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TMA Talks: What the Z-Score Says About Risk of Default Today

TMA Talks

Welcome to TMA Talks, a regular series of podcasts hosted by TMA Global CEO Scott Y. Stuart, Esq. Each segment features prominent TMA members, industry experts, and other special guests. These exchanges, edited transcripts of which are printed in the JCR, offer insights into key markets, forward-thinking economic outlooks, insider thoughts on industry trends, and much more. TMA Talks podcasts are available on the TMA podcast channel. Subscribe to our channel wherever you find your podcasts.

SCOTT STUART: Welcome to TMA Talks, where we talk everything TMA. I’m Scott Stuart, CEO of Turnaround Management Association. Today, we are pleased to have Edward Altman, Professor Emeritus of finance at New York University Stern School of Business, who recently published the fourth edition of Corporate Financial Distress, Restructuring, and Bankruptcy.

EDWARD ALTMAN: It was published about a month ago. The first one was in 1983, when TMA was just a dream for some people perhaps, and today it’s in its fourth edition. We always think the latest one is the best, but this one is clearly better than those that came before.

SCOTT: In 1968, Professor Altman published his Z-score for predicting the probability that a company will go into bankruptcy. Tell us a little bit about how the Z-score got started in its original iteration.

ED: It’s now 51 years ago that we built the original classic Z-score. I’m probably as surprised as anyone that it’s still around and, in fact, is used more today than ever before. I think there are three reasons for that. First, it’s still pretty accurate, 80% to 90% accurate within two years of bankruptcy, predicting distress and defaults. Two, it’s pretty simple. You don’t have to be a statistical guru or a financial wizard to use and understand it. And three, it’s free.

SCOTT: That’s a bargain.

ED: That was a big mistake of mine 50 years ago, but it was very difficult to patent intellectual property back then. Anyway, it’s an equation, which is very difficult to patent. It is free, which has really paid off for me and, hopefully, for a lot of people over the years.

I’m absolutely convinced that if I was a student at UCLA, where I was then, two years earlier or two years later, I would never have built the model. Two years earlier there wasn’t the computer power available to researchers in social sciences like economics and finance to build models of this type. We used an abacus or a handheld calculator. If I had been there two years later, someone else would have built a similar model. So, I was in the right place at the right time.

I think the secret of its longevity is the fact that although the markets have changed dramatically in credit, the basic fundamentals of what are good measurements and forecasters of firm performance have not changed.

SCOTT: We’ve been through a ton of cycles over the course of the last 50 years, and I think you and I would agree that this elongated period of artificial prosperity and huge leverage has been one of the great oddities in economics in some period of time. How has the Z-Score morphed to still be timely today, particularly in this most recent cycle that seems like it’s coming to an end for various reasons? How is it relevant in 2019?

ED: First, I should say the classic Z-Score is exactly the same. It has not morphed. It’s the same five variables, the same weighting of coefficients. What has changed is the basis for categorizing a company as vulnerable or in financial distress. I use a technique that I developed in 1989 to make it applicable over time, something called a “bond rating equivalent.”

The score might be 2.0, for example, for a company. Thirty or 40 years ago, a 2.0 was a very risky company, one that perhaps had a bond rating equivalent of triple-C and was on the verge of financial distress. Today, 2.0 indicates a fairly good company. If you get down to a score of zero, you’re getting into the highly distressed area. So, our model, based on calibration with bond ratings and scores of companies at various bond ratings, can change over time.

I’ll give you an example. In 1968, when we built the model, any firm with a score below 1.8 went bankrupt within two years—100% of them. Any company with a score above 3.0 remained healthy for at least five years. Today, a score of 1.8 is the average for a B-rated company, and our calibration shows that a B-rated company in the United States has about a 28% probability of default within five years; 72% of them do not default within five years.

SCOTT: But is that because of the state of lending and low interest rates, and the fact that potentially problematic situations are really just getting kicked down the road and not being addressed? Or is it a function of banks and other lending institutions feeling comfortable that in this environment that’s not a risky place to be?

ED: First of all, in the 1960s and ‘70s, there were no high-yield bonds, there were no junk bonds, so people had no understanding that companies could be non-investment grade and still be reasonably good investments. Therefore, there was no money flowing to companies that had very low scores and, if there were bonds, then equivalent ratings. Today, people are comfortable with financing a B-rated company. In fact, it’s the dominant junk bond out there because of the risk/return trade-offs of what they’re offered in terms of returns and the likelihood of default, plus very good statistics on recovery rates. The market has matured to understand that a B-rated company is a reasonable investment prospect.

