July 23 (Bloomberg) -- Edward Altman, a finance professor at New York University's Stern School of Business, talked with Bloomberg's Tom Keene in New York yesterday about the U.S. credit crisis, the chance of defaults by General Motors Corp. and Ford Motor Co. and the outlook for bankruptcy and default rates.

(This is not a legal transcript. Bloomberg LP cannot guarantee its accuracy.)

TOM KEENE, HOST 'BLOOMBERG ON THE ECONOMY': Professor Altman, welcome back to the program.

EDWARD ALTMAN, FINANCE PROFESSOR, NEW YORK UNIVERSITY'S STERN SCHOOL OF BUSINESS: Thank you very much, Tom.

KEENE: Lots to talk about when we - when we look at the moment. We go back now 11 months to a credit crisis. Were you surprised at the events of August, 11 months ago?

ALTMAN: No, and as a matter of fact, I'd been predicting a credit bubble bursting for about a year, year- and-a-half before August of last year, indeed June was the date that I look at. So, I was not surprised at all.

What I was surprised is how long it took actually.

KEENE: How long it took to get there?

ALTMAN: Yes.

KEENE: When you see Libor go up, which is away from your research, but you see commercial paper go up and there's movement, whether it's T-Bill or it's Libor-OIS, there's been some improvement but we are a long way back from normal in the short-term space.

ALTMAN: Yes, the pendulum swings very fast one way or the other. People were arguing the new paradigm prior to summer of '07, new instruments, new players, new structures out there, structured finance, the price of credit, they said was permanently going to be lower.

And I said, being an old traditionalist myself, said it can't be, paradigms don't become new very easily and indeed, fundamentals will show its face, and indeed it has.

What has surprising, as you mention up front, is that the default rate on corporate bonds and the bankruptcy rate hasn't increased as much as I had thought, even now in this crisis.

KEENE: Is there a why for that?

ALTMAN: Yes, there probably is. One of the reasons is that the benign credit cycle that we experienced had these new innovations which gave companies the ability not to pay interest if they didn't want to, they can pay it in more debt.

KEENE: PIK and something?

ALTMAN: PIK. PIK toggles.

KEENE: PIK toggles.

ALTMAN: PIK means payment in kind.

KEENE: Today's focus on Bloomberg on the economy folks, PIK toggles.

ALTMAN: Yes, a toggle means it can go back and forth, right? And that means you can pay interest or not. So, when these companies floated their debt, they were given that option as well as there weren't the usual covenants or triggers to default that normally had been in place.

And so there's been a big delay in defaults among certain low quality companies and it's only a matter of time for them to default. But so far, give it credit, the default rate is still stubbornly below historic averages.

KEENE: This entire hour, folks, Ed Altman of NYU. I - there's just so many ways to go here, but let's keep on this theme right now of the new paradigm, I've learned to circle the word hope whenever I see it within finance, it's a dangerous phrase. Also, time - I think Thomas Coon would even be upset by the use of it today.

Is new paradigm just a structure to get business done? Is it just about hey, we want to do business, lets invent something?

ALTMAN: Well, people began to believe what they were drinking. And in this case, those who argued a new paradigm were the ones who could most benefit from it along your point, private equity funds, certain hedge funds, and they became major players, and as a result, pumping money into the system.

Money came from the usual places that went into before, risk free assets started going to these alternative assets, such as hedge funds, private equity funds and the like. Sovereign wealth funds, petro dollars, they always were there, this money.

The point is now it was looking for higher returns and they believe in new paradigm argument and the returns up to them seem to substantiate it. It's all changed and the money now is flowing in different ways.

KEENE: Bank of International Settlements in a fabulous paper I've cited on this program before, makes a sharp distinction between synthetics on tangibles, where you're coming up with these new derivative instruments on a real thing, to where we shifted somewhere, I'm going to guess '05 to synthetics on synthetics.

Do you agree that there was a sea change a few years ago from a tangible business to something that was a new paradigm?

ALTMAN: Well, certainly the idea of hedging in the structured finance market in the credit default swap market, the markets you're talking about was the traditional way and had - and still does have a great function in our financial markets.

