Sony today. Who's next?
Even the largest and most sophisticated finance and credit departments experience unforeseen, painful credit defaults. Why does this happen and how can companies protect themselves? This insightful article illustrates the causes from various perspectives - most of which even the most experienced credit professionals have probably never before considered.
For companies that sell products and services on a b2b basis, there are a multitude of variables which drive a company's bad debt experience, the most important of which is the quality of the organization's finance and credit management process. Viewed at a high level, even the best managed corporate finance and credit departments sometimes encounter large, unexpected and painful credit losses. The effect on the company's stakeholders can be devastating. Regardless of a company's size, the stakeholders (shareholders, lenders, vendors, customers and employees) can lose a lot when a big customer defaults on its obligations to its supplier. This executive briefing identifies those basic drivers and provides illustrations which explain the cause/effect.
Reason I. It is extremely difficult for individuals to time markets perfectly.
Have you ever heard the saying in stock market circles that trying to time the market is a sucker's bet? What holds true in the stock market also holds true in other aspects of the capital markets, including those for bonds and credit. The graph below illustrates this very effectively.
Measured from a basket of publicly traded high-yield bonds (i.e., corporate debt instruments which are all rated less than Moody's Baa3 or S&P BBB-), Chart i shows how over the past 25+years, every major uptick in corporate credit defaults was preceded by a spike or widening in borrowing spreads. (This refers to the difference or "spread" between the borrowing costs of a high-yield bond issuer and a U.S. Treasury bond of a similar maturity date.)
This phenomenon was first seen during the economic recession of 1990-1991 when there was a spate of defaults in the markets for high-yield bonds and bank loans for highly leveraged transactions ("HLTs" as they were then known). We saw this happen again during the mild recession of late 2001, early 2002, which also coincided with the burst of the dot-com bubble. During this downturn, the spike in credit spreads was not as wide as in the prior decade, but during the Great Recession which followed only seven years later, this trend was really pronounced. During this most recent economic downturn, high-yield borrowing spreads widened even further than was the case during the early 1990s and another spike in defaults occurred shortly thereafter.
In this sense, the same principles that apply to bond investing or commercial lending apply to corporate credit management. Even the most talented credit executives will struggle to time the decision of purchasing credit protection on a high risk customer. Most corporate credit managers can only take a 6-to-i2 month future view on a given customer's credit quality since most non-finance or non-bank corporate credit is based on sales terms of 30,60 or 90 days. Very typically, by the point in time when a corporate credit executive believes that the probability of a key customer's default within the next 6-to-i2 months is high, it's often too late to buy credit protection on that customer because the coverage is either too expensive or unavailable. This is akin to trying to buy fire insurance on a burning building,
While the market can often provide clues to sophisticated finance and credit executives that the credit risk in the overall market is increasing, timing the default of specific customers is virtually impossible. Even today's best run corporate finance and credit departments face this reality.
Reason II. Bankruptcy Filing Is Now Viewed as a Legitimate Operating Strategy
During the post-WWII era through the late 1980s, American managers who were associated with a company that filed for protection under Chapter 11 of the U.S. Bankruptcy Code might be considered incompetent and ineffective business executives. In the United States, senior executives today face little of the stigma that they would have up until roughly 25 years ago. By the late 1980s and early 1990s, the high-yield (or "junk") bond market proliferated and many large banks jumped into the fray, providing financing for a number of large and high-profile leveraged buyout transactions. During the recession in the early 1990s, a number of these companies that borrowed money in the high-yield market defaulted on their debts in such wellpublicized bankruptcies as Olympia & York, Atlantic Gulf, Ames Department Stores, Continental Airlines, and America West, to name a few.
At that time, these defaults were unprecedented in their size and this first large wave spawned an entire cottage industry of distressed debt investors, forensic accountants, bankruptcy attorneys and specialty trading desks within major Wall Street investment banking firms. Though Congress did pass legislation in the late 1990s and early 2000s to streamline the bankruptcy process to address issues such as which and how claims are to be allowed, how long the process of reorganization should take, and preference actions, etc., the corporate bankruptcy industry developed quickly into a big business in the United States.
The U.S. marketplace has evolved (or devolved depending on how one looks at it) to the point where a company might seek relief from its creditors, not because the company is having cashflow problems or is in technical default to its lenders on a missed interest or principal payment, but because its operating strategies have failed. Nowadays, it's commonplace for large, medium and small companies to file for bankruptcy protection because they face underfunded pension liabilities, environmental litigation, labor union conflict or have obsolete technology, to name a few examples.
This type of operating environment makes it much more difficult for even the best run corporate credit departments to manage credit risk at an enterprise level. Risk management is fundamentally about mitigating the risk of factors beyond and within one's control. However, when the number of external factors beyond control of even the most effective and sophisticated credit management teams increases exponentially because of the country's business culture, the task of credit management becomes much more challenging.