SCOTT: Say you have a B-rated company, and all of a sudden something happens. Trade talks with China break down, for example, or the Fed gets jittery and pushes up interest rates a couple of times. All of a sudden, that B-rated company looks a heck of a lot riskier than it does in the environment we’ve been comfortably sitting in.

ED: That’s a good point because the ratings are not the basis of the model. Especially if you do a pro forma on what their financials will look like given trade problems with China, a reduction in GDP growth, or a big rise in the leverage of a company, that company is looking a lot worse than a B-rated company was just a short time ago. You’re absolutely right. Our models have not captured something, which is what you implied in that question, and that is, what would the score imply for a company in a recessionary period, as opposed to an expansion period like we’re in now?

I think a typical company with a score of 1.6, for example, in a recessionary period would find it more difficult to get financing. Banks are leery, required rates of return of investors are much higher, and such a company is more likely to go bankrupt than one in today’s benign credit cycle.

SCOTT: Is the Z-score used for investment opportunity, risk management, or a combination of both?

ED: Both, for sure. By the way, Bloomberg tells me that more people use the Z-score on their Bloomberg screen in the equity markets than in the debt markets.

SCOTT: That’s interesting. Why is that?

ED: In my opinion the reason is the following. If you own stock in a company that goes bankrupt, you’re more than likely going to be wiped out. If you own the bonds, you’re not going to be happy if it defaults, but the typical recovery rate on a corporate bond in default is around 45 cents on the dollar. If you own the loans, it’s probably 65 to 70 cents on the dollar recovery. The reason I think equity investors are really interested in it is to avoid that tail risk, that time when they’re going to be wiped out.

SCOTT: Would this be a good time to remind people that the book has a lot of these insightful pieces of information?

ED: We do have a chapter that does a retrospective on the past 50 years. I’ll give you an example of how things have changed in the debt markets. Twenty or 25 years ago there were about 100 industrial companies in the United States with triple-A ratings. How many today? Two. We’ve only got two triple-As left: Johnson & Johnson and Microsoft.

SCOTT: And yet people are still investing, and they are putting blinders on to risk, because risk has become an anomaly.

ED: It’s risk-on right now, exactly.

SCOTT: Risk-on and high leverage, but people have not seen any negative reverberations from taking the risk in these companies, even those you were defining as B-rated companies that in another time would be headed for the end.

ED: TMA members are all very savvy and know that companies that normally would have gone bankrupt 10, 20, or 30 years ago do not do so now because they have many avenues for survival—debt-for-equity swaps, for example, or distressed exchanges, which are much more popular now among bankruptcy lawyers than they were many years ago. Is it a Band-Aid, or is it something that really changed with the company?

SCOTT: That was my next question. Is it a Band-Aid, or is it that because we’ve gotten so used to risk being almost an irrelevancy and not cascading into a problematic situation? One of the things we talk about with our members is that we’re not only about corporate renewal and corporate restructuring. We’re about corporate health. Check in. Is the problem a big problem, or is it a small problem? Is the risk that you’re seeing something that you could or should be managing now before it gets out of control? Which really leads me into my next question: Does the Z-score offer insights into the state of the economy, what’s coming down the road? What are you seeing, if that’s the case?

ED: A lot of people are saying that there are similarities between the current market and what it was like in 2007. But if you ask the average analyst, is the American company today, on average, healthier or less healthy from a credit risk standpoint than it was in 2007, right before the financial crisis, I think most people would say they’re healthier—more profitability, more cash flow, and higher ratings, on average.

We looked at the Z-score, median Z-score, and Z”, which is a second-generation Z-score model we built. We looked at both Z and Z”, aggregated in 2007 and aggregated in 2017. Guess what? They were almost identical. In other words, the average risk of default from our model today is about the same as it was in ‘07.

SCOTT: So, the risk of default is the same as it was before the crash?

ED: Correct, one year before the crash.

SCOTT: But you’re not necessarily seeing signs that we’re situated for that kind of economic backlash right now?

ED: No, I don’t think we’re ready for a crash. Many people don’t think we’ll even have it. All I’m pointing out is the vulnerability of American high-yield companies, in particular, because those will crash first—the leverage loans, the high-yield bond issuers, as well as, of course, small and medium-sized firms that have similar Z-scores but are not rated.

