Now Comes the Great Corporate Deleveraging

Economic conditions appear to have stabilized, but GM's bankruptcy points to a long, difficult recovery as companies seek to refinance debt

By Frank Aquila

After a bleak winter of tumbling stock prices, continual government intervention in financial markets, and contracting debt markets, economic "green shoots" have begun to appear. Stock markets around the globe have rebounded, U.S. financial institutions have received massive injections of private capital, and consumer sentiment has improved over the last few months.

It's nice to see some optimism return to Wall Street and Main Street. But the June 1 General Motors Corp. (GM) bankruptcy filing serves as a stark reminder that the economy remains weak and recovery may be elusive.

Businesses large and small increasingly shifted their capital structures away from equity and towards a greater reliance on debt in the 1980s and 90's. In reaction to the bursting of the dot-com bubble and the recession that followed, the Federal Reserve further primed the pump with a series of interest-rate cuts. According to data from Morgan Stanley (MS), total U.S. debt rose from approximately 150% of gross domestic product in 1980 to over 350% by the end of 2008. As financial institutions increased their leverage significantly above historic norms, obtaining credit was easy for even the riskiest corporate borrowers.

The party ended abruptly in early 2007 as the smallest cracks began to appear in the subprime mortgage market. As 2007 rolled into 2008, credit issues were revealed to be more significant and pervasive than initially imagined. If anyone expected a quick return to pre-2007 credit conditions, those hopes were dramatically dashed on Sept. 15, 2008, when Lehman Brothers filed for bankruptcy.

"junk bond" refinancing: $1 trillion

Since last September, we have seen government intervention in the economy on an unprecedented scale. While massive government aid has allowed financial institutions to remain solvent, the future for many remains uncertain. The release of the stress test results has clarified the capital issues that the banks needed to address.

While the greater transparency afforded by the stress tests has permitted the banks to raise a lot of new capital, it has certainly not eliminated the underlying credit crunch. According to data from Standard & Poor's, approximately $800 billion in U.S. corporate debt matures in 2009. While that is a significant sum, the greater challenge lays ahead.

In order to understand the full extent of the problem, it is crucial to recognize that more than $1 trillion of corporate high-yield debt, often called "junk bonds," will come due between now and 2015. High-yield debt is issued by companies that do not have investment grade credit ratings—essentially the riskiest, most highly leveraged businesses.

You get a sense of the task ahead when you consider that these companies—many struggling to regain their financial footing—will have to somehow repay or refinance this mountain of debt in the coming years.

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