We Answer Your Questions: Dr. Altman on the Mammoth Debt Problem

During a recent webinar, NYU Stern School of Business Professor Dr. Edward Altman and CreditRiskMonitor CEO Jerry Flum discussed the mammoth debt problem facing the world in the wake of an unprecedentedly long benign credit cycle.

After the presentation, Flum addressed the unanswered questions from the audience which spoke to their concerns about this unique point in time.

To review all questions and answers in PDF form, please click here.

Question: If we are approaching “bubble” territory, with unsustainable levels of debt and high equity prices, what do you suggest a credit manager do with respect to the extension of credit?

Jerry Flum: As Dr. Altman said, keep your credit culture and keep your guard up. Make sure you have appropriate processes in place, especially for public companies, and your management is “bought in.” If you are prepared for a number of tough decisions, there's no reason to panic. 

We hope the rich financial detail provided on our website, backing up our FRISK® score, will help you to be persuasive. But there's no doubt being a credit professional is a tough job, and likely to get even tougher. If you and your company are not ready, get moving.

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Q: Central Bank of Europe implemented an expansionary monetary policy to stimulate economy. Did it stimulate the economy or increase the debt of operators? Is it sustainable in the long term?

JF: We've seen research showing that the actions of the ECB successfully stopped a number of bank failures from occurring; that the effect of these measures on healthy banks was stimulating. These actions created jobs and some investment. The effect of these measures on unhealthy banks was largely to enable them to 'extend and pretend' with their weakest loans, which was essentially wasteful. 

We can't say for sure but it seems unlikely to us that extended monetary expansion is sustainable, and it’s unlikely that if attempted it would have positive unintended consequences.

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Q: How can debt be reduced in a post-Brexit world? In what order should the debts be reduced: Large debts first or small debts first?

JF: Your question is beyond our pay grade! At the moment, too many are still expanding their debt. It may seem fatalistic, but we imagine that the most likely way in which the majority of debt will be reduced is that it will be written off. Of course, that means the debt carried as an asset by investors will be less valuable and their wealth will be reduced, small and large debts alike.

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Q: How do rising interest rates fit into this assessment? For a 25-50 BP rise, how are companies with a high debt to EBITDA ratio affected? Recent studies have shown that, despite refinancing efforts, large quantities of debt are scheduled to mature in the next three years in Europe and the U.S., how do debt maturities figure into this crisis?

JF: If the average rate currently paid by a junk-rated company is 8%, an increase of 50 BPs will boost servicing costs by 6.25% - for a deeply indebted firm with low profitability, this could be a significant fraction of profits.

As Dr. Altman said, most companies have been able to kick the debt can down the road, so the next two years in 2018 and 2019 look okay. It is a benign credit environment now, after all. If the environment changes, refinancing could become more difficult.

However, Dr. Altman pointed out that the issue of looming debt maturity is generally over-emphasized as a reason for default. Most default derives from insufficient cash flow relative to debt servicing and other expenses.

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Q: What are the top financial ratio indicators that a corporate is at a major risk of defaulting on its debt?

JF: Of financial ratios, Dr. Altman mentioned the market value-to-liabilities ratio. We agree on this. In the same breath, the FRISK® score is technically a "failure" score, since that is the extreme event we use to train the score. However, the score is an excellent indicator of default probability as well. Keep in mind that for every three defaults, there is roughly one bankruptcy.

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Q: When will this looming debt crisis happen?

JF: An excellent question, and one which keeps us up at night. My answer is: 4:46 p.m. on Nov. 13, 2017. Seriously, we can't know for sure, because it is in the hands of the investment community. The debt-plus-equity market value is four-and-a-half times GDP, so these guys will have their hands on the throat of the consumer and the economy.