Bankruptcy expert Ed Altman on economic outlook amid COVID-19

Z-Score Creator & Professor Emeritus at NYU Stern School of Business Edward Altman joins Yahoo Finance’s Zack Guzman and Julia La Roche to discuss the economic outlook amid the coronavirus pandemic.

Video Transcript

ZACK GUZMAN: But for now, we're getting worsening projections when it comes to analysts trying to figure out how big the slowdown that is underway will be-- potentially three million unemployment claims coming this week if you believe Bank of America, as we see second quarter growth potentially fall about 30%-- that projection from Morgan Stanley. For more on this, though, it's stretching a lot of businesses who might have pretty bad balance sheets out there to the brink.

And I want to bring in a man who has studied that-- I'm not going to call it an epidemic, but that problem for quite a while. Professor Edward Altman, he's the originator of the Altman Z-score-- a so-called standardized measure of bankruptcy risk. He's also professor emeritus at the NYU Stern School of Business, and he joins us now via phone alongside Julia La Roche, who is here on the hangout as well. Professor, first off-- there's been a lot of talk right now about how these business are going to be able to navigate the short term credit risks here. When we think about in the restaurant space, a lot of people not going out to eat, how some major restaurants are going to be able to deal with that.


I want to get into the sector by sector details in a little bit, but first, just when you look at the overall risks here, what's the overall percentage you're seeing in terms of US businesses, large and small, that might potentially have to file for bankruptcy here as the stresses continue to get bigger and bigger?

EDWARD ALTMAN: Well, things have changed dramatically since the beginning of the year. At the beginning of the year, we were forecasting a 3.3% default rate in the high yield bond market companies. And that's the metric that we use to gauge bankruptcy and default potential. Then we raised it to around 5.5% when I gave a speech on March 6.

Today, our numbers are showing a likely default over the next 12 months of just under 10%. That is a huge, unprecedented increase in such a short period of time. And it does signal a crisis in the credit markets whenever you get to that 10% level. And by the way, my forecast is actually lower than all the major rating agencies, which have come out with a trial forecast for the next 12 months. So it is looking very grim for all types of firms, particularly the marginal firms, that had been kept alive artificially by low interest rates and the high liquidity in the market.

ZACK GUZMAN: Yeah, professor, can I just follow up on that number-- I just want to make sure I heard you right-- did you say that the risks to businesses have doubled when you look at the potential amount of bankruptcies here in just a week?

EDWARD ALTMAN: That's correct. The distress ratio, which is the percentage of companies whose bonds are selling above 10% more than treasuries, have spiked to around 30%. That's incredible. The only time it's ever been higher was in 2008, December, when it was actually 80%. But that was, of course, right before the huge meltdown or right during it.

Right now, it is 30%, this distress ratio. And the yield spread that investors are requiring, not by high yield bonds, exceeds 10% of [INAUDIBLE] treasury yields as well. So that's the average yield spread. So the average [INAUDIBLE] in the market today is by our [INAUDIBLE], and that is just about unprecedented.

JULIA LA ROCHE: Dr. Altman, it's Julia La Roche here. Those numbers are striking when you share them, especially the change in the week. Going back to even last year, though, we were initially talking about some of the stress is going on in the credit markets. And I find the credit markets to be fascinating in terms of figuring out what's going on in the broader economy. What do you make of the numbers that you just said there? And how do you see that playing out? Are we past the point of no return at this point?

EDWARD ALTMAN: Well, there's no question now that we are heading into a recession. Just about everyone is forecasting that. So my analysis has always been, what will happen when we go into a recession, rather than what's happening given the good times that we had until the beginning of the year. And our analysis shows that when you go into a recession, then the percentage of companies issuing debt as a percentage of GDP is very important.

And that peaked-- in other words, there was this great debt balloon that peaked right at the beginning of this year-- at probably more than 48%, 49% of GDP for non-financial corporate debt. If it was followed by a recession, there's no question in my mind this would be the worst period for corporate default amounts that we've ever seen-- not necessarily the default rate, but the default amount, because there's so much outstanding.

So we estimate today probably in the high yield bond market something like $150 billion of corporate defaults just from that market. And that's not even counting the loan market, which has also grown dramatically.

