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Credit defaults: It’s different this time

Predicting corporate default rates on the basis of historical experience is a futile pastime.

In October, leveraged loans were trading below the level at which every loan in the market would have to default in order for investors to lose money. The typical recovery rate in bankruptcy is 70 cents on the dollar (according to Standard & Poor’s LCD), but US and European loan prices fell to 68% and 70% respectively in October, down from the mid-80s at the beginning of the month.

On the face of it, these levels have little to do with fundamentals and everything to do with forced unwinds. But if the loan market has learned one thing from this crisis, it is that historical precedent counts for very little indeed. Banks may have recovered 70 cents on the dollar in past defaults, but this time things could be very different.

High leverage multiples coupled with weak lending practices will result in insolvencies that are far more serious and messy than they have been before, with the result that recoveries could be far, far lower than previous experience would suggest. So maybe those secondary trading levels are not as nonsensical as they appear.

It is the unpredictability of this downturn that makes it so worrying. The trigger for today’s chaos was sub-prime mortgage defaults behaving very differently from all the historical data upon which the rating agencies had based their models.

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