Wednesday, February 11, 2009

Projecting the severity of the recession from credit market spreads.

When I was reading about the Great Depression in US I was struck by the following observation: the GDP decline of 28% peak to trough, which took somewhere between 2 and 3 years, correlates very well to the total number of failed companies (30%) and the peak unemployment (25%). After thinking about this for a while, I believe this is not a mere coincidence. In a severe, quick economic contraction, it would make sense that the number of working people directly relates to the GDP, since productivity does not have time to change much. It is also reasonable that the percentage of failed mid-size companies reduces GDP by the same amount, although this requires that the additional contraction among the surviving companies is offset by increased government activity and small businesses started by newly unemployed.

So while the number of failed companies is not a precise predictor of the depth of a depression, it should give the right ballpark number. Since we can deduce company failure rates by their bond spreads, one can therefore estimate market-implied severity of a recession.

From Financial Times:
US investment-grade corporate bond prices, for example, imply a cumulative default rate of 36 per cent over five years, assuming a typical recovery of 40 cents in the dollar, according to analysts at Morgan Stanley. This is more than 7.5 times higher than the worst default rate in any previous five-year period.
5 year default rate is not horribly useful, since a lot can change in 5 years. So let's convert it to a more relevant metric of roughly 8-9% of defaults per year. I think we can safely assume that the rate at which new mid-size companies are created goes down to roughly 1% from the typical 2-4% in 'normal' years. This means that within the next 2 years (typical time-frame for the worst part of recession) we are looking at the number of investment grade companies in US to shrink by roughly 15%.

So the market is pretty pessimistic and investors seem to project a recession with GDP decline in the ballpark of 10-20%, which puts it squarely in the depression camp.

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