Merrill Lynch has revised its forecast for the 2001 junk default rate to 9.2%, bringing it closer to the 9.5% prediction of Moody's Investors Service, which some had considered a radical outlier. "It is just coincidental that the number has come closer to Moody's figure," says Martin Fridson, Merrill Lynch's chief high- yield strategist. "Conditions have worsened--the reality has come in line with Moody's. It isn't that Moody's has finally come into line with reality."
The approach used to revise the forecast was based on three indicators: the downgrade/upgrade ratio, the distress ratio and the Federal Reserve's survey of the percent of bank loan officers tightening loan standards. This latter number jumped to nearly 60% in last month, while the downgrade/upgrade ratio nearly doubled from 2.59 times in the third quarter to 4.17 times in the fourth. The distress ratio did drop by about 5%, but it was not enough to have an effect.
For the 2001 default rate forecasts Merrill didn't use its predictive tool developed for this purpose because it doesn't work well in this changing economic environment, says Fridson. Weakness in the Fridson-Garman-Wu (FGW) model--named after its developers Fridson, and fellow staffers Chris Garman and Sheng Wu--stems from the fact it is based on real interest rates that have a two-year lag and new issuance from three years ago. In addition to this lack of timeliness, the FGW model uses gross domestic product, where deceleration below 1.5% fails to produce higher estimated defaults. GDP is currently at 1.4%.