Is it harder to borrow after you’ve defaulted?

April 5, 2009

There are lots of things a company spokesman can say to reassure reporters and investors that his firm is in good financial shape. This is not one of them:

In early March, the rating agency Moody’s included OSI Restaurant Partners on its list of “bottom-rung” companies that are most likely to default on debt payments. A company spokesman, Michael Fox, said the company had recently significantly improved its financial position by retiring $300 million of debt at a discounted cost of $85 million.

If you’re a bond investor who has sold out at 28 cents on the dollar, you are most likely extremely unhappy. When you bought the bond, you reckoned there was a small but significant chance of default — but you also reckoned that if the company did default, your recovery value would probably be 40 cents or so. If you end up selling for 28 cents, that’s worse than a default.

Which brings me to the latest declaration by Moody’s, over at Zero Hedge:

Exchanges made by distressed issuers at discounts to par which have the effect of allowing the issuer to avoid a bankruptcy filing or a payment default (i.e., “distressed exchanges”) are considered default events under Moody’s definition of default.

What this means, says Tyler, is much less room for maneuver at leveraged companies:

CFOs of highly leveraged companies that still have substantial cash amounts on their books, will now have to sweat the trade off of purchasing their cheap debt in the open market, since any tax benefit of doing so will be eliminated by the threat that Moody’s may assume the company merits a Hovnanian-like treatment and downgrade it to Limited Default, this making it impossible for the company to even have hope of accessing the capital markets in the future.

My feeling is that the capital markets have no morals. All they care about is the chance that you will default in the future, not whether or not you’ve defaulted in the past. Indeed, I remember at one point that Colombia complained regularly that it was being punished for never having defaulted: all the other Latin nations had defaulted, and therefore had lower debt burdens, after renegotiating their debt under the Brady Plan. While Colombia, which did the right thing all along, had more debt and therefore higher spreads.

A lot of Americans are surprised, after they declare bankruptcy, to find the credit offers rolling in almost immediately — they thought that filing would destroy their credit rating and render them incapable of borrowing anything for years. But of course that’s not how it works: having discharged their debts, they’re now free to rack up new ones, at interest rates which make such deals extremely profitable for the lenders.

Bond investors are similar. The less debt that a company has, the more attractive it is. Sure, there are lots of investors who aren’t allowed to invest in a company carrying a “Limited Default” rating. But there are even more investors who are allowed to invest in such companies — indeed, who pride themselves on lending to such companies and making lots of money by doing so.

So by all means let’s have a debate about when a distressed debt buyback constitutes an event of default for CDS purposes. But I’m not sure that Moody’s is really relevant any more.


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