A looming recession and tightened credit markets are creating a perfect storm for distressed debt investors.

Against this backdrop, hedge funds and private-equity shops that invest in financially troubled companies have been raising record amounts of capital. Their hope is to buy debt on the cheap and profit from the fallout of the sloppy lending and hefty debt loads of the leveraged buyout boom.

Credit markets remain under significant pressure because of worries about the fate of bond insurers such as MBIA ( MBI) and Ambac ( ABK), which are struggling for capital because of rising losses.

Since the start of the year, credit spreads have been soaring on the CDX investment grade index, which tracks the price of credit default swaps on a basket of corporate bonds. The rising spreads suggest that investors selling protection are looking for higher returns because credit qualities among corporate bonds are getting worse.

The spread on the index has vaulted from 42 basis points in July to around 124 basis points this week, according to Markit.

These moves are being primarily driven by the worries over the bond insurers, says a trader at a major investment bank who specializes in credit default swaps on the CDX. "If there is a bailout, how big will it be? Is it one or the entire industry? Even if there is a bailout, there are still credit concerns," the trader says.

The spreads today are pricing in higher corporate defaults than the ratings agencies are predicting, the trader says.

Moody's expects global default rates on speculative-grade corporate bonds will hit 4.2% in 2008.

"If Moody's is right, the spreads are too wide on the index," the trader says.

Rising default rates are a godsend for distressed debt firms, who specialize in buying distressed or defaulted corporate debt on the cheap and profiting from an ultimate recovery of the corporation.

Distressed debt investors gathered in New York this week for the 2008 Leadership in the Distressed Markets conference, and these increasing defaults and the economy's slowdown were at the forefront of the discussion.

The consensus at the conference was that an official recession, as defined by at least two consecutive quarters of negative GDP growth, has either started already or will show up in the next quarter or two. Although GDP growth has yet to turn negative, the companies on the S&P 500 collectively had negative earnings growth in the fourth quarter, breaking a string of 17 quarters of double-digit earnings growth.

With business fundamentals deteriorating, large debt loads become ever more onerous.

Bruce Richards, CEO of distressed specialist Marathon Asset Management, which manages $10 billion, says 162 companies will either default or restructure in the next 12 months.

"Private equity was the problem," he told investors at the conference, pointing to the large amounts of debt placed on firms.

Homebuilders, in particular, are seen as becoming even more troubled over the next year.

"Homebuilding and related industries are currently going through some difficulties which are expected to get worse," says Mohsin Meghji, managing director with restructuring advisory firm Loughlin Meghji + Company.

Richards is particularly bearish on housing. He expects housing price declines to continue through 2009 and possibly not trough until 2010.

He believes it is too early to find distressed opportunities among homebuilders (meaning they have more pain to play out in their fundamentals). Instead, he says, Marathon is focusing on opportunities in loans and asset-based securities tied to the subprime industry.

Since the Chapter 11 bankruptcy filing of homebuilder TOUSA last month, investors continue to wonder if more public homebuilders will be forced to restructure. So far, lenders have been willing to give limited waivers to builders who violate debt covenants, heading off a restructuring.

Steve Zelin, a managing director in the restructuring group at Blackstone, says lenders are granting the waivers in an attempt to step back and get local market experts to come in and value the builder's assets.

While real estate is clearly a hot distressed target, others sectors in focus are retail and autos, which have spillover real estate effects, as the consumer weakens from housing price declines.

Jim Malley, portfolio manager at Chilton Investment Company, says his distressed fund is researching forest products and basic materials companies. While he did not provide names, he says these companies are facing high input cost inflation, which cannot be passed along to consumers in the form of higher prices.

He said restaurants and retailers are facing a similar cost inflation issue.

Jim Chanos, the legendary short seller who bet on Enron's decline before it went bankrupt, says there is a huge spike of defaults coming from the fallout of the LBO boom.

"I don't know what crack pipe these people were smoking," he says.

Chanos also expects students lenders such as SLM Corp ( SLM), better known as Sallie Mae, will run into trouble as college student loan default rates spike.

Chanos also believes for-profit colleges are a "dicey proposition." He expects such colleges to face increasing student loan defaults, while he also questions the overall value of education such schools are offering.

Although Chanos did not name stocks in this group, Apollo Group ( APOL) is the largest for-profit educator, owning the ubiquitous University of Phoenix.
As originally published, this story contained an error. Please see Corrections and Clarifications.

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