Thursday, December 18, 2008

Bailout geology and credit rocks

An important post from FT Alphaville:

A rock and a hard place. Rocky terrain. Peaks and plateaus.

Bank of America has released its 2009 credit outlook — and it’s surprisingly geological in its main theme. The title: Matterhorn vs. Ayers Rock.

BoA - rocks

The credit version of the above pics is in Figure 7 below.

Put simply, they’re debating the depth — and structure — of the credit cycle. Specifically, whether we’ll see a ‘classical’ version of accelerating defaults followed by rapid improvement (the Matterhorn) or an Ayers Rock scenario, in which government intervention to stave off bankruptcy ends up prolonging the credit adjustment. So which exactly, should we be hoping for? BoA’s credit team has this to say (emphasis our own):
Investing before the peak of defaults in the past 2 cycles resulted in high Yield returns of 45% in 1991 and 28% in 2003. Those returns are a consequence of allowing bankruptcy to clean out future default uncertainty, resulting in better quality companies surviving and a reduction in the cost of credit and an improvement in its availability… Despite its headline figure of 30% cumulative default rates across 2009-11, the “Matterhorn” scenario should be hoped for as the economic implication of “Ayers Rock” increases cumulative defaults to 50%....MORE