Next victims of the credit squeeze
Trouble in the credit markets threatens to push companies already in poor health to the brink of bankruptcy.
LONDON (CNNMoney.com) -- Turbulence in the credit markets has already claimed several casualties - from highly leveraged hedge funds to mortgage providers whose lenders have cut them off.
But the fallout could get worse. Some experts say the debt crunch could squeeze underperforming companies that have, until now, been able to finance their way out of trouble - and trigger a wave of corporate bankruptcies.
"There have been a lot of operational problems and other problems within some companies that have been masked by liquidity in the marketplace and the ability to refinance their debt," said Jeff Marwil, a partner in Winston and Strawn's restructuring and insolvency practice in Chicago.
Until recently, investors have gorged on complex securities that include strips of corporate debt from a number of companies. The relentless demand for these securities has provided financing for some companies that might have otherwise collapsed.
"There are a lot of underperforming companies that have been able to finance their way out of problems and put off dealing with the operational need to fix their business," said Lisa Donahue, co-head of the turnaround and restructuring practice at AlixPartners in New York.
That's helped keep default rates among risky borrowers at historic lows, despite an explosion in the issuance of risky corporate debt - the default rate fell to 1.57 percent last year, the lowest since 1981, according to Moody's Investor Service.
But the subprime mortgage crisis has crimped investors' appetite for risk. Problems in the sector that gives home loans to borrowers with weak credit have spread and it's uncertain how deep the problems run.
For now, creditors like hedge funds have been hit hardest by the turmoil in the market as they've had to, in some cases, mark down the value of their assets. Many analysts expect some of these players won't regain their appetite until the market is finished repricing risk.
Corporate loan and bond deals have already come to a standstill. Some 46 financing deals representing over $60 billion have been pulled from the market since June 22, according to an analysis by investment management firm Baring Asset Management.
And some say it's only a matter of time before there's a rise in corporate default rates. "The recent increase in interest rates and credit spreads will really manifest in higher (corporate) defaults," said Edward Altman, a finance professor at New York University's Stern School of Business and corporate bankruptcy expert.
Donahue agreed, but said it could take some time before troubled companies start to come under pressure. "I do think there will be an uptick in defaults, but it takes time for this to cycle through," she said.
It could take six to 12 months before some companies start to trip up on covenants - the conditions which allow a lender to demand repayment of a loan, she said. Other troubled firms may be able to stay above water even longer since several loans issued in recent years have been "covenant-lite," which gives borrowers more leeway when they run into trouble.
While it's become harder for companies in poor condition to buy more time on the cheap, they aren't out of options. "There is plenty of money out there courtesy of private equity firms, distressed accounts and hedge funds to help fix troubled deals. The price simply is higher now than it's been in a while," Standard & Poor's Leveraged Commentary & Data said in a note Thursday.
Whether companies in troubled situations end up filing for bankruptcy ultimately depends on how they run their business and the overall health of the economy, Marwil from Winston and Strawn said. "As long as they are able to generate enough cash to make their debt payments, it doesn't matter what their debt trades for in the market," he said.