Bankruptcy guru Edward Altman sees similarities to 2007 in the credit market today – Yahoo Finance

Legendarybankruptcy expert Dr. Edward Altmancautioned that this benign credit cycle characterized by low default rates, low yields, low spreads, and lots of liquidity could come to an abrupt end.

Its been a terrific market for investors for quite a long time and if anything is concerning its that we now are more than eight years into a benign credit cycle, Altman, a professor at NYU Stern School of Business, told Yahoo Finance. Weve never had such a long benign cycle. And just that one little fact is something that we should be concerned about because if it comes to one and it could come to an end very dramatically.

Altman, the creator of the financial-distress sniffingAltman Z-Score, warned in mid-2007 of a Great Credit Bubble and that there was going to be trouble in the market.He predictedthat a meltdown would stem from corporate defaults. While the primary culprit of the financial crisis turned out to be mortgage-backed securities, investors who heeded Altmans warning nevertheless avoided a lot of grief.

So, how does todays market compare to the market in 2007.

There are some similarities, yes, although the situation back in the great financial crisis was pre-meditated by the mortgage-backed securities and we dont have that problem now, he said.

Troublingly, Altmansees the reckless behaviorof 2007 surfacing again.

Lehman Brothers world headquarters is shown in New York, the day the 158-year-old investment bank, choked by the credit crisis and falling real estate values, filed for bankruptcy. (AP Photo/Mark Lennihan)

Back in 2007 prior to the crisis in 08 and 09, the fundamentals of credit risk of the companies issuing bonds and taking out loans were quite low, he said.And the similarity that I see now between 2007 and 2016 is very similar fundamentals, quite a bit high risk and it doesnt seem to bother the market because its the only game in town in terms of getting yield greater than what you can get for low-risk securities like governments and high-grade corporates.

In other words, investors arent buying junk bonds just because the risk-reward balance is favorable. Theyre buying because the rewards of investing in lower risk bonds just arent cutting it anymore.

Altman is perhaps best known for the Z-Score, a formula he created 50 years ago thats used to predict bankruptcies. Since that time, he noticed that bankruptcies have gotten increasingly bigger.

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[What] Ive seen over the years is larger and larger companies filing for bankruptcy on a regular basis. On average, in the United States, something like 15 more than $1 billion companies, in terms of liabilities, go bankrupt every year, on average, Altman said. This year already its 13. Last year, it was almost 40.

He noted that inflation has something to do with it, but whats actually happening is companies have been taking advantage of debt and low interest rates like never before, and the corporate debt ratios are way up.

Speaking about the Z-score, if you compare the average Z-score of companies in 2007 with the average in 2016, which is the last time we looked at it, guess what. The average is actually lower today than it was in 2007, and 2007 was right before the great financial crisis, and of course, in 08 and 09 we saw a tremendous increase in corporate bond defaults and loans.

Low Z-scores are associated with financial distress.

He added: So the good news is that its no worse, but the bad news is, fundamentally, the companies are no better than they were back in 2007at least by our model.

At the moment whats keeping companies from going bankrupt as they did during the financial crisis is the incredible amount of liquidity and lowinterest rates.

Well see how long that lasts.

Julia La Roche is a finance reporter at Yahoo Finance. Follow her on Twitter.

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Bankruptcy guru Edward Altman sees similarities to 2007 in the credit market today - Yahoo Finance