We’ve looked at it very carefully. The spike in default rates and bankruptcies will start, in my opinion, before the next recession. But once there is a recession, it will spike to record levels, in dollar amount for sure and maybe even in percentages, but probably not in the 10% range.

SCOTT: Are we in a period of economic volatility? While your Z-score seems to indicate that there’s something afoot that is unsettled and people aren’t quite sure what it exactly means, it seems that we’re not in that period of stagnancy that we’ve been in for such a long time, where money was pouring in and leverage was building up. What do you think?

Germany’s biggest problem today is not the rest of the eurozone, and it’s not the United States. It’s China. I think Europe is most vulnerable now to a major downturn if China has, let’s just say, a hard landing, not necessarily a recession.


ED: It’s a tough question to answer, because my instinct, in terms of risk levels, is that I’ve never seen it as high as it is now in terms of the amount of leverage that’s been built up and the ability of companies to get financing even when their outlook is very grim, which can change on a dime. I believe that we are in this pretty high level of GDP growth, and if that stays at that level—and I don’t think it will—we will not have another crisis.

SCOTT: The 3.2% growth this last quarter was a surprise to everybody.

ED: But even if it was 2%, that’s not going to bring us down.

SCOTT: The predictions for the year, I think, were 2.7%, which is significantly below what we’ve seen in recent years but is still a very healthy clip of growth.

ED: Yes, but we’ve looked at the following. There’s a metric that I like very much, which is non-financial corporate debt as a percentage of GDP. You’ll find there were three times when that reached a very high level, a peak, and within 12 months we had a financial crisis. Those occurred in ‘90-’91, ‘01-’02, and, of course, ‘08-’09.

We are now in a peak higher than any of those prior three. That’s the amount of indebtedness relative to the cash flow of the economy. But every spike in default rates following a peak was coincident with an economic recession. So, I’m convinced that we will not have another crisis—we will not have another peak in default rates, in bankruptcies in general—unless we have an economic recession.

SCOTT: Let’s look outside of our little bubble called the United States of America and look into the eurozone. There are uncertainties there that can create instability that might reverberate negatively here. Are the stars aligning? Brexit is the great unknown out there, but it looks like Germany is well on its way to heading into a significant recessionary period.

ED: I agree.

SCOTT: Usually, that causes a good deal of Europe to follow. With that kind of volatility out there, how does this affect your more global analysis of what’s going on?

ED: I’m happy you mentioned Germany. Most people are not focusing on Germany, because they see the areas that are already soft. The Italian situation, for example, has been soft for more than 10 years, and it’s not getting any better.

Germany’s biggest problem today is not the rest of the eurozone, and it’s not the United States. It’s China. I think Europe is most vulnerable now to a major downturn if China has, let’s just say, a hard landing, not necessarily a recession. Nobody’s calling it that there, but if China goes to a 5% or 5.5% growth rate—a growth rate most people would love to have—that would be a big downturn.

That will, of course, affect companies normally selling to China, like Germany in particular. Germany’s getting weaker. They have political unrest, which is a background-type issue, but the main thing is that they can’t depend on sales to a lot of the other European countries as much as they could before. And definitely, China is down.

SCOTT: If you have the eurozone, particularly Germany, very dependent on its relationship with China and now we’re having trade issues with China, how does throwing that into the mix affect what might occur here?

ED: I don’t think the trade issue is a fundamental issue with Germany and the other countries. I think the trade issue is political posturing and will, of course, affect GDP growth. It doesn’t look like they’re going to come to an agreement tomorrow, so the tariffs will be increased. That will put pressure on the financial markets, and it will put pressure on the American consumer. Big mistake, I think. It will put pressure on companies that want to sell to China, because China is going to back up even more. That will exacerbate the problem. I think the fundamental problem in China is it’s been growing for so long for so high, it’s normal for it to be dropping in its growth rate.

SCOTT: Isn’t that something that’s happening right here at home, where we’ve been growing for so long and so high, and so much money has been poured into the markets, particularly from the private equity sector?

ED: That’s another issue, yes.

SCOTT: Let’s talk about that, because you talk a lot, both in your book and in a lot of articles, about long-term leverage and low-cost finance. I’ll go back to something I said earlier: Are we just floating through time with our blinders on, and not looking at the effects of that, including a possible correction even if we don’t go into a recession?

