2007 “Frontiers in Credit Forum” A Resounding Success Bubble Mania Redux?

New York, NY - 1 March 2007

Highlighted with keynote presentations from industry leaders like John Hull, Ed Altman and Don van Deventer, PRMIA New York’s 2007 “Frontiers in Credit Forum” raised issues of high importance for the risk profession. The general consensus among participating experts was a mixture of enthusiasm about the point to which the industry has evolved tempered with concerns about trends that, if not properly managed, portend trouble on the horizon.

After a welcome from PRMIA New York Regional Director James Tunkey, the morning kicked off with a panel on Frontiers in Credit Research moderated by Peter Davis, Director of Credit Risk Services in Ernst & Young’s Global Financial Services Advisory Practice. Co-panelists James Batterman, Senior Director in the Credit Policy Group at Fitch Ratings, and David Hamilton, Senior Vice President of Credit Policy Research at Moody’s Investors Service, addressed a rapt audience on the topics of credit derivatives product news and near-term expectations for default experience, respectively.

Mr. Batterman reviewed highlights of Fitch’s 2006 Global Credit Derivatives
Survey, subtitled: “Indices Dominate Growth as Banks’ Risk Position Shifts.” The survey found that the notional amount of outstanding credit derivatives contracts sold rose from US$5.3 trillion at year-end 2004 to nearly US$12.0 trillion at year-end 2005 – an increase of 122%; by year-end 2006 this number had more than doubled to over $25 trillion. Indices and index-related products (CDX, iTraxx, ABX.HE) continue to drive the growth in the synthetic CDS market: the segment grew by an astounding 900% and, at US$3.7 trillion, now constitutes 31% of gross sold positions.

Of course, a key theme throughout the day was the strong appetite in the market for corporate leveraged loans, an asset class within one of the most innovative and fastest growing sectors of the U.S. capital markets in 20 years. Mr. Batterman noted how the growing secondary market for leveraged loans is driving the market in credit derivatives for these loans. Europe has taken the lead with LevX®; dealers in the U.S. continue to work toward the introduction of the U.S. loan CDS index, LCDX.

Mr. Hamilton of Moody’s pointed out that the prevalence of corporate leveraged loans prompted Moody’s to update its model for assessing the speculative grade default rate and introduce an LGD scale. The addition of corporate loan issuers to the bond universe, especially in the high-yield sector, will allow for a more representative indicator of corporate defaults.

Mr. Hamilton noted that the default rate on speculative grade instruments has been low – at or below 2% – for a “long” time. (He was referring to the period from mid-2005 to February 2007.) For 2007, he forecasts a default rate of 3.1%, still well below the historical average of 4.9%. Mr. Hamilton pointed out that the proportion of high- yield ratings categories (B2 to Caa) in Moody’s portfolio has increased significantly. Like the morning’s keynote speaker, Edward I. Altman, Mr. Hamilton projects a negative turn in the cycle by 2008 due to weak fundamentals.

Throughout the day, speakers discussed their views on the state of the market in high yield bonds, loans and distressed debt. Since 2003, there has been a steady climb in the issuance of speculative-grade bonds and loans. Corporate loans – in particular second lien loans – have become an important substitute asset class for highly leveraged issuers, and 2006 saw a pronounced rise in the number of loan-only issuers.

Compounding concerns is the expectation, based on historical data, that deterioration in the credit quality of loan-only issuers will coincide with deterioration in loan-only recovery rates. (Many panelists commented on the current abnormally low default/ high recovery rate state of the market versus the historical rate.) It was noted that the rise of loans as a substitute asset class, as well as the presence of new institutional investors with distinct strategic objectives and tactics, are wildcards for the direction of the expected default and recovery rates.

The dramatic increase in liquidity resulting from the presence of aggressive investors (e.g., hedge funds, private equity firms) in search of yield, however little, has given rise to an imbalance in supply and demand. And these aggressive investors, who lend directly to troubled issuers, can act as a lifeline or precipitate their default.

