CDS Recovery Locks

Well, the primer on plain vanilla Credit Default Swaps is getting a little messy, so here’s a dedicate post to recovery locks.

There was a good discussion in the Derivatives chapter of the BIS Quarterly Review of June 2006:

Under certain circumstances, a shortage of deliverable debt can drive up the price of such paper beyond the level that might otherwise be justified by the expected size of repayment. In the case of Delphi, the settlement price of 63.5% (and an average CDS recovery price of 53.5%) was considerably higher than the settlement prices of other firms from the same sector or than rating agencies’ estimates of the ultimate recovery rates on Delphi’s debt.

The Delphi auction underlined the importance of recovery risk for pricing CDSs. Several products have emerged that permit investors to trade this risk separately from default risk (see box). The prices of such products could provide a benchmark against which deliverables could be priced following a credit event, perhaps leading to a more efficient settlement process.

Fixed recovery CDSs In a standard CDS contract, the protection seller is exposed to recovery rate risk upon default of the reference entity in the contract. A fixed recovery CDS eliminates the uncertainty on the recovery rate by fixing a specific recovery value for the CDS contract. In the event of the reference entity’s default, the protection seller makes a cash settlement equal to 100 minus the contract’s fixed recovery rate. If the fixed recovery rate is set to zero, the instrument is referred to as a zero recovery CDS.

Recovery locks

A recovery lock is a forward contract that fixes the recovery rate irrespective of what the secondary market price for the bond is. A recovery lock is documented as a single trade.
Recovery swaps or digital default swaps. In practice, a recovery lock can be structured using two separate trades: a fixed recovery CDS and a plain vanilla CDS. For example, the purchase of a recovery lock at 44% can be seen as two separate transactions, 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 at 44%. If the CDS spreads for both transactions happen to be identical, then the premium payments on the transactions will net to zero. If the reference entity defaults, the recovery buyer will take delivery of the defaulted debt and pay 44% of the face value of the bond to the counterparty in the transaction. If the premium payments are not identical for the two transactions, the notional amount for which the recovery is purchased can be adjusted to ensure that there are no interim cash flows in the absence of the reference entity’s default. The paired transaction described here is referred to as a recovery swap or digital default swap. A recovery swap, unlike a recovery lock, is documented as two separate trades.

It wasn’t just Delphi that highlighted the issue, there was a problem with Dana:

Dana Corporation filed for bankruptcy on March 3, 2006. The auto parts maker had about $2 billion in bonds outstanding. However, there was more than $20 billion of CDS outstanding in notional amount referencing the company. This ignited some concerns about a possibility of a short squeeze, as most single-name CDS contracts require physical settlement (i.e., delivery of a bond). Indeed, prices of Dana bonds started to climb from the low 60s reached in late February, one week before the filing (see the chart below). The bond prices soared above 80 on days leading up to the ISDA-led CDS index auction on March 31.

A template contract is available from ISDA.

There was a report dated August 14, however, that the recovery lock market is very thin:

In their latest research report, Bank of America analysts say there are many risks involved in the recovery lock market. They maintain they are not suitable for all investors. Particularly, recovery locks are a relatively new and untested market. They also say recovery locks have significantly less liquidity than regular CDS, such as a smaller size, wider bid-offer premium and fewer dealers making markets. Since recovery locks trade on reference entities that have suffered significant spead widening over the past year, it indicates a greater degree of protection buying and potential for a one-way market, they say. Recovery locks may also be more difficult and more expensive to roll than regular CDS. Also, they say it may be harder to monetize profits in a recovery lock relative to CDS.

This is a problem with all structured products. Typically, you buy (or sell) a structured product because there’s nothing else available that does precisely what you want. Trouble is, this becomes a much more specialized market by definition, and the market will be thin – sometimes very thin indeed. This doesn’t necessarily make the product a bad one, but remember Rule #1: Never invest in anything you’re not prepared to hold forever.

Update, 2008-9-9: An interesting nuance has arisen as a result of the Fannie/Freddie Fiasco: the structured preferred share issue RPB.PR.A has a recovery lock of 40% on its GSE exposure … which might be triggered even though actual recovery will be close to, if not equal to, 100%

3 Responses to “CDS Recovery Locks”

  1. […] to naked shorts of stocks? Well … hasn’t that been obvious from the beginning? The mechanics of CDSs have been discussed on PrefBlog; Mr. Cox’s full remarks have been posted at the SEC […]

  2. […] Update, 2008-9-4: See also CDS Recovery Locks. […]

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