Credit risk - Leverage suggests magnitude of problem not when it will occur

Looking at the current credit situation suggest that many investors confuse the timing of a credit crisis with the potential intensity of the crisis. The timing of the crisis will be defined by a shortfall in corporate cash flow. It could be from a slowdown in growth or any other impairment of cash which changes the probability of debt pay-off. The intensity of a credit crisis will be based on the overall leverage in the economy. For a given decline in cash flow, the severity will be worse based on the amount of leverage. The intersection of these two effects determines the probability of a crisis. As leverage grows, the shock to cash flow necessary to create a crisis declines. An X% decline in cash flow will have a greater chance of creating a crisis when leverage is higher, so any prediction of a crisis is more likely. However, we cannot say when.

Given this environment, the impact of a negative credit event increases on any negative economic news. However, there has to be focus on the where, how, and when. Our simple map displays some of the likely paths associated with a credit crisis.