Webinar Replay: Dr. Altman on the Mammoth Debt Problem
Two leading authorities on corporate financial health, Dr. Edward Altman, Professor of Finance, Emeritus, at New York University's Stern School of Business and creator of the Altman Z” score, and CreditRiskMonitor Founder and CEO Jerry Flum, recently presented a webinar to hundreds of credit and supply chain managers about today’s mammoth corporate debt.
Dr. Altman and Flum identified three unprecedented conditions putting pressure on the global economy and recommended specific steps to take to mitigate risk.
Credit and supply chain professionals are in uncharted territory because today’s corporate debt levels have never been seen before. Meanwhile, low interest rates and high corporate valuations make it far too easy to ignore corporate risk. Regardless of how much experience you have, nothing that we have seen or experienced has prepared us for the conditions we find ourselves in today.
Corporate Debt Level and Composition
In order to put today’s debt levels into perspective, Flum discussed them as a percentage of GDP. Total U.S. debt is currently at three-and-a-half times GDP. He pointed out that although it is correct to be concerned about those who borrowed so much, we should be equally concerned about the owners of that debt: investors such as pensions and 401Ks. Even a moderate drop in the value of those securities, Flum said, would involve a loss of wealth equivalent to a large fraction of GDP. For example, a 10% decline in the value of this debt would wipe out an amount of wealth equal to 35% of GDP.
Dr. Altman showed the remarkable growth in junk-debt (high-yield bonds and leveraged loans), and discussed that it is now between $2.5 and 3.0 trillion worldwide. Investors want income, he said, and so they invest in these securities despite the risk: “risk on.”
An Eight-Year Benign Credit Cycle
Dr. Altman defines a benign credit cycle as a combination of four variables: low default rates, high recovery rates in the case of default, low interest rates, yields, and spreads and, finally, high liquidity. In the past, such a cycle has never lasted more than seven years (between four and seven years, on average). The duration of the current cycle - eight years and counting - is what makes it so unprecedented and so dangerous. People can let their guard down in benign cycles. Flum calls this a "Minsky moment," which is defined as a sudden major collapse of asset values which is part of the credit cycle or business cycle. Such moments occur because long periods of prosperity and increasing value of investments lead to increasing speculation using borrowed money.
High Corporate Valuations
Much of the concern about corporate debt is on publicly traded companies, whose access to public capital markets enhances their ability to borrow. Public companies are also a big fraction of U.S. business activity, nearly half of assets and sales. In recent years, Flum showed, there has been massive borrowing to buy back stock and pay dividends.
He pointed out that this is fine for current investors, but results in higher liabilities without any new assets to generate cash to support the new debt. Flum also showed evidence that the stock market is now significantly over-valued, by historical measures. Other stakeholders such as employees, suppliers and general creditors should beware.
Dr. Altman said that the growing influence of private equity firms is important, too. Recently, they have been paying as much as 10-to-11 times cash flow to buy companies. This is more evidence of inflated valuations.
Whether companies give in to the mania or make a disciplined choice to break free from the pack, financial risk professionals can take action to mitigate risk and prepare their companies to handle the downturn when the next recession inevitably comes.