Reason III. Failing to Stay Informed on the Global Economy
Given the close linkage between corporate credit quality and credit availability on the one hand and the economic cycle on the other, finance and credit professionals need now more than ever to start thinking like investors, in this new, digitally-smaller world. As stated above, there is now an almost infinitely greater multitude of variables beyond the control of the best managed corporate finance and credit departments. Those industry practitioners failing to stay well informed as to the ebbs and flows of the global economy do so at great risk to their personal careers and their company's success.
Some of the most troubling challenges facing today's corporate finance and credit executives are:
I The world economy is more interconnected globally than ever before. Billions of dollars can be moved in a millisecond at a mouse click with the potential to trigger great volatility in the capital markets.
I Expansionist monetary and fiscal policies of G-7 governments will continue to distort global capital markets and public finance for the next generation.
I The explosion of public and private sector debt in this artificially-low interest rate environment bodes the possibility of grave credit problems come this decade's end, especially when interest rates begin to rise again. And rise again, they will.
I Excluding China, the world's industrialized economies will, at the most aggressive, limp along at the "new normal" of 1.5% - 2.5% real GDP growth for the next 2-to-3 years. This will fail to generate the non-farm, private sector job growth needed to fuel significant growth in capital investment and consumer spending.
What does all of this mean for your borrowers? Which economic indicators matter the most to your borrowers and to the credit quality of their customer base? Housing starts? Non-farm payroll growth? Industrial production? Consumer sentiment Index? National purchasing managers index? Etc, Etc. Etc. Do your borrowers have a systematic means of tracking those with the most significant credit impact to their customers so that the enterprise can adjust its credit management strategies and tactics accordingly?
Some economic indicators are applicable to just about everyone, regardless of the industry.
As an example, consider how closely corporate credit quality and the availability of credit are tied to the economic cycle as well as monetary and fiscal policy and take a look at the following projection of the Federal Government budget deficit through 2023.
Provided by the non-partisan Congressional Budget Office, these are staggering numbers, especially when viewed cumulatively. Often overlooked is that the fact that, for every year the U.S. Government (or state and local governments) operates at a deficit, that negative number carries into the next year and must be funded again, alongside of the current year's deficit - all with more borrowed money. All of this public sector borrowing has the potential to crowd out private sector borrowing, especially in the event of a financial crisis in a much higher-interest rate environment.
Every year that the Federal Government's expenses falls short of revenue, the U.S. Treasury must borrow the difference. This is happening on a massive and unprecedented scale every year, exacerbated by a very active Federal Reserve. What will happen to interest rates when the U.S. central bank ceases its gigantic bond buying scheme which has artificially boosted the money supply? What about the enormous and well-publicized budget deficits which are occurring in the rest of the U.S. public sector both at a state and municipal level? Lastly, consider how much corporate debt has been issued in the private sector during this time frame. What will be the impact on global credit markets when interest rates rise in the next few years and all of this public and private sector debt needs to be refinanced at a higher rate? Will the Chinese and Japanese central banks still have an appetite to lend to the U.S. government to the same historical degree in such a scenario?
In the absence of real economic and corporate profit growth, the possibility of a debt Armageddon remains real later this decade.
Reason IV. Poor Marketplace Education of Risk Mitigation Strategies
The market for trade credit risk mitigation products in general is exploding all over the world. The regions with the largest growth have been East Asia (Pacific Rim) and North America, especially the U.S. However, until the 1990s, the U.S. was a small market for trade credit insurance relative to the European Union, where its presence had always been traditionally strong. In 1992, there were only six insurers underwriting trade credit and political risk insurance in the USA. By 2013, that number increased to 13, not including the taxpayer-funded U.S. Export Import Bank.
More telling is that the relative size of the short-term trade credit insurance market has skyrocketed. Measured as the aggregated estimate of insured revenue between all underwriters, the market has increased more than ninefold in the last 20years. Increasingly embraced by many multinational corporations, this is no longer a risk management strategy undertaken solely at a middle-market or small-business level.
That so many senior executives in the U.S. have, at best, an awareness that trade credit insurance exists, speaks to the very poor job that the industry has done educating C-level executives.
Comprising a massive proportion of global GDP for so long, the U.S. economy was seen as so large that American companies traditionally took considerable comfort in selling on open terms to other American businesses. Domestic trade in the U.S. was seen as a lower risk proposition due to the common laws, currency, banking system and language. Europe, in contrast, comprises many smaller countries with varying languages, banking systems, laws and which, until only 14 years ago, had many different currencies. Arising from the ashes of the Second World War, Europe's economy was forced to become export-driven. All of these factors help explain why roughly one-third to one-half of all companies in the European Union use credit insurance.
