Covid-19 and SME ABS: liquidity crunch or fundamental decline?
Covid-19 could lead to the sharpest global recession in modern history. The impact on SME ABS will depend on the length of shutdowns and effectiveness of fiscal and monetary measures in providing corporates with a cushion against financial distress.
“A severe economic downturn is expected to have significant impact on structured finance instruments, especially non-performing loan securitisations,” said Chirag Shekhar, associate analyst in Scope’s structured finance team and co-author of a report out today. “For securitisations of performing credit, particularly SME ABS, a potential wave of bankruptcies remains a key downside risk.”
Prolonged and forced shutdowns have led to elevated liquidity and solvency risks for most companies, irrespective of their ex ante financial position. Scope analysis shows that contractions similar in magnitude to our latest forecasts of a drop in euro area real GDP of between 6% and 16% have led to an 80% rise in bankruptcies in the past.
Large, diversified and less volatile European economies, including France, Germany and the United Kingdom, have in the past generally seen new filings jump by 12%-13%. But more volatile economies like Ireland and Spain saw insolvencies rise by more than 80% during the global financial crisis. “We believe that the current uncertainty as well as a broad range of outcomes in historical data warrants caution and is best addressed by factoring in a range of scenarios into default-rate assumptions,” said Olivier Toutain, executive director in Scope’s structured finance team and co-author of the report.
Scope’s baseline scenario assumes a slowing of the pandemic by the end of Q2 2020 in Europe and US, followed by a gradual withdrawal of containment measures.
“However, even with such measures in place, we expect a significant rise in defaults, ranging from 10% to 25%, with effects more severe in historically volatile and structurally weaker economies, like Spain and Ireland,” said Thomas Miller-Jones, associate director in Scope’s structured finance team and co-author of the report. “The downside is expected to be driven by a sudden drop in corporate revenues, as well as the risk of being cut off by banks.”
The scenario is subject to several downside risks, including extension of containment measures (leading to more permanent business closures), a more pronounced recession in the US; inadequate or inefficient implementation of government relief packages; or a re-emergence of an epidemic in China. If one or several of these events were to occur, Scope expects especially severe depressions in the euro area periphery.
The only reference point for such an extreme scenario would be the Great Depression, when global default rates reached more than 200% of the global unconditional average while the corporate bond market saw defaults rise by 300%. “While bond markets were not as deep and diversified as today, bankruptcies may yet rise by up to 100% if the downside risks were to materialise,” said Sebastian Dietzsch, a director in Scope’s structured finance team and co-author of the report. “However, just as the baseline scenario, the impact of such a deep shock would vary by sector and size of companies.”
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