What happened was it also became a mechanism for speculation and it's very difficult to speculate on a small individual security that has a limited amount outstanding.

And so, what the markets did was invent indexes which were far more liquid with far more securities and much easier to - what's called tranche, cut it into sections and to speculate on the performance of those sections.

This was not well understood, however, by the rating agencies in terms of their default rates and that's what happened in the subprime in particular, but it's also possibly going to happen in some of the other structured instruments, which up to now, to be perfectly fair, have performed quite well. Such as collateralized loan obligations where pools of loans are put together.

There there's something tangible. But when you start speculating on structured instruments, which are not based on the underlying, but based on the structured themselves then you've begun - begin to get into much more difficult analytical areas.

KEENE: Just in 30 seconds here, is the underlying still the home price, what we hear interview after interview is none of this is going to get fixed until house prices stop going down, stabilize. Do you agree with that, that the underlying is the generalization in the American home price?

ALTMAN: I would say that's only part of it. For one thing, I do believe home prices, which by the way could drop some people estimate, another 20 percent from what the 22 percent they've already fallen. I'm no expert on home prices, but real estate and home prices and building materials do drive many economies.

One more thing. The other thing is that the areas that also will drive home are other types of industries that are tied to oil et cetera, also in very desperate shape.

KEENE: If you look at the giants of what you do financial investments and quantitative finance. Is the elite - the Altman elite, have you been humbled by these events or is there a feeling of hey, I told you so.

ALTMAN: Well, yes, a little of both. My materials, my models were built many, many years ago. Sure we've honed them. and I thought that it was a long time ago that things were say no longer going to be as relevant as they once were. Just the opposite.

The bankruptcy prediction models, the credit analysis, the stress debt investing, junk bonds have never been more front and center in our markets. Yes, they're playing a backseat a little bit to the subprime problem, but absolutely both humbled and excited too, because frankly a lot of people look at these models now and try to make some sense out of what's going on.

KEENE: I want to talk about those models in our next half hour, but right now, the new thing on the block are credit default swap indices, which folks, if you're not in this day by day, is the gaming of the quality of credit and the future of credit of a given or distressed company.

These are a big deal and they're being used to hedge instruments that aren't credit default swaps and come of these banks have challenges using these indices to hedge other big things and they take big write downs.

Why are they using credit default swap indices?

ALTMAN: Well, I think for one reason, they're more liquid than say the plain vanilla credit default swaps is how it started on individual securities.

Secondly, you can cut, slice and dice them more finely. So if you're trying to hedge, for example investment grade or non-investment grade or double D or whatever, you can do so through credit defaults while its much more efficiently and cheaply.

The problem is that these markets are untested, but seem to be, both in terms of the counter parties that are on the other side of the transaction in a highly distressed period, like we could be coming up with in the future, if we have a long-U shaped severe recession. Which is not out of the question from what I read.

And while its not my specialty predicting default rates - sorry, predicting recessions, we have done some work in simulating what could be the result if we have a severe or minor or no recession.

KEENE: You have in a terrific article - and folks, this from the Journal of Applied Corporate Finance of Morgan Stanley, a prescient article summer of 2007. There's a second lien chart, subordinated chart and this is sort of like I want a higher yield and I'm willing to be second in line if things get in trouble. The explosion of the business is just breathtaking.

Is that size of exposure still there?

ALTMAN: Yes, it hasn't grown very much of late, but interesting Tom, there's nothing new about second lien. I remember when I studied corporate finance 50 years ago, or close to that anyway, there were text books that talked about second lien all the time.

In other words, you have an asset, you use it as collateral once, and then you use it as collateral as a second time, knowing that your second in line and if that collateral values is very good, there's going to be something left over for the second lien.

But if its not - and this is what, of course, happened in the most recent period, when the companies involved could not raise money except for putting some sort of lien on it and the market said, hey, prices are going you, housing prices are going up, wonderful, second lien is going to be valuable.

The impact of second lien defaults has not been felt yet. The most important one will be the very low recovery rates should there be a default on the company in general, on the second lien vis-a-vis the first lien or even other types of debt.

