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December 31, 2001   




Heard on the Street


Some Early Warning Signs

For Exiting Distressed Firms






On Friday, Nov. 30, two days before Enron filed for bankruptcy-court protection, its shares were trading at 26 cents -- down from a high of $90 and a little late for investors to decide to ditch the stock. Ditto for investors in any number of other big corporate casualties this fall, including Bethlehem Steel, Federal-Mogul and Polaroid.


But astute investors realize there are some early-warning signals that work better than plunging stock prices to tell them to head for the exits. And as more companies seek protection from U.S. Bankruptcy Court, predicting whether a company may file becomes an ever-more-relevant skill.


The stakes are higher than they used to be in reading the market equivalent of tea leaves. First, the number of bankruptcy filings is up sharply this year, and many experts believe more are to come in the current unsettled economic climate. Chapter-11 bankruptcy filings by publicly traded companies hit a record 143 this year, affecting $76 billion of debt, compared with 119 the previous year on $30 billion of debt, according to David Hamilton, a specialist on defaults for Moody's Investors Service in New York.


Moreover, many companies that file for bankruptcy protection nowadays are more likely to end up in liquidation than in the past, analysts say, making the stock of a distressed company less likely to be worth much. It isn't only New Age telecommunications companies -- becoming famous for the plummeting values of their fiber-optic networks and other assets -- that may be valued less in bankruptcy court than their shareholders hoped. The same may prove true for retailers now in Chapter 11 proceedings, restructuring advisers warn.


Here is a guide to a half-dozen barometers of financial health watched by sophisticated investors for signs of potential bankruptcy, some are easier than others for average investors to follow on their own:


SWAPS THAT SWEAT IT OUT: The derivatives markets can be especially valuable as an early-warning signal -- particularly the credit-default swap market, where institutional investors seek financial protection against corporate bankruptcies. The default swap market is probably the most sensitive measure of how market participants view corporate prospects.


For example, the credit-derivatives market was far ahead of the rating agencies in suggesting that once-mighty energy trader Enron was a weak credit. Weeks before the Houston company sought bankruptcy-court protection, pricing on Enron protection was far more expensive than it should have been, given Enron's then investment-grade rating. Essentially, these credit swaps are a form of insurance on Enron debt; if Enron defaults, the buyer of such a swap goes to the seller of the swap and receives 100 cents on the dollar, regardless of how worthless the debt may have become.

See full coverage of the rise and fall of Enron


Increase in Corporate Debt Could Hurt U.S. Recovery


Stock Gurus Disregard Most Big Write-Offs, but They Often Hold Vital Clues to Outlook


In September, shortly after Enron Chief Executive Jeffrey Skilling stepped down, there was a drastic increase in Enron credit-default swap volumes, and spreads doubled on Enron risk to a steep 2.75 percentage points over the London Interbank Offered Rate, the short-term rate off which banks price some loans.


By October, with the announcement that the Securities and Exchange Commission was investigating Enron's financial statements for accounting irregularities, spreads doubled again, to more than five percentage points. Then, after Enron lost access to the commercial-paper market, spreads rose to an almost prohibitively expensive 15 percentage points, according to data from KMV LLC, a credit-risk-management service in San Francisco. Meanwhile, the shares edged down to $13 from $37 during the course of the month, levels that didn't hint at the fate that would overtake Enron just a few weeks later. Indeed, the shares didn't drop below $1 until Nov. 28, from above $4 on Nov. 27.


(Unfortunately, there isn't a market for many corporate names below investment grade, unless, like Enron, they plunge rapidly into junk territory.)


DEBT THAT DIVES IN VALUE: Often the secondary bond market can provide valuable clues about a troubled company's fate, as bond analysts are much more focused on a company's ability to repay its debts. They scour information pertinent to the sort of distress that leads to a filing.


Henry Miller, vice chairman of Dresdner Kleinwort Wasserstein, an investment-banking and advisory boutique, has worked out a formula as follows. "When the bonds start trading between 90 cents and 80 cents on the dollar, a light bulb goes on," he says. "When the bonds then fall to between 60 cents and 80 cents, that tells you that somebody is nervous. And when they start trading between 40 cents and 60 cents, it is a question of when, not whether. And when they go below 40 cents, a filing is -- to varying degrees -- imminent."


BANKING ON TROUBLE: Another indication that a company may be about to seek bankruptcy-court protection is when it draws down all its credit or standby credit lines from its bankers, according to Brad Eric Scheler, head of the restructuring practice for law firm Fried Frank Harris Shriver & Jacobson in New York. Such drawdowns are also an early-warning symptom that a company anticipates a turn for the worse in its fortunes.


CONSCIOUSNESS OF RATIOS: Financial distress quickly translates into a company violating its lending agreements with its bankers. Such violations allow the banks to pull their lending lines or even declare a company in default. While information about the relationship between bank and client usually isn't public, there are certain relevant financial ratios that can provide clues. For example, lending agreements oblige most companies across a wide range of industries to keep the debt level at no more than about seven or eight times earnings before interest payments, taxes and depreciation. If the amount of the debt is far greater, investors can assume the banks aren't happy. Unhappy bankers can even petition the courts to push their client into involuntary bankruptcy.


A DATE WITH DEBTHOLDERS: Figuring out the timing of a filing can be tricky, of course. One indicator watched by many hedge funds: whether a potential Chapter 11 candidate has an onerous interest payment coming up. Managers of these sophisticated investment pools assume that a troubled company would prefer to file before, rather than after, paying out large sums of precious cash.


But that may not be a sure thing. For example, in advance of a scheduled payment on Global Crossing bonds in November, many hedge funds made bearish bets on the telecommunications company, which already had drawn down bank lines, anticipating it soon would be in violation of its bank covenants and would seek bankruptcy protection. The company, though, met the cash call, and the hedge funds closed out their losing positions. On Friday, Global Crossing announced it had come to agreement with its bankers on loan covenants.


FLASHING RED LIGHT: Some signals couldn't be more glaring. If a company retains bankruptcy counsel or calls in restructuring-advisory boutiques, such as Greenhill & Co. or Blackstone Group or Lazard Freres & Co., it is reasonably certain a company is at least considering bankruptcy. (Another reason for some hedge funds' bearishness on Global Crossing: It has hired a restructuring adviser, according to people familiar with the matter; it won't comment on the matter, saying its relationships with any advisers are confidential.)


One of the messages that restructuring advisers tell their clients is to file early. That means investors can be caught off guard more easily since some recent bankruptcy-court filers, such as Covad Communications Group, have had significant amounts of cash on their balance sheets.


Write to Henny Sender at