ZACK GUZMAN: And, professor, I mean, when we look at this, a lot of analysts have been flagging the corporate debt bubble as a potential problem here, even before coronavirus came around. When you look at it, almost half the investment grade corporate bonds out there right now, rated BBB-- triple-B-- which means it could be downgraded to junk levels, which is a problem for a lot of investors who aren't allowed to hold debt that is rated as such. So when you look at that, what potential risks are on top of all this considering what investors might have to do to shave down some of those holdings there in problems?

EDWARD ALTMAN: Yes, that is an absolutely key question, Zack. Let me try to put it into the right perspective. A triple-B company is the lowest of the investment grade. , And of course, as you mentioned, if they are downgraded, they're downgraded to high yield junk status. That is a very drastic issue. The rating agencies all said that the likely amount of that, even in a downturn, would be a maximum of around 10% of that market, which is more than $3 trillion, and more than 50% of the investment grade market in triple-B's.

So they said it would be around 10% over a two or three-year period. My analysis showed that, using the z-score method, that more than 30% of the triple-B's already look like non-investment grade companies-- that they will be the first ones to be downgraded, and that the impact would be much greater than this 10%. So I think, if I could also switch to what the Fed is trying to do in this respect, I think it's all together very important.

So we have this huge amount of triple-B's, as you mentioned. They are very vulnerable to be downgraded. And they will be, and they've started to be, even before today, be downgraded-- companies like Kraft and now some three or four of the big energy companies. So there is already the beginning of this downgrade.

The Fed now, as you may have mentioned earlier in your show today, has done a number of very important, very big, huge, unprecedented actions with respect to many areas. But in the area of corporate debt for investment grade companies, the Fed now is playing the role that the old investment banks always used to play as a major market maker.

ZACK GUZMAN: Yeah, no for sure. They need to take more drastic measures on that front. I just want to, lastly, before we let you go, I just want to highlight the z-score for people out there who might not be familiar with it. When we look at standardizing bankruptcy risk, you basically-- that's what you're famous for here-- looking at scores above 2.6 are good ratings, 1.1 to 2.6 the gray zone, so-called, below 1.1 is where you start to get into bankruptcy risk.

I'm not sure if there are any companies that you've been looking at flagging potential problems here. I know we've highlighted a few in the restaurant sector when we look at Darden Restaurants at 2.59 last I checked and Bloomin' Brands at 1.38. You're starting to see restaurants potentially getting into that risk zone here too. So what do you make of what you're seeing using your own standardized bankruptcy score?

EDWARD ALTMAN: Saying a very large percentage of those mining, oil and gas companies that were already in these zones even before the drop of the oil prices to very low levels-- $22, $23 a barrel-- they will be going very quickly into bankruptcy, or they'll try what's called distressed exchanges. That's where they offer the bondholders some package of securities, and they're offering a kind of moratorium to pay their bills in a forbearance period.

By the way, a large percentage of those distressed changes will go bankrupt anyway. So it's a bit of a Band-Aid. So oil and gas companies, airlines-- I don't think they're likely to go bankrupt, because they've done so well lately, and they've built up their [INAUDIBLE] reserves, but they are hit hard. And so they were likely to be downgraded.

Retail companies across the board are in trouble. Leisure and hospitality-- and one area that you haven't talked about is the health care industry. You know, health care, everyone thinks everyone is going to spend a lot of money on health care now. Well, the truth is that hospitals make far less money on these cases of COVID-19 coming in than they would on elective surgery and other types of very expensive operations, et cetera that go on in hospitals normally.

They're going to be crowded out. And so I would expect there is going to be a lot of disruption in the health care industry, above and beyond all the problems they're having with their employees getting sick and the like. So be careful about that sector too-- nursing homes, hospitals, et cetera as well. But oil and gas is the one--



ZACK GUZMAN: No, it's a very good point you're raising there as well, as people might overlook the risks the health care sector because of all the attention that's been paid to airlines, the slowdown we've seen there. But for now, I just want to thank you again for coming on to bring us all this. Professor Altman, creator the the z-score-- the Altman Z-score and NYU professor emeritus at NYU School of Business, thank you so much for joining us, sir. And our thanks to Julia La Roche as well.