As companies already affected by sector-specific stress can testify, the number of problem accounts can mushroom alarmingly, says Pam Krank, president of The Credit Department, a St. Paul, Minn.-based consulting and outsourcing firm that manages credit for U.S. companies. She gives the example of one mid-cap construction company which, three years ago, classified $450,000 of its $65 million in outstanding receivables as high risk, while $29 million were seen as low risk. Today, total receivables are slightly lower, but $11.5 million are high risk, while zero are low risk. "For a lot of companies, this is what the future looks like," she says. "If they're not managing credit well, they need to ask themselves whether they can afford to write off 15% of their sales to bad debts."

This kind of stress is spreading. Consumer spending has accounted for 70% of the U.S. economy in recent years but, squeezed by falling house prices and rising energy costs, consumers are now cutting back on purchases. The pain will be felt by a broad swath of companies.

"My view is that we're heading into a consumer-led recession, and we haven't seen one of those for a very long time," says Chris Ballinger, the Torrance, Calif.-based treasurer with Toyota Financial Services, which lends consumers money to buy cars. The company's portfolio contains millions of loans and $55 billion in outstanding receivables in the U.S., and those accounts are not performing as well as they were a year ago, says Adem Yilmaz, national manager for consumer risk. Toyota lost $809 million on credit risk in the last financial year, up from $410 million a year earlier. In response, Toyota is taking on less risk when originating loans and also manages the outstanding loans more pro-actively, says Yilmaz.

So, how bad could it get? Don van Deventer, chairman and chief executive of the Honolulu, Hawaii-based Kamakura Corp., which specializes in working out the probability of corporate bankruptcies, says the early signs are worrying. At the moment, Kamakura's index of 20,000 global companies classifies 13.2% as troubled – meaning they have a greater-than-1% chance of going bust in the next 12 months. That's a long way off the index's peak of 28%, recorded when the tech sector imploded, but van Deventer warns that the proportion of troubled companies has grown for 10 of the past 11 months and is likely to continue rising.

"We're in the initial up-leg of an increase in credit risk, and there are certainly problems lurking," warns Diane Vazza, head of global fixed-income research with rating agency Standard & Poor's (S&P) in New York. Today, two-thirds of non-financial companies are rated below investment-grade by S&P, but go back to 1990-91 and only 40% fell into the lower rating brackets. "That's significant because companies with below-investment grade ratings are more volatile. In other words, as we head into this unfolding recessionary environment, two-thirds of companies have this propensity to fall more sharply into default or into stress," she says.

One form of defense is the receivables put, which completely or partially hedges the risk of a customer defaulting on its payments. Structured as a simple option contract, this tool is popular in part because it's easy to understand, says JP Morgan's Calil. The trigger is a Chapter 11 filing, at which time the bank pays the hedger an agreed amount and receives in return the unpaid receivables claim, which it takes to bankruptcy court with other creditors seeking recovery. The bank can hedge this kind of risk in a variety of ways – by shorting the stock of its client's obligor, putting in place a default swap, or offering hedge funds a slice of the trade.

Ron Wells, vice president for credit at London, U.K.-based commodity trading firm, RBS Sempra, says the receivables put works pretty well, but warns that banks will typically expect the hedger to accept 10% of the risk – if a company wanted to cover $20 million in receivables, a bank would only commit to repaying the hedger $18 million. Often, that's all a company wants, says Calil. It's common to see puts structured that pay 50 or 60 cents on the dollar and are cheaper to buy, he says. Other variants on the receivables put include options that cover the credit risk arising from leasing agreements, and also the liquidation put – in which the pay-out is triggered when bankruptcy proceedings fail and a customer has to be wound up.

Two other types of hedge – default swaps and securitization – have been affected directly by the subprime crisis. Structurally, these transactions are very different, but the economics in both cases depend on credit spreads – or the amount in basis points above an interest rate benchmark that the market will charge to accept the risk. During the first half of last year, credit spreads were at all-time lows. Since then, many have blown out to all-time wides. Mike Rodgers, executive vice president with Stamford, Conn.-based Finacity Corp., says the corresponding increase in cost may scare some hedgers off, but the market hasn't been stopped dead: "Both kinds of trades are still happening. The market may not be as active as it was last summer, but the increased risk means that some companies feel compelled to act – they just have to pay more for the privilege of passing it on to someone else."

Default swaps do more or less the same thing as a receivables put – joining together two parties in a bilateral transaction, with the protection seller guaranteeing to cover the protection buyer's loss if an underlying company defaults. Unlike a receivables put, however, the actual risk being covered is the risk of default on borrowed money, rather than a payment obligation – and this has limited their use by corporates, says Valerio Pace, head of credit strategies with BNP Paribas in Paris, France. RBS Sempra's Wells, a frequent speaker at credit management conferences, says he once asked an audience of corporate credit managers to put their hands up if they'd traded a default swap – no-one had.

However, some corporates do use default swaps, says Finacity's Rodgers. The big advantage of a default swap is that even when things look dire for a customer, it's still possible to find a bank that will write credit protection, he says. That's partly because the products are priced high enough to tempt a bank to take on the risk, but it also helps that the default swap market is deep enough that the bank could lay off some or all of that risk if it decided it didn't want to keep it. "The classic use for a default swap would be when a company had an insured portfolio of receivables and the credit insurer decided to stop providing cover for a certain name. If the company wanted to keep doing business with that particular customer, they'd go to a bank and buy a put or a default swap. It was a fairly strong business for the banks until the subprime crisis hit," he says.

Finacity itself specializes in setting up receivables securitizations. The idea is that a company sells its outstanding payments to investors in the form of a bond – the cashflows from those payments are used to pay a certain rate of interest and, if the payments don't materialize, it's the investors who bear the credit risk: "These are true sale transactions. Your risk is gone, you've laid it off. It's someone else's responsibility." This year, Finacity expects to arrange $20 billion to $30 billion in securitizations, says Rodgers.

That might sound like a tempting route, but it too has its drawbacks, says RBS Sempra's Wells: "With securitization, you really need to be doing either a very large transaction or an ongoing stream of deals because the legal issues, paperwork and costs involved are pretty onerous."