Bankruptcies in America | Waiting for Armageddon | Economist.com - The Diigo Meta page

• 31 Mar 08
  

  Amira .

  The recent rise in corporate bankruptcies in America may well be a sign of much worse to come. CAPITALISM without bankruptcy, it is said, is like Christianity without hell. With recession looming, the air in America's bankruptcy courts is thick with brims

  USA Economy

• 

  Zhuu Ming Ang

  economics

  • If the debt markets are to be believed, companies could be in at least as much trouble as they were in the previous two downturns, in the early 1990s and at the start of this decade, after the dotcom bubble burst. A leading indicator is the spread between yields on speculative “junk” bonds and American Treasury bonds. A year ago, the spread was only about 280 basis points; the long-term average is around 500 points. This month the spread exceeded 800 points for the first time since March 2003, reaching 862 on March 17th.

       

     

                                  

     

     

    The bankruptcy rate (in the previous 12 months) for high-yielding bonds has so far edged only modestly higher, to 1.28% from a record low of 0.87% in November. But most forecasters expect it to rise sharply over the coming months. For instance, Moody's, a ratings agency, predicts that the default rate will rise to 5.4% by the end of this year, mostly due to problems in America. (Moody's also expects a rise in European bankruptcies this year, but only to 3.4%, thanks to lower levels of borrowing and less exposure to economic weakness.)

  • A big concern for company bosses will be the role of speculative investors, especially hedge funds. They can use derivatives to pursue complex strategies that may not be in the best interests of the firm that has issued the underlying debt, says Henry Hu, a law professor at the University of Texas, Austin. In a bankruptcy, a hedge fund could use the voting rights attached to different securities to maximise the overall value of its holdings in the firm at the expense of other investors.

      

    Imagine, for instance, a hedge fund that owns debt secured against a company asset. It may prefer to force the firm into liquidation in order to win that asset rather than engage in a restructuring negotiation that will keep the firm alive. Meanwhile, it can boost its returns by short selling its unsecured debt and its equity. Or suppose that a hedge fund owns credit-default swaps as well as a firm's debt. If the fund makes enough money from the pay-out of the credit-default swaps, it may prefer to use the voting rights on its debt to ensure that the firm goes bust rather than negotiate a way to avoid bankruptcy.

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