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Dr. Edward Altman

Current Conditions in Global Credit Markets. A Tale of Three Periods. Dr. Edward Altman. NYU Stern School of Business. Credit Risk Seminar SF/No.CA CFA/TMA San Francisco, CA October 17, 2008. Changes in the Credit Environment: Are Historical Default and Recovery Estimates Still Relevant?.

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Dr. Edward Altman

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  1. Current Conditions in Global Credit Markets A Tale of Three Periods Dr. Edward Altman NYU Stern School of Business Credit Risk Seminar SF/No.CA CFA/TMA San Francisco, CA October 17, 2008

  2. Changes in the Credit Environment:Are Historical Default and Recovery Estimates Still Relevant? Default and Recovery Forecasting Models • Macro-Economic Models: Default Probabilities • Mortality Rate Models: Default Probabilities • Market Based Models: Default Probabilities • Recovery Rate Models: Loss-Given-Default • Distressed Debt Market Size Estimate

  3. Factors Affecting the Transformation of Credit Markets in Last Few Years • Massive Global Liquidity • Petrodollars, Foreign Governments, Financial Institutions, Global Money Supply Expansion, etc. • Explosion of Hedge Fund Activity • Frenetic Activity in M&A/LBO transactions • Growth of the Institutional Loan Market, esp. Leveraged Loans • Easy Credit Standards by both Bank and Non-Bank Lenders • Record Low Required Yield Spreads in a Higher Credit Risk Profile Environment until June ‘07 • Second-Half 2007 Spread Volatility

  4. Factors Affecting the Transformation of Credit Markets in Last Few Years • Rapid Growth in Derivatives and Synthetics, esp. CDOs • Rescue Financings Restructurings (Privatization of Bankruptcy) • Distressed Debt Control Investing (Loan-to-Own) • Historically Low Default Rates and High Recoveries • Extremely Low Equity and Debt Volatility until Summer ‘07 • Recession in 2008/2009? • Hard Landing Default Rate • Soft Landing Default Rate

  5. Major Agencies Bond Rating Categories

  6. Size of the US High-Yield Bond Market 1978 – 2008 (1H) (Mid-year US$ billions) $1,093

  7. Historical Default Rates Straight Bonds Only Excluding Defaulted Issues From Par Value Outstanding, 1971 – 2008 (3Q - Preliminary) (US$ millions) Par Value Par Value Default Year Outstandinga Defaults Rates (%) 2007 $1,075,400 $5,473 0.509 2006 $993,600 $7,559 0.761 2005 $1,073,000 $36,181 3.372 2004 $933,100 $11,657 1.249 2003 $825,000 $38,451 4.661 2002 $757,000 $96,855 12.795 2001 $649,000 $63,609 9.801 2000 $597,200 $30,295 5.073 1999 $567,400 $23,532 4.147 1998 $465,500 $7,464 1.603 1997 $335,400 $4,200 1.252 1996 $271,000 $3,336 1.231 1995 $240,000 $4,551 1.896 1994 $235,000 $3,418 1.454 1993 $206,907 $2,287 1.105 1992 $163,000 $5,545 3.402 1991 $183,600 $18,862 10.273 1990 $181,000 $18,354 10.140 1989 $189,258 $8,110 4.285 1988 $148,187 $3,944 2.662 1987 $129,557 $7,486 5.778 1986 $90,243 $3,156 3.497 1985 $58,088 $992 1.708 1984 $40,939 $344 0.840 1983 $27,492 $301 1.095 * Weighted by par value of amount outstanding for each year. Source: Author’s compilation and Citigroup estimates Par Value Par Value Default Year Outstandinga Defaults Rates (%) 1982 $18,109 $5773.186 1981 $17,115 $27 0.158 1980 $14,935 $224 1.500 1979 $10,356 $20 0.193 1978 $8,946 $119 1.330 1977 $8,157 $381 4.671 1976 $7,735 $30 0.388 1975 $7,471 $204 2.731 1974 $10,894 $123 1.129 1973 $7,824 $49 0.626 1972 $6,928 $193 2.786 1971 $6,602 $82 1.242 Standard Deviation (%) Arithmetic Average Default Rate 1971 to 20073.096%3.061% 1978 to 20073.365%3.272% 1985 to 2007 4.029%3.435% Weighted Average Default Rate* 1971 to 2007 3.863% 1978 to 2007 3.874% 1985 to 2007 3.910% Median Annual Default Rate 1971 to 20071.708% 2008 (3Q) $1,092,624 $22,112 2.024%

  8. Historical Default Rates QUARTERLY DEFAULT RATE AND FOUR QUARTER MOVING AVERAGE 1991 – 2008 (3Q - Preliminary) Source: Author’s Compilations

