|By Wagman, Marc|
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.