A market for trading credit recovery risk is getting underway because firms such as Morgan Stanley,Lehman Brothers andCitigroup have started issuing collateralized debt obligations backed by fixed recovery loan-only credit-default swaps. The firms are entering so-called recovery locks to hedge recovery assumptions and that creates a role for arbitrage funds looking to take a view on how much will be recovered in the event of default.
A dealer selling protection on a loan with fixed recovery is exposed to the risk the loan may recover at a rate higher than that predicted by the dealer's model. An arbitrage fund, however, may want to take on this risk to express the view recovery rates will be higher in the future.
In the event of the loan's default, the fixed-recovery protection seller makes a cash settlement equal to 100 minus the recovery level. A recovery lock is two contracts, the first one selling protection on a standard CDS, and the second one buying protection through a fixed recovery CDS on the same reference entity. The Delphi auction last year showcased a potential use of recovery swaps. The auction priced fixed recovery for the CDS in index tranches at 63.375%--below where the bonds traded pre-auction and above analysts' fair-value estimates. While analysts priced Delphi's real value at about 55%, traders ran recovery rates as high as 72% before the auction. This squeeze was driven by a huge discrepancy between the number of contracts--USD27.5 billion--and the number of bonds available--USD2.2 billion.
CDOs are being issued using fixed recovery CDS because some potential users--such as insurance companies--can only buy synthetic deals with fixed recoveries. Issuers also noted that there is a structural benefit in using fixed recoveries in CDOs, as rating agency models will allow for lower attachment points and lower subordination when fixed recovery is used. As a result, there has been an increase in fixed recovery CDOs in the past year. But a handful of dealers reached their internal limits for recovery risk and looked to swap it in the inter-dealer market or with hedge funds.
"There are lots of dealers pushing the trades because we want to print these deals. And there are also lots of loan guys who could potentially profit and are throwing a lot of research at understanding recovery," said one head of CDO trading in the U.S.