  9. Lagging Twelve-Month Leveraged Loan Default Rate by Principal Amount & Number of Issuers September 30 September 30 3.32% 1.91% Default rate is calculated as the amount default over the last twelve months divided by the amount outstanding at the beginning of the twelve-month period. Source: S&P LCD

  10. Historical Default Rates and Recession Periods in the U.S. HIGH YIELD BOND MARKET 1972 – 2008 (3Q - Preliminary)* Periods of Recession: 11/73 - 3/75, 1/80 - 7/80, 7/81 - 11/82, 7/90 - 3/91, 4/01 – 12/01 *All annual rates except 2008 (9 months). Source: E. Altman (NYU Salomon Center) & National Bureau of Economic Research

  11. Rating Distributions Prior To Recessions (Percent of Issuers, Moody’s) Subsequent Default Rates By Rating Category *Moody’s Issuer Based Default Rate Source: M. Friedson: Distressed Debt Investor (September 28, 2006, April 17, 2008)

  12. Filings for Chapter 11 • Number of Filings and Pre-petition Liabilities of Public Companies • 1989 – 2008 (3Q - Preliminary) Note: Minimum $100 million in liabilitiesSource: NYU Salomon Center Bankruptcy Filings Database

  13. Credit Statistics Trends and Leveraged Market Activity

  14. New Issues Rated B- or Below as Percentage of all New Issues (1993 – 2008 (1H)) Source: Standard & Poor’s Global Fixed Income Research

  15. Default Lag After Issuance: ‘B’ & ‘CCC’ Rated Corporate Bonds Source: Altman Mortality Tables (1971-2007) Source: Altman Mortality Tables (1971-2007)

  16. Below Investment Grade Debt Maturity Schedule (U.S.) ($Bil.) • Includes Term Loans, Revolvers, and Other Loans; Assumes Revolvers are Fully Drawn. • Source: DealLogic, Fitch Ratings.

  17. A Credit Default Analysis of LBOs (2004 – 2007)

  18. Purchase Price Multiples Purchase Price Multiple excluding Fees for LBO Transactions 59 Deals 13 Deals Source: Standard and Poor’s LCD

  19. Average Total Debt Leverage Ratio for LBO’s: Europe and US with EBITDA of €/$50M or More Source: Standard & Poor’s LCD

  20. Average Equity Contribution to Leveraged Buyouts 1987 – 2008 (3Q) Equity includes common equity and preferred stock as well as holding company debt and seller note proceeds downstreamed to the operating company as common equity; Rollover Equity prior to 1996 is not available; There were too few deals in 1991 to form a meaningful sample. Source: Standard & Poor’s LCD

  21. European Initial/Secondary Buyouts: Volume Annual Senior Loan Volume LBO Transaction Volume 2008 (Jan-Sep 08) Total Funding from All Sources : €71.59B; €41.25B Funded Sr., €30.34B Other Sources Deal Count: 75 Volume:€33.43B * Deal Count counts First and Second Lien portions of a single transaction as one event; Deal Count also excludes any amendments. Reflects total sources of funding of initial or secondary buyout by a private equity firm (excludes recaps, refinancings, etc) Source: Standard & Poor’s LCD