ED: I don’t think we have blinders on completely, because if I were CFO of a company, I would take advantage of these low interest rates over this period of time, too. It makes a lot of sense to be opportunistic with respect to interest rates.

But here’s the difference between now and in the ‘60s, when I was a graduate student at UCLA, or even in the ‘70s. Back then, you took advantage of low-cost debt, knowing that you could usually issue equity in the future to keep your target debt/equity ratio pretty much intact. You moved up and down depending on the cycle of interest rates and stock prices. What has changed is that since the financial crisis of ‘08-’09, the correlation between stock prices and risky debt prices has spiked dramatically. It’s now between 0.7 and 0.75 correlation.

That doesn’t mean necessarily too much to a lot of people. It’s a number that I calculate. What I think is more important is that when we have a reversal in the credit markets, there more than likely will be a reversal in the equity markets of an equal or greater amount.

SCOTT: That’s not traditional, correct?

ED: Usually, the correlation was much lower. Now you can switch so easily to equity when you have problems with your debt, which will happen. I’m not an economic forecaster, so don’t ...

SCOTT: Anyone in this industry is an armchair economic forecaster.

ED: I don’t even try. What I like to do is look at surveys. I like to look at the way the trends are going. I would say that 75% of economists today believe we will have a recession no later than 2021, about 55% think it’ll happen in 2020, and about 10% think it’ll happen in 2019. So, that is a relatively small potential this year, a much bigger potential in 2020, and culminating in three-quarters of economists thinking it’ll happen by 2021.

SCOTT: Why is that, because the writing is not on the wall that clearly, although agree with me if you will that there is segment volatility that is causing people to scrutinize where the economy is going. Even if we don’t have growth as robust as we’ve had, and everybody does see a slowdown as inevitable because the steam’s running out, the tax breaks have worn thin, and stimulus is all eaten up. So, there’s nothing left to fuel it outside of low interest rates and risk aversion lending. Are these the factors that are going into the thinking about a potential recession within the next two years?

ED: Those are the ones that I read about also. It’s inevitable that we’ll have a slowdown in the economy because of the fact that, as you mentioned, companies’ cash flow will be insufficient at the marginal level—say at the B-minus, triple-C level—whereas before it was able to cover the interest costs. What is not talked about as much, and the thing that I look at more forcefully, is the fact that when there is a downturn, even if it’s not a recession, there will be a pullback on risk capital. In other words, it will be much more difficult to get the liquidity that’s in the system. It’s almost like the waves are going out and then coming in, and right now they’re ready to go out.

I scratch my head, too, to see us going from 3% to negative that quickly, but this has to do with the flow effect and the risk tolerance out there. Right now, the risk tolerance is very high, and therefore it’s risk-on. That can change overnight—literally overnight. But I scratch my head, too, as to what the catalyst will be. I have a feeling that a part of it is going to be the lack of our ability to sell our products to other countries, because they’re going to have the problem. They already have the problem, in many cases, and they’re going to have it even worse.

SCOTT: Professor Edward Altman, thank you so much for joining me on TMA Talks. Always a pleasure to spend time with you.

ED: Thank you.

Tell us what you want to hear on upcoming TMA Talks. Send your thoughts, ideas, and comments to sstuart@turnaround.org.

Scott Stuart

Scott Y. Stuart, Esq.

TMA Global CEO

Scott Y. Stuart, Esq. is the Chief Executive Officer of Turnaround Management Association, a professional community of 9,000 members that seeks to strengthen the global economy by working save distressed businesses, assist management to navigate off-plan events, and help healthy companies avoid similar pitfalls. He brings nearly 30 years of experience in the restructuring, legal, and distressed investment sectors and has a proven track record of building, growing, and leading successful companies, from corporations to startups.

Edward Altman

Edward I. Altman

New York University Stern School of Business

Edward I. Altman is the Max L. Heine Professor Emeritus of Finance at New York University’s Stern School of Business and director of theCredit and Fixed Income Research Program at the NYU Salomon Center. He is an internationally recognized expert on corporate bankruptcy, high yield bonds, distressed debt, and credit risk analysis, and is an advisor to Paulson & Co., a consultant to FINRA, and a member of the board of the Franklin Series Funds. He was an inaugural inductee into the Turnaround, Restructuring, and Distressed Investing Industry Hall of Fame and is a member of the Fixed Income Analysts Society Hall of Fame. 

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