The Fires May Not Be Out

The crisis appears to have passed for the U.S. financial system, but scores of companies still face default and bankruptcy

Illustration by Edel Rodriguez

by David Henry and Matthew Goldstein

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Investors in recent weeks have breathed a great sigh of relief about the financial system. But like any patient who has survived a brush with death, the markets and economy now face a long period of convalescence—one marked by rising corporate defaults, mounting bankruptcies, and, even among those companies with solid prospects, continued unease.

The underlying problem: Banks, which continue to raise billions for mounting losses, don't want to lend money. Given the high price they're paying for that replacement capital, it could be a year or more before they start to loosen their purse strings, much less lend at normal levels. And investors still have little appetite for risky corporate debt.

That has painful implications, especially in the midst of a recession. Corporations, many of which borrowed to the hilt in 2006 and 2007, will find it hard to refinance their debt, sparking a wave of trouble, particularly among those companies that depend on consumers' discretionary dollars. On May 5, casino operator Tropicana Entertainment followed other privately held companies that already have headed into bankruptcy this year, including retailer Linens 'n Things and restaurant chain Buffet Holdings. An additional 43 public companies have gone the same route since January.

Even companies that didn't binge on debt may find their growth plans crimped. That's because businesses have few options for financing new ventures or capital expenditures. Those with a hefty amount of cash on their books don't seem inclined to spend money aggressively, either. "[The lending environment] is a problem for the economy," says David Hendler, a senior analyst at research firm Credit Sights.

Of course, the wild card in all this may just be the economy. Stronger-than-expected growth would do wonders for the ability of highly leveraged companies to generate cash to pay down debt. A mild bout of inflation might also help by allowing companies to raise prices. While revenues would increase, bond payments would remain the same.

DECEPTIVE NUMBERS

At first blush, the corporate environment doesn't seem all that bad. After all, balance sheets in the aggregate are in great shape. Companies in the Standard & Poor's 500-stock index hold near-record amounts of cash. Earnings per share at nonfinancial companies are expected to rise at a nice 11% clip this year, according to Thomson Reuters (TRI). What's more, defaults remain around their historical lows.

But the numbers, says George Feiger, chief executive of wealth management firm Contango Capital Advisors, "are deeply deceptive." For one, the cash levels look good on the whole mainly because big companies like Microsoft (MSFT), Apple (AAPL), and Pfizer have hundreds of billions of dollars at their disposal. Profits this year will be skewed by the results of ExxonMobil (XOM) and a handful of others benefiting from the commodities boom. And the low default rates are merely a reflection of how easy it has been for companies to refinance their way out of trouble in previous years—not unlike what homeowners did in the past.

There are plenty of problems festering beneath the surface. Nearly two-thirds of nonfinancial companies, some 1,600, now carry a noninvestment, or junk, credit rating, according to S&P (MHP), which like BusinessWeek is owned by The McGraw-Hill Companies (MHP). That's up from 50% at the beginning of the last bust in 2000 and 40% in 1990. At the same time, Wall Street dramatically expanded the market for speculative, floating-rate loans, with companies raising $1.2 trillion in the four years through 2007, according to Thomson Reuters.

And today's junk is junkier than in the past.