  22. Vulnerable LBOs as of LTM in 2007: Class of 2004 to 2007 LBOs (As of June 2008) Source: Author’s Compilation

  23. Recovery Rate Analysis

  24. Default Rates and Lossesa 1978 – 2008 (3Q - Preliminary) Par Value Par Value Outstandinga Of Default Default Weighted Price Weighted Default Year ($MM)($MMs) Rate (%) After Default Coupon (%) Loss (%) 2008 (3Q) $1,092,624 $22,112 2.02 $45.1 8.55 1.20 2007 $1,075,400 $5,473 0.51 $66.6 9.64 0.19 2006 $993,600 $7,559 0.76 $65.3 9.33 0.30 2005 $1,073,000 $36,181 3.37 $61.1 8.61 1.46 2004 $933,100 $11,657 1.25 $57.7 10.30 0.61 2003 $825,000$ 38,4514.66 $45.5 9.55 2.76 2002 $757,000$96,85812.79 $25.39.3710.15 2001 $649,000 $63,609 9.80 $25.5 9.18 7.76 2000 $597,200 $30,248 5.06 $26.4 8.54 3.94 1999 $567,400 $23,532 4.15 $27.9 10.55 3.21 1998 $465,500 $7,464 1.60 $35.9 9.46 1.10 1997 $335,400 $4,200 1.25 $54.2 11.87 0.65 1996 $271,000 $3,336 1.23 $51.9 8.92 0.65 1995 $240,000 $4,551 1.90 $40.6 11.83 1.24 1994 $235,000 $3,418 1.45 $39.4 10.25 0.96 1993 $206,907 $2,287 1.11 $56.6 12.98 0.56 1992 $163,000 $5,545 3.40 $50.1 12.32 1.91 1991 $183,600 $18,862 10.27 $36.0 11.59 7.16 1990 $181,000 $18,354 10.14 $23.4 12.94 8.42 1989 $189,258 $8,110 4.29 $38.3 13.40 2.93 1988 $148,187 $3,944 2.66 $43.6 11.91 1.66 1987 $129,557 $7,486 5.78 $75.9 12.07 1.74 1986 $90,243 $3,156 3.50 $34.5 10.61 2.48 1985 $58,088 $992 1.71 $45.9 13.69 1.04 1984 $40,939 $344 0.84 $48.6 12.23 0.48 1983 $27,492 $301 1.09 $55.7 10.11 0.54 1982 $18,109 $577 3.19 $38.6 9.61 2.11 1981 $17,115 $27 0.16 $12.0 15.75 0.15 1980 $14,935 $224 1.50 $21.1 8.43 1.25 1979 $10,356 $20 0.19 $31.0 10.63 0.14 1978 $8,946 $119 1.33 $60.0 8.38 0.59 Arithmetic Average 1978-2007:3.37$45.1510.802.27 Weighted Average 1978-2007:3.872.66 a Excludes defaulted issues.Source: Authors’ compilations and various dealer price quotes.

  25. Source: E. Altman, et. al., “The Link Between Default and Recovery Rates”, NYU Salomon Center, S-03-4.

  26. Annual Returns Yields and Spreads on 10-Year Treasury (Treas) and High Yield (HY) Bonds 1978 – 2008 (3Q) Return (%) Promised Yield (%)a Year HY Treas Spread HY Treas Spread 2008 (3Q) (10.51) 4.51 (15.02) 14.20 3.82 10.38 2007 1.83 9.77 (7.95) 9.69 4.03 5.66 200611.851.3710.477.82 4.70 3.11 20052.082.04 0.048.44 4.39 4.05 2004 10.794.87 5.92 7.35 4.21 3.14 2003 30.62 1.25 29.37 8.00 4.26 3.74 2002 (1.53) 14.66 (16.19) 12.383.828.56 20015.44 4.01 1.43 12.31 5.04 7.27 2000(5.68)14.45(20.13)14.56 5.129.44 1999 1.73 (8.41) 10.14 11.41 6.44 4.97 1998 4.04 12.77 (8.73) 10.04 4.65 5.39 1997 14.27 11.16 3.11 9.20 5.75 3.45 1996 11.24 0.04 11.20 9.58 6.42 3.16 1995 22.40 23.58 (1.18) 9.76 5.58 4.18 1994 (2.55) (8.29) 5.74 11.50 7.83 3.67 1993 18.33 12.08 6.25 9.08 5.80 3.28 1992 18.29 6.50 11.79 10.44 6.69 3.75 1991 43.23 17.18 26.05 12.56 6.70 5.86 1990 (8.46) 6.88 (15.34) 18.57 8.07 10.50 1989 1.98 16.72 (14.74) 15.17 7.93 7.24 1988 15.25 6.34 8.91 13.70 9.15 4.55 1987 4.57 (2.67) 7.24 13.89 8.83 5.06 1986 16.50 24.08 (7.58) 12.67 7.21 5.46 1985 26.08 31.54 (5.46) 13.50 8.99 4.51 1984 8.50 14.82 (6.32) 14.97 11.87 3.10 1983 21.80 2.23 19.57 15.74 10.70 5.04 1982 32.45 42.08 (9.63) 17.84 13.86 3.98 1981 7.56 0.48 7.08 15.97 12.08 3.89 1980 (1.00) (2.96) 1.96 13.46 10.23 3.23 1979 3.69 (0.86) 4.55 12.07 9.13 2.94 1978 7.57 (1.11) 8.68 10.92 8.11 2.81 Arithmetic Annual Average 1978-2007 10.76 8.55 2.21  12.09 7.25  4.83 Compound Annual Average 1978-2007 10.16   8.00  2.16 a End-of-year yields. Source: Citigroup’s High Yield Composite Index

  27. YTM Spread Between High Yield Markets & 10 Year Treasury Notes June 01, 2007 – September 30, 2008 9/30/08 (1,038 bps) 6/30/08 (715 bps) 6/12/07 (260 bps) Source: Citigroup Yieldbook Index Data

  28. Size of Distressed Debt Market

  29. Distresseda And Defaulted Debt as a Percentage of High Yield And Defaulted Debt Marketsb(Not Including LEH Bond Defaults)1990 – 2008 (3Q - Preliminary) (a) Defined as yield-to-maturity spread greater than or equal to 1000bp over comparable Treasuries.  (b) $1.227 trillion as of 9/30/2008 Note: Some years not available as no survey results available Source: NYU Salomon Center

