federal Reserve's actions. The most recent Fed tightening was in June 2006, and a general rule of thumb says that Fed moves take a year to affect the economy. Consequently, the consequences of its 2006 move are looming.
Moreover, with one more gauge of the overall economy going sour, North points to the slowing housing market. Prices have declined for six consecutive months, erasing $2 trillion of value from the economy. In the past 35 years, the only other time prices fell even as many as two consecutive months was November and December 1990.
Prognosis: Banks will certainly have to tighten corporate-lending standards. A recent Federal Reserve survey of senior loan officers indicates some banks are expecting to do so. The survey, conducted in January, says 5.3 percent of banks will tighten lending standards for large and middle-market firms, or those with annual sales of $50 million or more. For small firms, those with annual sales of $50 million or less, standards will tighten 7.1 percent. Even a five percent showing represents a net tightening of standards and is a condition that the market has not seen for three and a half years, says North. "We have yet to use the 'R' word [recession], but it will be tough," he says.
Another area that will impact banks is an expected hike in debtor-in-possession financing, says Theresa Brown-Edwards, a bankruptcy attorney at Potter Anderson & Corroon, who expects a "healthy" increase in filings this year. Indeed, the first step to a corporate bankruptcy is often a loan default, says Bill O'Connor, a distressed-debt lawyer at Crowell & Moring. And defaults appear poised for rising, especially among mid-cap companies and firms serving the home-building and the automotive industries, "It's like throwing a rock in a pond," he says. He notes a recent increase in "technical defaults," which are not defaults in payments, but rather violations of a supporting agreement to a loan, such as a company's sales ratios. An increase in technical defaults often points to trouble down the road, he says.
The most troubling aspect to a decline in corporate-loan quality is that many banks will have no control over the problems they face. Many regional banks extend warehouse loans, which often entails giving decision-making authority to an outside specialty lender, and those lenders do not always scrutinize the property as well as a bank would. "You're outsourcing your underwriting to another entity that may not have the same rigorous infrastructure," he says.
That said, banks have a much better safety valve than they did even in the early 1990s, when they faced a bout of bad loans in the secondary market. Back then, banks mostly "worked through their own loans," he says. But now, they have an array of other institutional buyers who will take the extra risk of those loans. He expects an additional $1 billion to $2 billion in bad loans to be sold in the secondary market this year. Indeed, the first quarter this year has been the busiest for O'Connor in the past two years, he says.
To a large extent, the expected increase in defaults of corporate loans is simply the latest ebb and flow of the economy, says Tanya Azarch, banking analyst at Standard & Poor's. In late 2004, banks started loosening their credit standards, she says, so a lot of risky corporate loans were extended. And many of those decisions will manifest as defaults. It usually takes about two years for that shakeout, she says. And even though there hasn't been a meaningful increase yet, she still sees it coming sometime in late 2007. "I keep extending the predictions, but it stands to reason there will be an increase," she says. (c) 2007 U.S. Banker and SourceMedia, Inc. All Rights Reserved. http://www.us-banker.com http://www.sourcemedia.com
