The New York Times published this article about rising business defaults and another article describing why people from abroad want to invest in the U.S. economy. In a Humming Economy, a Rising Din of Defaults ROBERT D. HERSHEY Jr. With the economic expansion setting records for longevity, much of American business is reveling in prosperity. But all is hardly well. For reasons that include profligate lending and underwriting in the second half of the 1990's, many large businesses, and even entire industries, are suffocating from their debts. A major portion of the health care industry is in shambles. In retailing, competition from category killers has contributed to huge consolidation. And some auto parts suppliers, already beleaguered despite record car sales by Detroit last year, seem to have no place to go but south. That's not all. Household names like Pathmark Stores and United Artists Theatre Company defaulted on bonds this spring and are contributors to a total of $15 billion in defaulted debt across corporate America for the first half of 2000 -- a rate that could smash last year's record of $23.5 billion. Though the financial disruption at Pathmark and United Artists is nearly invisible to their customers, it is very visible to the bankruptcy lawyers and other people -- please don't call them vultures -- who make their living from corporate distress. For them, business has rarely been better. And judging from the agony in the market for high-yield bonds, probably the best predictor, it is likely to get better still. "The restructuring industry is in an expansion phase right now," said Al Koch, managing principal at Jay Alix & Associates, a leading specialist in the category. Its staff has nearly tripled in size over the last five years as more companies have needed help in fixing operations and recasting notes and bonds. "Insolvency attorneys are all very, very busy," Mr. Koch added. Deryck A. Palmer, a partner and restructuring specialist at Weil, Gotshal & Manges, can vouch for that. He points particularly to the bounty that awaits those involved in refinancing hospitals, which he believes are only beginning to feel the crunch that has affected other businesses. "What's amazing is you have this much activity in a robust economy," Mr. Palmer said. Whether these exceptions to the boom will lead to a full-fledged credit crunch depends on whom you ask. But there is no doubt that a rising number of companies, running out of financing options, are having to default. And with nearly all economists agreeing that the Federal Reserve will succeed, sooner or later, in slowing the nation's growth, the corporate distress will probably widen. If the Fed's tightening brings on a recession, as a few analysts now predict for next year, the defaults could intensify the contraction. As Henry S. Miller, vice chairman of Wasserstein Perella & Company and head of its restructuring business, put it, "Most people who play in this business believe there is a lot more to come." Moody's Investors Service calculates that 6.2 percent of high-yield, or junk, bonds are now in default. It projects that the rate will rise to 7.1 percent by year-end, and to 8.4 percent by July 2001. Globally, the United States, which has the world's most accessible capital markets, accounts for 75 percent of the defaulted bonds by amount and 85 percent by number of companies. Most economists doubt that the soured debt will cause more than a blip in the nation's overall economic performance. But Alan Greenspan, the chairman of the Federal Reserve, watches the figures on distressed loans. And his staff has made inquiries recently about the ill health of the market for high-yield debt, defined as securities rated no higher than Ba-1 by Moody's or BB+ by Standard & Poor's. ome casualties are in long-ailing businesses like steel. Others are in highly cyclical ones like heavy equipment. Harnischfeger Industries, a maker of mining equipment, survived the Rust Belt vicissitudes of the 1980's only to be driven into Chapter 11 bankruptcy by overwhelming fixed costs and falling prices in 1999. Borrowing for what analysts regard as ill-conceived acquisitions has also caused problems. Safety-Kleen, for example, tried to combine such fundamentally different businesses as hazardous-waste disposal with the more routine collection of used motor oil and recyclable materials. In still others, companies fell prey to rapid technological change or, as with hospitals and nursing homes, to new restrictions on government reimbursements. With a few exceptions, Internet companies have not made much use of the bond market, because of a ready supply, at least until this year, of equity capital. As a result, few have defaulted. Analysts say bad strategies or bad execution, or sometimes both, could not have occurred without a severe relaxation in standards that allowed weak companies to borrow freely from banks and bond investors. From 1996 to 1999, said Edward Altman, a finance professor at New York University and a consultant to Salomon Smith Barney, "you had a huge number of low-quality issues coming to market." As proof, Dr. Altman said, defaults showed up within a year or two of the financings, instead of the more typical three or four years. Mr. Hamilton agreed that the ease of raising money in the bond market in 1997 and 1998 "sowed the seeds for the current crop of defaults." As the cash flows necessary for repaying bonds and loans failed to materialize, banks began to tighten their credit standards, even more so in the wake of Russia's 1998 default. The Fed put pressure on the banks to acknowledge their mistakes by using some of their profits to increase reserves to cover dubious loans. Also, lenders and debt markets became far less hospitable to companies needing to refinance. "Credit standards have tightened up and they've got nowhere to go," Mr. Koch said. "Three years ago, you could go to the bank across the street but you can't do that anymore. And the bond markets are closed to them." In the past, Mr. Koch said, companies could routinely be rescued with fairly straightforward financial fixes like persuading investors to swap their bonds for freshly issued stock. But companies now find that they need to make their operations far more efficient, too. He cited Trans World Airlines as a company that still needed to improve operations if it is to head off its third descent into bankruptcy. In a report published last month by Salomon Smith Barney, Dr. Altman found not only that the default rate on bonds jumped to 1.58 percent in the second quarter, from 1 percent in the first quarter, but also that so-called distressed debt had reached "somewhat ominous" levels. Distressed bonds have yields to maturity at least 10 percentage points above those of similar Treasury securities. Some 17 percent of high-yield debt was in this category on June 30, compared with 9 percent at the end of last year and just 3 percent at the end of 1998. And Moody's downgraded the debt of twice as many companies as it upgraded in the first half of this year, the highest ratio since 1991, when the last recession ended. Still, the cumulative total of defaulted and distressed debt, estimated at 23 percent of the amount outstanding at midyear, remains far below the 43 percent in 1992. In fact, some analysts contend that prices on high-yield debt have fallen to bargain levels, with the average yield at 13 percent. "We feel the Fed is basically done with interest-rate increases," said Steven A. Ruggiero, director of high-yield research at Chase Securities. He calls high-yield debt a "good place to be" for investors, provided that they are in a mutual fund or closed-end fund and that it constitutes no more than 10 percent of a portfolio. -- Michael Perelman Economics Department California State University Chico, CA 95929 Tel. 530-898-5321 E-Mail [EMAIL PROTECTED]
