February 22, 2007 / 9:22 PM / 12 years ago

US HIGH YIELD-Credit defaults may rise to Depression levels

NEW YORK, Feb 22 (Reuters) - When the credit cycle finally does turn, U.S. corporate default rates may exceed those seen at any time since the Great Depression.

For now, investors are marveling at new bond products and the growth of a derivatives market that’s contributed to a benign credit environment marked by default rates near historical lows.

What concerns fund managers such as Sam DeRosa-Farag, who has $2.1 billion of assets under management, is new investors attracted to higher-risk assets such as high-yield bonds, real estate, and debt structures known as collateralized debt obligations, or CDOs.

“What we are really witnessing is a rapid increase in idiosyncratic risk,” DeRosa-Farag, president of hedge fund Ore Hill Partners, said during a conference in New York on Thursday.

“The next recession is going to make the Great Depression look like a walk in the park.”

During the Great Depression of 1929-1933, the U.S. suffered 30 percent unemployment and 21.2 percent of U.S. corporations defaulted on their debt, according to the U.S. Bureau of Economic Analysis.

Default rates could rise to those levels as “a best-case scenario,” DeRosa-Farag told an audience of about 700 participants at a CDO and credit derivatives conference.

Such a market meltdown is a view few are forecasting. Most Wall Street analysts believe spreads will begin to widen gradually and default rates rise.

Global default rates among speculative rated corporates fell to 1.09 percent last year, and may rise to about 3 percent, Standard & Poor’s said in a January report.

“Distress and defaults continue to be suppressed by abundant liquidity and generous financing provisions,” said S&P analyst Diane Vazza wrote in the report.

The global liquidity boom also has its downside and at some point will dry up, according to Mark Kiesel, portfolio manager at Newport Beach, California-based PIMCO.

“In this environment, investors with relatively short memories have embraced this recent period of economic nirvana as if it were here to last, by taking on more leverage and adding even risker investments,” Kiesel wrote in a March 2007 research note.


DeRosa-Farag, the former co-head of high-yield research at Credit Suisse, does not forecast a crash any time soon. In fact, the credit environment may even get better before it gets worse, he said.

Analysts and rating companies have been wrong, over and over, about the direction default rates and credit spreads, or the yield gap between U.S. Treasuries and corporate bonds, he said.

“Spreads will tighten in the next one, three, five, seven years,” which may fuel greater proportions of low-quality debt to be contained in investment portfolios, he said.

During bull markets, corporate default rates generally fall about 30 percent to 40 percent with each cycle, along with spreads, he said.

Default rates averaged about 2.5 percent during the 1980s bull market and about 1.5 percent in the 1990s, DeRosa said. Default rates currently are about 1.0 percent.

Current corporate bond spreads, on this historic basis, should be even narrower, he said. The gap between junk bond yields and U.S. Treasuries is likely to keep shrinking in 2007, even though junk bond spreads at 253 basis points are at the lowest levels in a decade, according to Merrill Lynch & Co. data.

“This is going to be an extreme bull market followed by one of the worst bear markets we’ve seen in our history,” DeRosa-Farag said.

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