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2009 could be worse than Great Depression
Sunil Kewalramani
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February 07, 2009

Increasing bond yields for companies, while the yields on government securities are falling, seem to indicate rising probability of corporate defaults in 2009. Moody's, the credit rating agency, has forecast a 'severe recession' in 2009, with high-yield corporate default rates climbing to between 10 and 12 per cent from 7.5-8 per cent currently.

With estimates of total losses on risky assets ranging from $2,800 billion to $6,000 billion, a chain reaction is underway that will leave no sector of the world economy unscathed.

The market for CDS (Credit Default Swaps) is pointing to a surge in defaults on corporate bonds. JP Morgan estimates that a whole host of companies in developing countries need to refinance more than $200 billion in external debt in 2009, with the largest borrowings in Russia, Turkey, Mexico, UAE and South Korea.

Those at risk of technical default include Russian steel company OAO Severstal, Chinese real estate firm Greentown China Holdings and Indonesian shipper PT Arpeni Pratama Ocean Line.

Over the past three years, the sum of syndicated loans and bonds raised by emerging market companies exceeded $1,300 billion. Most of them were segmented until early to mid-September, when Lehman hit. That was the catalyst.

According to HSBC, corporate debt spreads are now implying cumulative default rates of 30 per cent for investment grade companies, as compared to 20 per cent during the Great Depression.

The Markit iTraxx Crossover index has risen over 1000 basis points for the first time since it was created in 2004, implying that a record number of companies are on the verge of defaulting.

The index, mainly comprising of 50 mostly junk-rated companies in Europe, rose more than 60 basis points to trade at highs of about 1020 bps, according to Markit Group. It has somewhat receded in January 2009. Interestingly, before the credit crisis began, it was trading below 200 bps.

While default risk had dropped dramatically since November 20, 2008 for various financial companies, it is beginning to rise again. Default risk is the highest for Morgan Stanley, followed by Goldman Sachs, American Express, UBS, and Citigroup.

According to Euler Hermes, part of the world's largest credit insurer Allianz, a record number of companies will go bankrupt in 2009 with 200,000 insolvencies in Europe alone and 'an explosion' of failed businesses in the US.

The German insurer estimates that the US will see 62,000 companies go bust in 2009, compared with 42,000 in 2008 and 28,000 in 2007.  Europe, with its share of larger number of small companies, will see insolvencies rise by a third from 149,000 last year to 197,000 in the next.

In a bid to avoid a Detroit collapse before Christmas, General Motors and Chrysler were put on life support of $13.4 billion by way of short-term funds. However, the two companies are required to come up with comprehensive restructuring plans by February 17.

There is no way to force all the interested parties to make the concessions necessary for the car companies to survive on the proposed time scale, which means the two automobile giants are nearing 'orderly bankruptcy' sometime around March 2009. 

Wachovia's freeze-up led to a sharp reduction in the most-vanilla emerging-market credit, namely trade finance, for many Latin American companies. During the commodity upsurge, a whole host of Brazilian companies were hedging against commodities' risks, and are now faced with margin calls on underwater hedges. Although Brazil and Mexico have substantial reserves, there isn't enough cash for everyone.

The rich countries do not have enough cash either, but they do have virtually unlimited swap lines with each other. Such swap lines, or bilateral agreements between central banks for short-term, otherwise unsecured, exchanges of currencies, are rather smaller in the emerging market world.

Asian countries have swap lines under the Chiang Mai initiative, but those are tiny in relation to today's capital flows and are highly conditional. For example, Japan has swap agreements with Korea for $7 billion and with Thailand, Indonesia and China for $3 billion.

The financial strength of banks in South Korea, Taiwan, Singapore, India and Hong Kong will be tested in the coming downturn. Also, leading firms in the steel, cement and mining industries in China and other developing countries have taken on more debt than is prudent.

The debt was taken in pursuance of over-zealous acquisitions in 2006 and 2007. The cash spent on deals in 2006 and 2007 account for four-fifths of the total net debt of $136 billion of the six leading firms reviewed by The Economist.

Arcelor-Mittal has high gearing in part due to its cash-and-stock financed merger; India's Tata Steel [Get Quote] is leveraged on account of its takeover of Anglo-Dutch peer Corus; the world's largest cement producer, France's Lafarge, has bought Orascom Cement of Egypt; the third-largest, Mexico's Cemex, has purchased its Australian counterpart Rinker; Xstrata, the mining giant who believes in inorganic growth is highly-geared; and Rio Tinto has joined the 'leverage club' thanks to its purchase of Alcan.

Relying on the debt market with credit lines still choked is not advisable. Mexico's Cemex has $8 billion of its $16 billion net debt maturing in the next 18 months, according to Standard & Poor's, and only $560 million in cash. It is trying to arrange a new debt package with a syndicate of banks.

Arcelor-Mittal, Rio and Lafarge have sufficient liquidity to cover maturing debt for about a year; Xstrata and Tata Steel for two years. $6 billion of the $10.7 billion net debt of Tata Steel is on Corus' balance sheet and is not guaranteed by the Indian parent.

Which means Tata Steel could technically renege on its acquisition, should the scenario turn for the worse. The Credit Default Swaps market is reflecting these concerns and has risen to alarming levels for all the six firms.

The author is CEO, Global Capital Advisors

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