Extend and Pretend is Not Our Friend in the End

Recently ran across a post from a favorite blogger of mine, Mike Shedlock, aka Mish.  I started reading him in early ’05, and have been reading his stuff ever since.  He wrote a post recently that I thought was again, important, but not juicy enough to get folks to salivate over.  The basis of his post was an article in the Wall Street Journal.  From the article:

Corporate failures have slowed, as companies once on the verge of default have found a new life. These companies are now refinancing their balance sheets with new debt, pushing out maturities on existing loans or using distressed-debt exchanges to avoid a bankruptcy filing.

Speculative-grade companies — or those with “junk” credit ratings — have issued about $123 billion in new bonds this year, compared with roughly $48 billion in all of last year, according to data provider Dealogic. That’s on pace to challenge 2006’s record issuance of more than $143 billion, Barclays Capital analysts said late last week.

Many analysts worry the refinancing wave is just “kicking the can” down the road, without fundamentally fixing companies’ deeper problems. Among weaker companies, about $1.4 trillion in bonds and loans will still come due in the next five years, said Dominic DiNapoli of FTI Consulting, a business advisory firm.

Instead of “kicking the can down the road,” I have another visualization in mind: Luca Brasi standing over someone with a pillow, ready to suffocate them in their sleep.  As an example, I found this snippet in an article about hotels, by Steve Van:

The race between LIBOR and RevPAR will start to sink most floating loans as soon as the economy starts to recover. When each of the past recoveries has taken hold, LIBOR increased around 300-400 basis points in 12 months. So today’s fairy land of 2 percent hotel loans (175 over LIBOR at 0.24 today) will evaporate, and payment rates will increase by 150 percent to 300 percent. Some of these loans won’t even make it to the end of the canyon.

What Van is talking about, pure and simple, is the deterioration we will see in one of those God-awful ratios that nobody likes to deal with (Because that involves math and thinking.  Collectively, we as a nation hate that.), called Interest Coverage.  From Investopedia:

So we want this ratio to be higher as opposed to lower.  Typically, a ratio of 1.5 indicates a healthy company, while a ratio below 1 means the business does not generate enough income to meet interest on its debt – an obvious bad sign.  But let’s put numbers around this.  The following comes from Starwood Hotels (NYSE: HOT) 9-30-09 10-Q:

Interest expense increased year-over-year, so let’s see how this impacts interest coverage.  I posted the calculation over on Scribd:

You can see the deterioration clearly.  Because you have interest expense moving higher at the same time operating income is heading lower.  This isn’t really a knock on Starwood.  I love their hotels and in the interest of full disclosure, I’ve been an SPG member for far longer than the 3 whole days I’ve been blogging.  The point is income will take a lot longer to improve than it will take rates to worsen.

And here’s another thing to think about: the longer metrics like interest coverage, debt-to-EBITDA, etc. get worse, the eventual default will end up with a bigger charge-off.

Which then leads to bigger hits against allowance and capital for the banks.

Who will be more reluctant to lend, and rightfully so.

Which would prompt our current government to offer more taxpayer money in an effort to make it go away.  But as you can see, it won’t.

So again, what are we supposed to do to get ourselves out of this mess?  We need to start by being realistic.  Not all of the hotels/resorts, retailers, manufacturers, wholesalers, etc. who have debt to service are going to be able to service it.  Some will, some won’t.

But extending & pretending won’t help anyone.  Like I said: extend & pretend is not our friend  in the end.


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