KEENE: Ed Altman, there's the Altman Z Score, its legendary, folks, at gunpoint if you do the CFA program or any finance program, you must memorize all those ratios. Is it as true today as it was in 1968? Is it good at analyzing a General Motors like it was 40, 50 years ago?

ALTMAN: Absolutely, it seem to be even more in vogue, in use. Now, you say, is it as good? Well, I think you have to use the result of this multivariate model scoring system that boils down fundamentals of a company into a single metric you have to use it intelligently. You can't use it the way we did 40 years ago where a score below 1.8 meant almost instant death.

Now, 1.8 is a pretty average high-yield bond, junk bond company, single B for example. So what has changed in the interpretation of the score, rather than it's - the effectiveness. The effectiveness is still 80 to 90 percent accuracy in predicting default, one to two years in advance.

KEENE: What does this say - we've done a lot recently in Detroit, what does it say about Ford and GM now?

ALTMAN: Ford and GM, actually have been in a highly vulnerable low Z Score range for about three-and-a-half to four years. It's not a new phenomena. However, the recent data we looked and admittedly its only as of March of '08, we're waiting for the June '08 numbers to come out, balance sheet, income statements.

The March '08 numbers show that both companies, GM slightly worse than Ford, look like either triple-C-minus or triple-C company in terms of a bond rating equivalent from that score, which is very low, but not yet in the default zone yet.

Still, a triple-C or triple-C minus bond rating equivalent implied a very high probability of default for five years and even for one year.

KEENE: When you look at the leadership of these troubled companies and the challenges they face, and maybe it's a Rick Wagoner or his colleague, Fritz Henderson, a young guy on the block at GM, within all of the ratios that you deal with within accounting, what should they focus on to pull themselves away from that difficult Altman Z Score?

ALTMAN: Interesting you bring it up, in some cases firms have used Z model as a guide for managing their financial turn around and this is a very simple way to do it, but its not easy to pull it off, it's very simple to understand.

Reduce your exposures in terms of assets and start paying down your debt, even though it seems that you should be doing other things spectacularly with respect to marketing and we have a - trying to raise sales.

Your Z Score will improve dramatically and your likelihood of survival if you have less assets, less liabilities and home (ph) cutting assets that are losing money.

KEENE: And I know the history of the Altman, is the Altman Z Score is manufacturing and that, but let's take this over to the financial crisis and these challenges of these big banks. Okay?

They've just blown up their assets to a big size to bring all this stuff on board. They've gone off balance sheet, on balance sheet, now they're going to take the Altman prescription, they're going to reduce assets, but they got to go out and get capital.

Within your caution on this U-shaped recovery, is that the critical Altman concern is okay, within that exercise, how do you go out and get the capital after the first or the second dilution?

ALTMAN: Well, it's not always easy if your outlook is as pessimistic as the autos are right now. But clearly, you don't improve your Z Score and survival by raising more debt. And that's the natural instinct to do as long as there are silly investors wiling to put money in, yes it yields 14, 15, 16, 20 percent, but that's not a prescription I'd recommend.

The way to do it is either in some sort of convertible preferreds or convertible equities, which will convert into equity, or directly to equity. You've got to reduce that debt load because oftentimes people are myopic about their problems.

One problem that stands out is the debt load and the ability to refinance the debt load.

KEENE: Then over to the banks, whether its Citigroup or Merrill Lynch, you can pick any name you want to. Keycorp came out with earnings today. when you look at the bank banks, and their deliberating, going from say 21 times down to 15 times, or whatever.

Is the Altman prescription, like we've heard from Henry Kaufman that they're just going to shrink down to an older mandate?

ALTMAN: Absolutely. They've got to get rid of assets that are not core, even though they - and by the way, we know that the ones that are making money, the ones that are bringing in more equity, more cash, and that unfortunately has to be done sometimes, even though they're elegant assets.

And I would say, bigness is no longer a panacea for success in anything. It used to be in banking, everyone wanted to grow assets rather than to shrink assets. The prescription in Z Score - and by the way, the models that I built were not for financials. I don't have a prescription for Citigroup, for example, or UBS or any of the others.

