The Cost Of Restructuring

This article examines the impact of removing restructuring as a trigger event in the credit-default swap contract. It concludes that removing restructuring would be constructive and lead to greater market liquidity. It would likely shave off 10-20% of the premium. However, it is looks at alternatives for market participants who need restructuring.

The Xerox Chronicle

An example of OldR's limitations, as well as restructuring in general, was when Xerox renegotiated a USD7 billion revolving credit line. The major difference between old and modified restructuring is OldR allows more deliverable obligations. The three changes to the loan occurred on June 21, 2002, and were 1) to repay USD2.8 billion, 2) pledge a substantial amount of assets to secure a portion of the remaining USD4.2 billion, and 3) extend the maturity from October 2002 by 30 months to April 2005.

The maturity extension triggered a credit event. Most of the outstanding contracts pre-dated ModR, therefore allowing the holder of protection to deliver a long-dated maturity bond that is now suffering from structural subordination but not defaulting. The cheapest to deliver bond had a maturity date in 2016 and traded at USD0.70. The restructuring credit event and structural subordination impact to the holder of protection was a potential USD0.30 gain. The loser? The seller of protection.

An extremely important point to understand regarding the CDS market is that selling protection or owning a bond should be fundamentally identical. In the Xerox situation, no default occurred, but because of the Restructuring definition, the CDS seller actually had to pony up the USD0.30 differential. Because of the existence of restructuring language, the bondholder and the protection seller are no longer economically equal.

While ModR is an enhancement over OldR, restructuring itself causes inefficiencies that contribute to the positive basis between the cash and default swap. Imagine selling credit protection on XYZ expiring August. On July 31, XYZ has a loan restructured extending the maturity by 30 months. Under ModR, the holder of protection can deliver to the seller a security maturing no later than January 2006. Although the seller may have been a day away from ever having to perform on the contract, because of ModR the seller had to pay USD100 and receive a security that trades about USD85.

As long as restructuring continues to exist as a credit event, one should get adequately paid for the potential risk of the restructuring option. Quantifying the probability that a restructuring event occurs inside the potential 30-month restructuring/expiration window (window event) is not apparent, but using both historical data and empirical evidence, ModR's impact on the default-swap premium can be estimated.

Exhibit 4 reveals that an additional 20% or so in premium is necessary to take on the restructuring risk. So, a contract trading with ModR at 100 basis points should trade around 80bps without any restructuring language.

Methodology

The key to determining the amount a protection seller should get paid to be economically indifferent to a contract with or without ModR is establishing the probability that a restructuring event will occur during the window period. Once that is defined, one can take the present value of the expected cost divided by the duration to find the approximate basis point impact.

BP impact = PV ( Expected Cost)/Duration of Contract
Expected Cost = Probability Weighted Cost

Establishing the probability of a restructuring is certainly the more difficult task. We will use bootstrapping to locate the implied probability of "an event" that makes the price of a default swap (at a stated recovery rate) equal to zero. Some base assumptions we use to establish the market implied default and restructuring rates are as follows:

* Our calculations use a 2:1 ratio of restructuring to default. The

data and experience of senior commercial loan officers suggest a

2-5 times greater likelihood of restructuring than default. (We will

show the impact of using different ratios.)

* For simplicity, the event of restructuring only affects the contract

in the last two years.

* A restructuring loss level assumption of USD15 is used. In

the past couple of years, the "window event" has occurred just

four times and, on average, the post event short-term debt traded

at USD85.

The Calculation

Beginning with the basics-- a default swap is an agreement in which a party buys protection against certain events happening. A standard contract with no restructuring language is only triggered in the event of a bankruptcy or failure to pay by the reference entity. At a given spread and recovery rate, an implied default rate can be calculated by iterating the default probability until the value of the contract is equal to zero.

Example 1: An investor sells protection on XYZ company for five years assuming a 40% recovery rate and trading at 83bps per annum. The event tree represents potential default and survival of XYZ. The implied default rate where the present value of cash flows equals zero is a 1.38% annual default rate.

Example 2: An investor wants to sell the same contract as in Example 1but includes ModR language. If restructuring constitutes an event, the probability of a trigger event must increase. Using the assumptions of a 2:1 ratio of restructuring over default, the restructuring impact only in the last two years and a restructuring loss of USD15, the implied default rate on a par dollar contract with ModR trading at 100bps per annum is 1.38%. The implied restructuring is two times that, or 2.76%.

The total probability of an event in Example 2 is 4.14%. The seller of protection potentially loses USD60 and the unearned premium during years one, two and three and either USD60 or USD15 (and the unearned premium) during years four and five.

Once you have solved the implied restructuring probability, the calculation in the Methodology section is used to find the per annum basis point impact of ModR. In the previous example, if you are the seller of credit protection and you want to be economically indifferent to ModR, using our previous assumptions you would need to get paid 100bps per annum with ModR and 17bps less, or 83bps, without ModR.

The impact of different restructuring/default ratios are depicted in Exhibit 7. While conversations with senior commercial lending officers have empirically concluded a 3:1 ratio, hard historical evidence is virtually nonexistent.

Where contracts without restructuring actually trade is not clear but the evaluation should include the implied rates previously discussed and technical considerations, as well as how far the contract is perceived to be in or out of the money. So, those reference entities that are perceived to be close to an event--be it default or restructuring--would probably trade much greater than a 2:1 restructuring to default ratio. A differential of 10-20% of the nominal spread is not an unreasonable expectation.

The market has begun to dabble in trading default swaps contracts without restructuring.

One recent Ford transaction revealed a roughly 15bps differential between contracts with and without restructuring. The client bought protection for 5-years without restructuring at roughly 285bps. The market on the same credit with ModR was being offered at around 300bps. Our analysis would imply that the economic differential should have been roughly 50bps. In this case the market is implying something less than the theoretical value, or that the restructuring to default ratio is less than 2:1.

A Potential Solution

We believe that the elimination of restructuring as a credit event would be an important improvement. But if restructuring does continue to exist, the elimination of the negative option could be achieved by allowing the seller of protection the right to choose either the deliverable security or the restructured loan (including all of its economics) itself, effectively eliminating the seller of protection's negative option.

In summary, ModR didn't substantially alter the triggering of contracts--only the economics. The changes have helped the maturation of the credit derivatives market but haven't completely eliminated unfettered risk. Given that the protection seller or the bondholder should be indifferent, restructuring as a credit event continues to perpetuate additional basis between cash and the credit-default swap.

 

This week's Learning Curve was written by Lisa Watkinson, a credit derivatives strategist at Morgan Stanley in New York.