The Real Cost of Default
Six of the ten biggest corporate bankruptcies in history have occurred since late 2008 — and all ten of the top ten, if you include companies that escaped bankruptcy by being bailed out. The names are etched in our memories: Lehman Brothers, General Motors, Chrysler, A.I.G., Fannie Mae, and Freddie Mac.
However, for all that, the actual costs of corporate defaults and bankruptcy remain murky and mysterious. Calculations about default risk loom behind almost every decision by investors and corporate strategists. They affect how much it costs a company to borrow, how it structures its finances, and what it does if it edges near the abyss.
It’s obvious that filing for bankruptcy takes a huge toll, on top of the costs that stem from a company’s underlying problems with sales and profits. Whatever else may be happening, defaults bring a slew of costs on their own: customers and major suppliers often flee; brands can be permanently damaged; assets may have to be sold at fire-sale prices. All that is quickly reflected in a stricken company’s stock and bond prices.
But it’s hard to untangle the cost of a default from the cost of everything else going on with stock and bond valuations. Cash problems and operating losses often overlap and reinforce each other, but they have different causes and consequences. If the costs of a default are lower than the players assume, investors and corporate architects risk making miscalculations that will haunt them for years in the future.
Ilya A. Strebulaev, associate professor of finance at Stanford’s Graduate School of Business, says those costs are higher than assumed. In a new paper, coauthored with Sergei A. Davydenko and Xiaofei Zhao of the University of Toronto, Strebulaev combined historical data on corporate defaults with a new analytical model to tease out investor reactions to a default both before and after it happens.
Their conclusion: default causes a much bigger decline in a company’s total market value than is generally assumed. They estimate that defaults, which can range from missed bond payments to outright bankruptcy filings, will, on average, reduce a corporation’s total market value by 21.7%. For “fallen angels” — companies that started out with investment-grade ratings — default will destroy about 30% of the total asset value.
That is an eye-opener. Until now, the best estimate had been that corporate defaults cost companies about 20% of their value. But that estimate was based only on defaults at 30 companies that had originally been financed with high-yield junk bonds. Strebulaev analyzed 175 corporations, including many fallen angels that defaulted between 1997 and 2010.
The real breakthrough, however, was to come up with a way to distinguish the cost of default from the cost of economic deterioration. In the real world, a troubled company’s stock price usually plunges for a host of different reasons at the same time. A company with falling sales and mounting losses will lose value and edge closer to bankruptcy. But the prospect of bankruptcy itself usually adds many other costs.
That was the case with United Airlines, which filed for bankruptcy in 2002 after being battered by brutal cost competition and slumping traffic volumes. Once it filed for bankruptcy, it lost additional value as suppliers and industry partners, such as regional airlines, backed away.
How to unravel the mess? Strebulaev has been working for years to tease out the causes and consequences of corporate defaults. In a series of papers, he and his colleagues have analyzed defaults going back as far as 150 years. Along the way, he has turned up a number of unexpected discoveries. One surprise: cash-heavy companies are actually more likely to default over the long-term than companies with smaller reserves. Why? Because executives often shore up cash when they are worried. The seemingly rich coffers can be a sign of trouble, rather than a sign of health. Another surprise: many companies wait to liquidate unsuccessful projects until a broader industrial downturn, so their failures will “blend into the crowd” and won’t be as embarrassing. When the downturn comes, though, the accumulation of living-dead zombie ventures can aggravate an industry-wide investment bust.
For Strebulaev, the patterns and practices of companies in financial distress constitute a rich new opportunity. The goal isn’t simply to provide a new tool for corporate strategists. The real purpose is to illuminate why corporations and investors make the choices they do, and to understand the consequences. Corporate defaults are costly — their losses extend well beyond the ones caused by a company’s underlying business problems.
But how big are those costs? Strebulaev and his colleagues measured the total cost by looking at the drop in market value of a company’s equity and debt. The first step was measuring the drop in stock and bond prices right after a company announced a default.
In most cases, though, investors anticipate a default weeks or months in advance and begin to discount a company’s valuation long before it defaults. The full cost of a default needs to include the anticipatory drop in value, but it needs to exclude the losses tied to the company’s economic deterioration.
It sounds impossible, which is why there had only been one other major empirical study of the subject. But Strebulaev and his colleagues came up with a novel approach. They built a sophisticated, yet intuitive, model of how investors typically anticipate a corporate default, and applied this model to historical data stretching back two decades. The crux of the new approach is that investors only partially predict a corporate default, and that there is always an element of surprise when it occurs. This surprise causes a reaction in stock and bond prices at default. The approach uses historical default patterns to mathematically model investors’ typical anticipation of default.
The difference between the actual and predicted reaction is essentially a measure of how much investors were surprised by the default. Flip that around, and you suddenly have a line on how much investors anticipated the default and how much of the pre-default drop in valuation reflects that anticipation.
“If we know what the probability of default is at each instant, based on the analysis of past defaults at similar firms, we can assess mathematically what the overall anticipation effect on prices should be,” Strebulaev explains. “Comparing predicted prices with observed ones, we can isolate the total effect of anticipation on observed prices.”
If the Federal Reserve and the Treasury had had these insights, would they have been any less sanguine about letting Lehman Brothers go bankrupt in September 2008? One lesson from the new research is that default costs are much higher for multiple defaults across an industry. In part, that’s because multiple defaults in an industry increase the likelihood of fire sales of assets — exactly what happened with mortgage-backed securities. If officials had known that Lehman would trigger a wave of other defaults, and they knew that each of those defaults would be more costly than assumed, Strebulaev says, they might have been more cautious.