S&P predicts defaults to snowball in 2009 and 2010

The ratings agency predicted the deteriorating economic outlook and illiquid market conditions of 2008 will continue into next year and beyond.

"Investors should be braced for a record number of defaults among European companies... caused by plummeting confidence in the banking sector, the virtual closure of the corporate bond market in September, and the non-existent high-yield market," said Blaise Ganguin, S&P's chief credit officer for Europe.

Turbulent market conditions could push the cumulative default rate on speculative-grade issuers above 20%, and between 60 and 75 of S&P's 715 rated companies in the speculative grade category could default in 2009, putting €20-€25 billion at risk, the report forecasted. As of December 15, 18 public companies in western Europe had been rated by S&P as very vulnerable to default - so-called 'weakest links'.

Such a large number of defaults will likely put pressure on the credit default swap market. "As defaults rise, there are going to be more executions of these contracts and resultantly there will be a lot of money changing hands from sellers to buyers of default protection," explained Andreas Zsiga, a credit analyst at S&P and a co-author of the report.

"Counterparty risk is obviously a big issue in this environment," added Mahesh Bhimalingam, director of high yield and leveraged finance at Barclays Capital. Companies can be exposed to increasing default rates not only from corporate counterparties but also from derivatives providers, such as banks, which might themselves be struggling. However, Bhimalingam continued: "Now that some banks have been guaranteed and have got debt guaranteed on their balance sheets, I would think that some of the counterparty risk has calmed down."

Icelandic firm, Glitnir Bank, was the first firm from S&P's top 100 rated western European financials to default. However, the rating agency noted that "while no other rated banks have defaulted, we believe several would have done so were it not for the provisions of government support".

The intervention of central banks and governments across Europe to shore up their domestic institutions has helped stave off a greater wave of downgrades and defaults, but with the support only temporary and the cyclical downturn expected to last for some time, S&P anticipates a bleak outlook for 2009.

While funding will remain tight or inaccessible for the speculative grade companies, investment grade firms are also predicted to feel the pinch in the coming year. Zsiga noted: "The deeper the economic recession is and the longer the liquidity freeze continues, the greater the risk implied on higher-rated entities."

Downgrades for investment grade firms seem likely to accelerate in 2009. Bhimalingam explained: "Most investment grade firms won't default, but you will see a deterioration of the credit quality of CDO collateral and some of those tranches being downgraded."

In October, the median rating for the top 50 western European banks slipped to A+ from AA-, and as of December 16, S&P noted positive outlooks were assigned to only 4% of the western European bank ratings.

Negative outlooks for companies rated A or BBB have increased to 25% and 33% from 10% and 15% respectively in 2007, while for companies rated B and CCC, the figure has reached 40% and 75%. Christian Dinwoodie, head of corporate ratings at S&P, noted S&P's downgrade-to-upgrade ratio had moved from 2:1 in the first quarter of 2008 to 10:1 in Q4 2008.

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