The unprecedented amount of liquidity in the market is impairing forecasters' estimates of future default rates, leading some to ask whether traditional techniques for predicting defaults needs to be adjusted. Speaking at the 8th Annual Distressed Debt Investing Forum, Edward Altman, a professor of finance at the New York University Stern School of Business, said the high level of liquidity makes it difficult to predict using traditional forecasting techniques and asked whether historical models for default are still relevant.
"We are in a remarkable situation today for default rates," said Altman. "The market is awash with liquidity and the default rate, as a result, is tremendously down." This liquidity has tainted Altman's default predictions; he forecasted default rates in the high-yield market in 2006 to be 3-4%, but the actual default rate in the third quarter of this year is 0.506%. The last time the default rate for the high-yield market was at a comparable low was in 1984 when it reached 0.84%.
The large amount of liquidity is resulting in high recovery rates the price investors pay for a security after default. In the third quarter of 2006, the average price paid for a defaulted security was 70 cents on the dollar, compared to the historical average of 43 cents. Bank loans continue to have higher recovery rates; this year the recovery rate on bank loans is around 95 cents on the dollar, compared to 45 cents in 2002.
Altman's estimated market value of distressed and defaulted public debt in the third quarter of 2006 was $125.7 billion, compared to $99.8 billion in 2004. His estimated value of distressed and defaulted private debt in the third quarter was $360.6 billion, compared with $302.6 billion in 2004.