The vast majority of synthetic structured finance collateralized debt obligations are cash-settled and these require a market valuation process to determine the percentage loss following several types of credit event. The valuation process is necessary for the bankruptcy, failure-to-pay interest, or being downgraded to CC credit events, but although a valuation process could be avoided for failure-to-pay principal at maturity or writedown the documents often include it for all credit events.
Fitch believes that avoiding a market valuation process for these two credit events, where the loss on the underlying asset can be established with certainty if documented accordingly, may align the risk profile on the underlying cash and synthetic instruments more closely. Although in the synthetic corporate CDO market, physical settlement provides a viable alternative to a valuation processes, in the synthetic structured finance CDO market, physical settlement can present problems.
Deflated Pricing Period
For corporate credits pricing in the 30-day period immediately following a credit event may be deflated. Fitch believes this deflated pricing period is much longer for SF securities, although it is difficult to pinpoint exactly how much longer.
Total Return Swaps
To date, very few deals have had the option for physical settlement. Moreover, any deals that have had such an option were subject to the swap counterparty's ability to source the underlying SF reference asset, which could prove very difficult. Synthetic SF reference portfolios may reference any dollar amount of an SF security. For example, $100 million may be referenced in a portfolio, while only $20 million of the underlying cash SF security is outstanding. In addition, many different reference portfolios may reference the same underlying cash SF security, making demand for the security greater than supply. As a result, physical settlement may be extremely difficult to actually achieve. The limited supply of any cash SF security also increases valuation risk in cash-settled deals, since dealers solicited for bids in any valuation process may submit unrealistic bids if the dealer knows it will be impossible for the larger referenced amount to be delivered.
Certain transactions have attempted to alleviate such uncertainty associated with valuation processes by implementing total return swaps as a deliverable obligation for which more realistic bids may be obtained from dealers, since such TRS make it possible for the referenced amount to be delivered. TRS are constructed for the applicable notional amount to essentially mimic the underlying cash flows on the referenced SF security. Such TRS may then be used for valuation purposes, which may help mitigate moral hazard risk in the bidding process because dealers will be bidding for a security they ultimately could own.
Minimum Recovery Rates
Minimum recovery rates establish a floor on the price at which an asset could be valued following a credit event and typically apply to the first stage of the valuation process. MRR are disregarded in the second stage of the process. These are minimal levels that must be met in order for the valuation to be accepted.
MRR were intended to provide some downside protection for CDO investors by rejecting potential low ball valuations, which could result from illiquidity or shortages of information in the early stages following a credit event. Conversely, if set at a level that is too high, MRR could cause a valuation determined early in the process to be rejected, on the basis that it is lower than the MRR. There is a risk, however, that the second round bids may result in a valuation lower than the bid rejected in round one and at this point there is no MRR backstop.
Given the consequences associated with MRR that are set either too low or too high, the question becomes who should determine these levels in the first place. The difficulty in determining the level is twofold. First, there have not been nearly as many defaults on SF securities as there have been on corporate or sovereign credits and therefore few benchmarks with respect to realized recovery rates following such events have materialized. Second, few credit events have been called to date on any SF CDS and as a result, it is difficult to predict exactly how the valuation process will, in practice, unfold. Moreover, Fitch's recovery rate assumptions used on the liability side are tiered by stress scenario and therefore an AAA recovery rate assumption would be much lower than a BBB recovery rate for an SF security with the same characteristics. Although tiered recovery rate assumptions may be appropriate to model the risk for a given stress scenario inflicted on a portfolio to determine ratings on the liability side of the transaction, the same tiered recovery rates are not appropriate to evaluate the recoveries that would ultimately be achieved on the asset side (underlying assets) of the transaction. Fitch has developed recovery rate assumptions to be used on the asset side. However, such rates will reflect a worst-case average of observed recoveries and would be intended for use for portfolios, as opposed to specific referenced SF securities. In addition, tranche thickness also will impact ultimate recovery rates, which may be difficult to capture in MRR.
Fixed Recovery Rates
Fixed recovery rates establish the price at which cash settlement would occur following a credit event. As mentioned, FRR do not require a valuation process at all; instead, the recovery levels are predetermined and specified in the documents at the origination of the deal. As a result of this predetermination of recovery levels, investors are entirely aware of the rates at the outset of the deal and therefore should be in agreement with such rates as evidenced by their acceptance of the terms of the deal. In this way, market valuation risk is removed from the deal completely.
Moral hazard risk may also be a concern for FRR since the protection buyer may have an increased incentive to call all credit events because the protection buyer is guaranteed a predetermined protection payment, which could be worth a lot more than any economic loss realized on the underlying referenced security. As a result, investors should consider FRR carefully and work with the protection buyer to establish appropriate rates.
Considerations
Investors should consider the implications on valuation processes as expanding types of SF reference assets are included in deals. In particular, investors should think about the consequences of a one size fits all solution for valuation. A predefined process aimed at determining fair value for a multitude of different SF securities may be difficult to accomplish. Even with the inclusion of protection mechanisms and other structural features, there is still a great deal of uncertainty inherent in any SF valuation process.
This week's Learning Curve was written by Tania Cunningham, a structured finance analyst at Fitch Ratings in New York.