  30. Distresseda And Defaulted Debt as a Percentage of High Yield And Defaulted Debt Marketsb(Including LEH Bond Defaultsc)(1990 – 2008 (3Q - Preliminary) (a) Defined as yield-to-maturity spread greater than or equal to 1000bp over comparable Treasuries.  (b) $1.382 trillion as of 9/30/2008 (c) $155 billion Note: Some years not available as no survey results available Source: NYU Salomon Center

  31. Estimated Face And Market Values Of Defaulted And Distressed Debt ($ Billions)(Not Including LEH Bond Defaults) 2006 - 2008 (3Q - Preliminary)

  32. Estimated Face And Market Values Of Defaulted And Distressed Debt ($ Billions)(Including LEH Bond Defaults) 2006 - 2008 (3Q - Preliminary)

  33. Size Of The US Defaulted And Distressed Debt Market ($ Billions) (Not Including LEH Bond Defaults) 1990 – 2008 (3Q - Preliminary) Source: Author’s Compilations

  34. Size Of The US Defaulted And Distressed Debt Market ($ Billions) (Including LEH Bond Defaults) 1990 – 2008 (3Q - Preliminary) Source: Author’s Compilations

  35. Returns and Correlations of the Defaulted Debt Markets

  36. Defaulted Debt Indexes: Market-to-Face Value Ratios (1987 – 2008 (9/30) Loans Median Market-to-Face value is 0.67 and Average Market-to-Face value is 0.68 Bonds Median Market-to-Face value is 0.46 and Average Market-to-Face value is 0.42 36 Source: Altman-NYU Salomon Center Defaulted Debt Indexes

  37. 37

  38. Regression (Correlation) Analysis of Defaulted Bond Returns vs. Default Rates Defaulted Bonds (t+1) = -9.45 + 4.34 (Default Rate (t)) Correlation (y/x) = 58.0% R2 test = 33.6% t-test = 3.01 (.05 level) Defaulted Bonds (t+2) = -6.80 + 3.38 (Default Rate (t)) Correlation (y/x) = 44.0% R2 = 19.4% t-test = 2.04 (.05 level) Defaulted Bonds (t) = 10.60 + 0.03 (Default Rate (t)) Correlation (y/x) = 0.0% R2 = 0.0% t-test = 0.02 (not significant)

  39. 39

  40. Regression (Correlation) Analysis of Defaulted Loan Returns vs. Default Rates Defaulted Loans (t+1) = -2.56 + 1.77 (Default Rate (t)) Correlation (y/x) = 66.0% R2 test = 43.6% t-test = 2.48 (.05 level) Defaulted Loans (t+2) = -1.22 + 1.71 (Default Rate (t)) Correlation (y/x) = 69.8% R2 = 48.6% t-test = 2.57 (.05 level) Defaulted Loans (t) = 3.12 + 0.47 (Default Rate (t)) Correlation (y/x) = 18.5% R2 = 3.3% t-test = 0.02 (not significant)

  41. 41

  42. Regression (Correlation) Analysis of Combined Index Returns vs. Default Rates Combined Index (t+1) = -4.13 + 2.88 (Default Rate (t)) Correlation (y/x) = 59.8% R2 test = 35.8% t-test = 2.36 (.05 level) Combined Index (t+2) = -5.56 + 2.85 (Default Rate (t)) Correlation (y/x) = 57.5% R2 = 33.0% t-test = 2.10 (.05 level) Combined Index (t) = 7.27 + 0.02 (Default Rate (t)) Correlation (y/x) = 0.0% R2 = 0.0% t-test = 0.02 (not significant)

  43. CORRELATION OF ALTMAN NYU-SALOMON CENTER INDEXES OF DEFAULTED BONDS WITH OTHER SECURITIES INDEXES 1987 – 2008 (June 30th) Correlation of Altman Bond Index Monthly Returns 43

  44. CORRELATION OF ALTMAN NYU-SALOMON CENTER INDEXES OF DEFAULTED LOANS WITH OTHER SECURITIES INDEXES 1996 – 2008 (June 30th) Correlation of Altman Indices Monthly Returns

  45. U.S. Distressed Debt Managers (September 2008)

  46. U.S. Distressed Debt Managers (September 2008)

  47. U.S. Distressed Debt Managers (September 2008)

  48. U.S. Distressed Funds with European Offices European DistressedDebt Managers (Home Grown)

  49. Distressed Active/Control Investors

  50. Investment Styles and Target Returns in Distressed Debt Investing

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