A Standard & Poor's collateralized debt obligation conference last week divulged two revelations about recovery rates in CDOs, something that bankers and investors have started to look at more closely since the rating agencies published data showing how much they can vary between deals (DW, 12/9). The conference disclosed innovations in both securitizing recovery rates and their relationship with the trading prices of defaulted assets.
Nik Khakee, director at S&P in New York, said CDO houses, including JPMorgan, are now looking at isolating the risk of fluctuating recovery rates and securitizing protection against this. S&P has not yet viewed any proposals to rate securitizations of recovery risk, but noted that there is demand to buy protection and structured deals will eventually filter through to the ratings agencies.
Another breakthrough was research by S&P that showed that the trading prices of defaulted assets are not as correlated with ultimate recovery rates as had previously been thought. Trading prices and recovery rates of collateral, including defaulted bank debt and bonds, are driven by different variables, according to the analysis. This finding is significant for credit derivatives pros as recoveries of credit-default swaps are largely determined by their underlying assets, noted Khakee.
Recovery assumptions of credit-default swaps are driven by the legal, regulatory and market characteristics of the domicile of the reference obligation, he said.
David Keisman, managing director in New York, explained that trading prices of debt 30-days after default have traditionally offered much lower prices than those ultimately recovered. For example in 1997 defaulted senior unsecured bonds traded for 55.6% of their value, however the ultimate recovery was 81.4%. This year market prices on the same defaulted assets traded above their recovery price for the first time, going for 39.3% of their value in the market, but only recovering 32.3%.
Trading prices are affected by news, such as changes in gross domestic product. These factors, however, do not impact recoveries, said Keisman. A possible reason that defaulted senior unsecured bonds may have traded above that of their recovery values this year may be that there is increased interest for distressed securities at the same time as the market is having a dip in supply, he speculated. Collateral seniority and the percentage of debt cushion--the amount of debt below the instrument on the balance sheet--are by contrast the largest factors in determining ultimate recovery rates, he said.
To determine probable recoveries in synthetic deals S&P applies haircuts to recovery assumptions on the underlying. These are used to account for settlement provisions such as cheapest-to-deliver, specified currencies, the 1999 restructuring definition and physical settlement, said Khakee.
