Thursday, December 25, 2008

Weaker companies may be in real trouble

Even in the best of economies there are a lot of weaker companies that manage to survive and get funded by so-called junk bonds. But, when times get tough, these companies run into trouble real quick since people are reluctant to buy lots of junk debt when these weak companies are at much higher risk of failure. It may make sense that weak companies should perish in a darwinian world, but there are a lot of people employed by these companies and the companies spend a lot of money buying goods and services, so failures can cause a lot of harm to the economy. Until now, we have been hearing about data that is the worst since the Great Depression, but now we have a data point that is worse than the Great Depression. Gary Shilling says that "Junk bond spreads vs. Treasurys now imply a 21% default rate, higher than in 1933 at the bottom of the Depression." That could mean trouble. Not just worse than the depression, but worse than the worst point of the depression.

The open issue is whether the mad rush to quality by investors has simply caused investors to dump junk bonds regardless of their likelihood of default or whether the fundamentals of these weak companies are really so bad that more that one out of five are in fact likely to fail. I simply do not have any data to answer that question.

Ultimately, we will be able to infer the answer from whether payroll employment continues to fall by 500,000 or more for more than a few more months.

I would also note that although the Federal Reserve is currently supporting the commercial paper market, that is only for high quality commercial paper, not the comercial paper issues by companies whose debt is considered junk. So, weaker companies could be in a lot of trouble.

Quite a few of these companies can probably squeak by for a few months, but going more than a few months may break the camel's back for junk-funded companies.

Sure, massive fiscal stimulus will help the overall economy, but it may mean that the government has to pump in even more massive doses of money to compensate for a significant failure rate for junk-funded companies, since fiscal stimulus is unlikely to flow directly into very many junk-funded companies.

I have not heard anybody make an estimate of what fraction of the conomy is composed of junk-funded companies.

-- Jack Krupansky


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