Today roughly 1 in 10 U.S. companies use credit insurance or some other form of credit risk mitigation and, while considerably lower than the EU, this is still up from roughly 1 in 50 American companies only 20 years ago.
Over the past 20 years and particularly since the Great Recession of 2008-2009, more and more businesses, large and small, are using credit insurance to protect their accounts receivable. The fact that this coverage type has existed for decades, but has only recently taken off in terms of market-size speaks to the trend among sophisticated finance and credit professionals to manage enterprise credit risk, using all available tools in an increasing challenging and volatile environment.
Reason V. Companies Choose to SelfInsure Credit Risk
No executive in the industrialized world would ever contemplate operating its business without insuring the company's fixed assets against fire or its professional or product liabilities or its directors and officers against lawsuits. This is because those types of coverage are considered routine and universally assumed to be a necessary cost of doing business. However, many companies often leave the largest asset on their balance sheet, their accounts receivable, uninsured.
Some financial and credit executives justify self-insuring their customers' credit risk by taking comfort in adequate bad debt reserves. However, under U.S. Generally Accepted Accounting Principles, bad debt reserve allocations are only a non-cash accounting entry and they are not tax-deductible. Moreover, a bad debt reserve provides no relief to cash flow when the customer default occurs. For companies that don't have a sufficiently large balance sheet, the cash flow pain from a large, unexpected credit loss can be significant. For some companies, a big customer default can put the corporation In default of its bank loan covenants, sow doubt and fear amongst the company's stakeholders and, in the worst case, put the company itself out of business.
There are a multitude of credit risk mitigation strategies such as credit insurance, political risk insurance and accounts receivable put options, which serve as viable alternatives to self-insurance or bad debt reserve allocations.
The following is a case study of a credit insurance program which was implemented for an unregulated natural gas marketing subsidiary of a U.S.-based Fortune 1000 Utility. This utility was looking for a way to more efficiently leverage and augment its existing self-insurance (i.e., its bad debt reserve):
I The subsidiary's bad debt reserve as of 12/31/2012 was approximately $7,800,000
I Based upon the loss experience, this was an arguably highly over-reserved position
I The bad debt reserve afforded no leverage and no tax benefit
I The credit insurance program was structured to target the client's customers who are rated at or just below minimum investment grade (S&P rated BBB and BB+)
I This customer segment was targeted due to its high potential for a materially negative impact on the client's balance sheet, income statement and cash flow
I Annualized premium in the range of $500,000 to $600,000
I Credit insurance policy leveraged premium dollars significantly (i.e., at least 40:1 based upon the policy's underwritten limits) relative to bad debt reserve (i.e., 1:1).
I Allowed the client to exchange a non-tax deductible reserve allocation for bad debt for a fully tax-deductible premium funded fully by existing overreserved allowance
Self-insuring corporate credit risk through the use of the bad debt reserves provides no tax benefit and no leverage. However, the premium for trade credit insurance and other related instruments can be expensed and leveraged to provide an exponentially higher level of coverage relative to bad debt reserves.
I Markets and capital move much too fast to accurately time when a customer is going to default.
I American companies now commonly file for bankruptcy protection under U.S. law as an operating strategy even if they have sufficient cash flow to pay their debt obligations or are not even technically insolvent on a balance sheet basis.
I The current low interest-rate environment is deceiving and distorting.
I Mismanaged monetary and fiscal policies promise a painful reckoning day in the private sector later this decade, especially from a credit risk perspective.
I Finance and credit professionals need to think more like investors and stay well informed about economic variables relevant to their business.
I In such a complex operating environment, getting educated on enterprise level credit risk mitigation alternatives is vital so as to:
- protect stakeholders well in advance of a default event
- minimize the impact when borrowing costs increase or the economy goes into a downturn
- protect the careers and livelihoods of finance and credit professional tsl
Marc D. Wagman is the managing partner of Aequus Trade Credit, an expert specialty broker of credit protection products ranging from traditional credit insurance to political risk insurance and credit derivatives. With more than 20 years of experience in credit risk mitigation, the capital markets and commercial finance, Wagman is a nationally recognized leader in his field. Prior to joining Aequus in 2003, Wagman was vice president-sales for Euler Hermes ACI in New York where he concentrated primarily on export-oriented companies. In the early 1990s, he sourced trade claims and sold receivable puts for Avenue Capital, a New York City-based hedge fund.
Wagman began his career as a treasury and financial analyst for The CIT Group, Inc., where he co-managed CIT's interest rate swap portfolio and received formal credit training. Later in his tenure with CIT, he worked as a research analyst in CIT's economics department. He graduated from Rutgers University with a Bachelor Degree in political science, and he obtained his M.B.A. in finance from Fordham University'sGraduate School of Business.