And Citi, by the way, has done, I think a lot of the right things of late and I think they're on the right path. They just, like everyone else, invested too much concentration, what they thought were relatively risk free triple-A, double-A assets on their balance sheet and they were - they were wrong and the rating agencies were wrong.

And so this is a major problem and all of a sudden now, they need capital in stead of taking advantage of Basel II, which is coming on board, which was supposed to reduce their capital.

KEENE: Right.

ALTMAN: I mean, it's almost ironic that Basel II is happening at this point in time.

KEENE: Just in 10 seconds, do we need a Basel III?

ALTMAN: With respect to, I think, liquidity, yes.

KEENE: You talk in your incredibly prescient article of a year ago, new paradigm of the great credit bubble, how close are we to a great credit bubble?

ALTMAN: Well, we're already in it. The thing that hasn't shown yet is the manifest increase in bankruptcies and defaults. Although there have been 60 bankruptcies this year greater than 100 million in liabilities and seven greater than a billion, these are not household names, but their bankruptcy rate is definitely on the upsurge.

KEENE: Did IndyMac get your attention.

ALTMAN: Certainly did, but IndyMac is not even one of my - first of all, IndyMac did not officialy go bankrupt and they did not have any bonds outstanding. So it doesn't even get into my default rate calculation.

KEENE: Really?

ALTMAN: No, it doesn't.

KEENE: That's the most interesting thing in the hour. That's - IndyMac is not in the Altman math right?

ALTMAN: No, it isn't. I'm sorry to say. I would have liked to have seen them get in there because they deserved to do it, but of course, their exposures were related to the real estate bubble as well.

And I'm talking about a general credit bubble where the price of credit was so incredibly out of line. June 12, 2007, you could have raised money in the high-yield bond market at two standard deviations below the historic average, 260 basis points.

Absolutely incredibly out of line, and yet we went merrily a long. There were a lot of people who would say, oh this is terrible, but I have not choice. Well, they had a choice, they didn't have to.

KEENE: No, and a mix of 12 (ph). Just because of time, I want to jump forward, Secretary Paulson speaking today. How's the secretary doing?

ALTMAN: Well, he's under incredible pressure, the job is a lot tougher than he or anybody else thought about it. I think he and Bernanke get generally good grades, the problem is there's one crisis after another and they're doing what they think is right.

An issue is moral hazard, are we as taxpayers left to carry the burden when the companies that made these terrible decisions go away with getting bail outs.

Frankly, it's a rock and a hard place. I would have bailed out Bear Stearns, just as they did. I would have bailed out Freddie and Fanny, just as they did, maybe not with - frankly, my prescription is bail them out but get warrants, get the pubic some upside potential instead of only downside.

The answer is, yes, I think he's doing as good a job as probably he might have. The problem was the Fed and he did not realize how serious the situation was until November or December of '07 when, to others, like myself, it was clear it was serious back in the summer.

KEENE: Now, we've heard that on the show as well, many other people predicting that the tumult of this - just in a final minute here. You're going to go into a full lecture at NYU Stern, what are you going to tell the student over one year out from this credit crisis?

ALTMAN: There's going to be incredible opportunities going forward. Let's take the distressed investment area? That is now a hedge fund space, probably 350 to 400 billion under management, growing, a lot of money moving in, why? Because there's going to be opportunities, but I won't happen until the default rate is near its peak, which I don't think will happen until the end of '09 at the earliest.

KEENE: Really, the end of '09?

ALTMAN: Yes, I think we're going to see the big increase in '09, this year the default rate may be the historical average, around 4 percent, maybe a little less, a little more, my forecast is 4.64 for high-yield default rates, but I think it's '09, after the election year, after the Beijing Olympics, this is when we're going to see the default rate peak.

KEENE: Ed Altman, thank you. This is just brilliant. We got to do two hours sometimes to get it all in. We left a lot on the table. Folks, Edward Altman, Professor at the New York's University Stern School of Business.

***END OF TRANSCRIPT***

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#<256905.807900.1.0.82.31279.25># -0- Jul/23/2008 16:47 GMT

Last Updated: July 23, 2008 12:47 EDT