Distress prediction models have intrigued researchers and practitioners for

Distress prediction models have intrigued researchers

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be desirable to speed up the process and restrict managerial abuse. Distress prediction models have intrigued researchers and practitioners for more than 50 years. Models have evolved from univariate financial statement ratios to multivariate statistical classification models, to contingent claim and market value–based approaches, and finally to using artificial intelligence techniques. Most large financial institutions have one or more of these types of models in place as more sophisticated credit risk management frameworks are being introduced, sometimes combined with aggressive credit asset portfolio strategies. Increasingly, private credit assets are being treated as securities with estimates of default and recovery given default the critical inputs to their valuation. Perhaps the most intriguing by-product of corporate distress is the development of a relatively new class of investors known as . These money managers specialize in securities of distressed and defaulted companies. Defaulted bonds have had a small following ever since the Great Depression of the 1930s, but this has grown to more than 70 institutional “vulture” specialists, actively managing over $60 billion in 2003. The size of the distressed and defaulted market grew dramatically in recent years, and by year-end 2002, estimates by this author were over $940 billion (face value) and $510 billion (market value) for the public and private markets combined (mainly public defaulted and distressed bonds and private bank loans). Distressed debt investors have target annual rates of return of 15 to 25 percent. Although these annual returns are sometimes earned, the overall annual rate of return from 1987 through 2002 has been less than 10 percent—similar to high-yield bonds and considerably below returns in the stock market. Yet, the incredible supply of potential investment opportunities has created unprecedented interest in this class. The priority rule in liquidation is the absolute priority rule (APR). One qualification to this list concerns secured creditors. Liens on property are outside APR ordering. However, if the secured property is liquidated and provides cash insufficient to cover the amount owed them, the secured creditors join with unsecured creditors in dividing the remaining liquidating value. In contrast, if the secured property is liquidated for proceeds greater than the secured claim, the net proceeds are used to pay unsecured creditors and others. EXAMPLE 30.1 APR The B. O. Drug Company is to be liquidated. Its liquidating value is $2.7 million. Bonds worth $1.5 million are secured by a mortgage on the B.O. Drug Company corporate headquarters building, which is sold for $1 million; $200,000 is used to cover administrative costs and other claims (including unpaid wages, pension benefits, consumer claims, and taxes). After paying $200,000 to the administrative priority claims, the amount available to pay secured and unsecured creditors is $2.5 million. This is less
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than the amount of unpaid debt of $4 million.
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