Matthieu Royer, Director in the Portfolio & Balance Sheet Management Group at CALYON (a division of Crédit Agricole Group), moderated a panel on The Credit Model Spectrum. This group included Stephen Figlewski, Professor of Finance at New York University, who presented recent research and findings on the macro-economic aspects of default likelihood and migration forecasts; Bjorn Flesaker of Bloomberg who spoke about the use of CDS to replicate or price other default contingent claims; and Sivan Mahadevan of Morgan Stanley who provided a market perspective on default correlation.

In the afternoon Practitioners Forum, Martin Fridson, CEO of FridsonVision, LLC, spoke abut the benefits, and costs, of liquidity. He referred to a “credit spiral” that lets companies borrow their way out of trouble. Indeed, fewer troubled companies are filing for Chapter 11 because hedge funds are eager to step in with financing in the current market environment. Mr. Fridson spoke of the power of liquidity to keep the default rate low (at least temporarily). And he raised concern about the quality of new issuances that he speculated could lead to a peak in the default rate in 2009. This idea was broached by an earlier presenter who indicated that the rating distribution of first-time issuers since 2004 leads many to think the default rate is primed for a rise: 30% of issuers are rated “Caa” out of the gate.

Curt Deane, principal of the Deane Group, pointed out that there is no apparent reward for the level of risk in this market, and questions how the liquidity can justify the homes it is seeking. Mr. Deane worries that you don’t know who the ultimate counterparty is. He wonders why nobody kicks tires anymore and asks: are we too complacent about the concept of credit protection?

Chris Whalen, Managing Director of Institutional Risk Analysis, reiterated many of Mr. Deane’s concerns. He asserts that we need a more critical view and must look at deeper default experience. He’d like answers to questions such as “When do you normalize a data series?” and “How does a company compare to its peers?” He, too, notes that there is no compensation for risk today, and that a hedge fund manager has zero incentive to enter into a restructuring driven by a bank workout department; the incentive is to liquidate.

The size of the distressed debt market and performance are what continue to drive investment in this asset class. Assets under management at distressed debt hedge funds range from $5 billion to $20 billion. In 2006, BB-rated bonds yielded 10%; CCCs yielded 20%; distressed CCCs yielded 40%; and the average return on defaulted bonds was 40% to 60%. Although more and more players see assets in bankruptcy as an exciting asset class, the big unknown is whether these investors will be capable of withstanding defaults and write-offs during a downturn.

Indeed Edward Altman, Max L. Heine Professor of Finance at New York University’s Stern School of Business, sounded a note of caution for risk professionals. At 2.5% in 2007 and 3.7% in 2008, his default rate forecast for corporate high-yield non-investment grade bonds is higher than the current rate of 0.76%, but well below the historical average of 4.2%. While Professor Altman is not necessarily forecasting a drying up of liquidity, he does caution that corporate fundamentals and poor new bond and loan quality point toward significantly higher default rates in the future.

The issue for Professor Altman is: are historical default/recovery models still relevant or is there a new paradigm? He questions the conventional wisdom that recession paves the way for defaults. As he points out, this was not the case in the last two recessions. In his view, new models are needed.

Today’s average loan in default sells at $0.93 on the dollar, an amount very close to that of the average on new defaults. Ed Altman wonders if these companies are really worth that much in asset value? And he poses this important question: will excess liquidity continue to dominate the market or will we observe a regression to the long-term mean and where defaults and recoveries are once again based on firm-fundamental and more traditional supply/demand risk patterns?

Sound familiar?

If PRMIA’s 2007 “Frontiers in Credit Forum” is used to gauge quality for future programs, members will want to make a point of reserving a slot for upcoming events. Matthieu Royer summed it up by saying that he had never seen such a high caliber of panelists in a one-day event. This forum is just one example of PRMIA’s level of commitment to delivering high-value programs to its membership.

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