Wienerberger’s EDF at the end of July was more than double its level in June, and ten times higher than it was three years ago. At around 0.2%, the company’s current EDF implies a credit rating a full grade below its current status (BBB/Baa2), notes Dvorak of MKMV. And though it remains a relatively safe credit, the speed with which its business deteriorated, and the severity with which the markets punished the earnings shortfall, is startling.
Despite the current strength of the average corporate balance sheet, the anxiety captured in historically high credit spreads suggests that investors reckon more companies are heading for trouble. In the UK, David Owen of Dresdner Kleinwort notes that the aggregate ratio of cash and bank deposits to bank lending for non-financial companies fell to “recession levels” in the first half of this year. With companies drawing down deposits while continuing to borrow — deposits tend to build up at the same rate as borrowing in “normal” times — the analyst warns that “companies are running into increasing cash-flow difficulties.”
In July Spanish property group Martinsa-Fadesa defaulted on more than €5 billion of debt, “the first large-cap European leveraged-finance failure in this cycle,” according to Secker of Morgan Stanley. “We suspect there will be more,” he adds.
Jason Karaian is deputy editor at CFO Europe.
How Moody’s KMV Calculates Credit Risk
Moody’s KMV Expected Default Frequency (EDF) credit measure is the probability that a company will fail to make scheduled debt payments over a certain period of time, typically one year. EDF scores range from 0.01% (the safest credit) to 35% (the highest measured potential for default). Essentially, these scores represent default information contained in a company’s share price combined with its latest financial statements. A proprietary, market-based measure, EDF scores typically lead traditional ratings agency changes by around 11 months.
According to the EDF model, a company defaults when the market value of its assets falls below its outstanding liabilities due. Each company has its own “default point,” a specific market value below which it would probably fail to make debt payments. These estimates reflect the observation of thousands of defaulting companies over more than 30 years, specifically how each firm’s “default point” behaved in relation to the market value of its assets at the time.
The calculation of the value of a company’s assets reflects the market’s view of the enterprise value of the firm, as determined by its equity value, equity volatility and liability structure. Moody’s KMV treats the company’s equity value as a call option on its underlying assets, allowing it to determine a company’s market value from the market characteristics of its equity value and the book value of its liabilities.
The ratio of a company’s default point to the market value of its assets is its “market leverage.” The vulnerability of market value to large changes (“asset volatility”) is a measure of the business risk of the company — technically, the standard deviation of the annual percentage change in the market value of its assets. The higher the asset volatility, the less certain investors are about the market value of the company, and the more likely its value will fall below its default point.