Saturday, March 28, 2009

Recoveries: Down and Out

Posted on "A Credit Trader":

Taken out to the woodshed and shot” is a phrase you often hear from CDS traders when one of their names blows up. The same can easily apply for recovery rates in the last few months across the credit markets.
High grade data: 2007 had 1 default and was taken out of the sample

High grade data: 2007 had 1 default and was taken out of the sample

This year’s trend is falling:

collapsenew2

Lehman
When Lehman Brothers went bust, its bonds were trading in the low 20s, which for a market used to 40% recoveries (and recovery marks in the 50s for Financials) was shockingly low. A saving grace was that the bonds were expected to trade up as typically happens, especially in cases when CDS notional outweights outstanding bond principal which was true in this case. FT estimated that CDS notional was $400bn vs. $127bn of the bonds. (It’s not clear what seniorities went into this estimate or whether FT took other deliverable obligations i.e. loans into account).

leh1

That bonds are expected to trade up post a credit event was a precedent largely formed around the Delphi credit event in late 2005 when bonds hit a local low exactly around the weekend bankruptcy filing and then traded up. This effect was believed to be due to buyers of protection seeking bonds to deliver into the credit event settlement. In reality, you could, theoretically, settle a credit event with a single bond (just passing the fax back and forth). The price action was also possibly due to the “buy the rumour, sell the fact” phenomenon, when the bankruptcy was priced in and the actual filing left the field open to distressed players who saw value in the assets.

What actually happened, unlike in the case of Delphi, was that Lehman bonds started falling in price. And they didn’t stop until the credit event auction held about a month later. The recovery at the auction was 8.625%.

Reasons for Falling Recoveries

Excessive subordination: A top heavy optimized capital structure of many companies that favored loans over bonds will cause senior unsecured recovery to fall dramatically.

Liquidation possibilities: Many consumer sensitive sectors have witnessed large declines in earnings that have left them with high leverage. Normally such firms would be valued as a going concern however those that started out the cycle with high leverage (such as the 2006 private equity vintage) may face difficulty obtaining DIP financing which increases the chance of their liquidation.

Supply: There is a strong correlation between default rates and recoveries which is likely a symptom of excessive leverage but also of large supply of distressed paper. With many investors still sitting on the sidelines, a flood of distressed debt will not find a strong bid.

defaults-rec1

Recovery Valuation

Default rates
To get a rough idea of market-wide recovery expectations, we can use the graph above. Current expectation of the default rate maps to a mid 20’s recovery, which is about 2 standard deviations below the historic average.

Recovery locks
A recovery lock is a tradeable product that allows investors to isolate and monetize their views on recoveries. It consists of two credit default swaps: one vanilla (i.e. floating recovery) and one with a fixed recovery. Depending on his view, the investor buys the protection on one and sells the protection on the other. Upon a credit event, both CDS are triggered and the resulting cashflow is the difference between the actual and fixed recoveries. You don’t have to wait for a default to make money on the trade, as a move in the recovery market will lead to P/L on the position.

Citi

Citi

Recovery locks tend to trade in distressed names at 5-10% bid/offer in the 5y tenor. Liquidity is increasing and markets are being made in 30+ names.

Recovery locks nicely dovetail into DDS or digital default swaps which pay out a fixed unit of $1 upon a credit event. There has been a consistent push to replace vanilla CDS by DDS whch will allow the market to essentially trade the probability of default rather than both probability of default and recovery. It will also make unwinds much more transparent as there will be no argument about which recovery to use. The problem with DDS is that the product is not a perfect hedge for a bond position as a recovery view will need to be made and translated into the notional of DDS.

CDS spreads and expected default rate
In the valuation of a CDS, there is a relationship between three variables: spread, default rate and recovery. Any two will give you a result for the third. Though normally, the traded spread and marked recoveries are used to come up with the expectation of default, the relationship can be used in the other direction given a fundamental view on the default rate and market traded spreads giving us the expected recovery.

Capital Structure Arbitrage
In some sectors, especially in Financials, CDS trades across the capital structure. We can use the fact that the probability of default is the same for senior unsecured and subordinated bonds, due to cross-default provisions, plus an estimate of the recovery of one of the CDS in one part of the capital structure to find the market expectation of the recovery of another part of the capital structure. This is the relationship:
arb

Odds-and-ends: Jurisdiction, Sectors and Ratings

Europe has tended to have lower recoveries than US due to the fact that companies are normally liquidated rather than allowed to restructure as under the Chapter 11 process, though this has recently changed. The threat of liquidation means there is less of a premium for the probability the company comes out of bankruptcy. Also, a company that is more likely to be liquidated is going to try harder to milk its assets to the last drop to survive which will result in lower recovery.

Sectors have tended to have different historic recoveries with Utilities the highest (as these companies own hard assets) and Telecoms the lowest.

sector-rec1

There is also a correlation between the rating of a company and its subsequent recovery as a slow bleed of a company’s assets is more likely to result in downgrades as well as lower recoveries.

rating-rec2

Low recoveries is just another symptom of the excess leverage and stress in the credit markets. Equity tranches held by banks are likely to have been completely written down by now. The danger is that investors in the mezz and senior parts of the ABS/Corporate capital structures will take an actual hit (rather than an MTM hit) that will cause severe losses within pensions funds, insurance companies and municipalities.

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