Legendary bankruptcy expert Dr. Edward Altman, the creator of the financial-distress sniffing Altman Z-Score, warned in mid-2007 of a “Great Credit Bubble” and that there was going to be trouble in the market. He predicted that a meltdown would stem from corporate defaults. While the primary culprit of the financial crisis turned out to be mortgage-backed securities, investors who heeded Altman’s warning nevertheless avoided a lot of grief.
As a reminder, the Altman Z-Score is the output of a credit-strength test that gauges a publicly traded company's likelihood of bankruptcy. The Altman Z-score is based on five financial ratios that can be calculated from data found on a company's annual 10K report. It uses profitability, leverage, liquidity, solvency and activity to predict whether a company has a high degree of probability of being insolvent.
Troublingly, Yahoo Finance's Julia La Roche notes that Altman sees the reckless behavior of 2007 surfacing again.
“We’ve never had such a long benign cycle. And just that one little fact is something that we should be concerned about because if it comes to one and it could come to an end very dramatically.”
“Back in 2007 prior to the crisis in ’08 and ’09, the fundamentals of credit risk of the companies issuing bonds and taking out loans were quite low,” he said.
“And the similarity that I see now between 2007 and 2016 is very similar fundamentals, quite a bit high risk and it doesn’t seem to bother the market because it’s the only game in town in terms of getting yield greater than what you can get for low-risk securities like governments and high-grade corporates.”
“Speaking about the Z-score, if you compare the average Z-score of companies in 2007 with the average in 2016, which is the last time we looked at it, guess what. The average is actually lower today than it was in 2007, and 2007 was right before the great financial crisis, and of course, in ’08 and ’09 we saw a tremendous increase in corporate bond defaults and loans.”
Click the image below for a link to La Roche's full interview...
Low Z-scores are associated with financial distress. Here are some examples from Retail, Tech, and Energy...
“So the good news is that it’s no worse, but the bad news is, fundamentally, the companies are no better than they were back in 2007 at least by our model.”
And, just as Moody's predicts, if the gusher of liquidity and low rates is about to end (Janet?) then a pessimistic scenario looks very ominous...