News Analysis

Recovery revisited

Wednesday 1 April 2009 00:00 London/ 19.00 (- 1 day) New York/ 08.00 Tokyo

Call for increased transparency around CDS recovery rates

With the string of single-digit recoveries hitting the market in the wake of Lehman Brothers' default, it has become apparent that the standard 40% implied CDS recovery rate is too optimistic for distressed names. The lack of transparency around the issue means that the majority of buy-siders are still typically quoted the standard figure, however.

Eric Benhamou, ceo of independent valuation firm Pricing Partners, confirms that there is little transparency or standardisation around CDS recovery rates. "This aspect of market infrastructure has been overlooked in comparison to, for example, the noise around the simplistic Gaussian copula model for CDOs," he says. "Whereas there is a strong quant dialogue on the modelling side, there isn't that much communication around trading inputs - perhaps because this is an activity focused on the trading floor."

While a number of banks have begun adjusting their recovery rate assumptions downwards on an internal basis, a lack of consensus on the issue remains for the market more broadly. "Conflict of interest issues arise when asking a dealer for a quote; similarly, basing your recovery rate assumptions on market data could be misleading," Benhamou adds. "Industry participants don't hesitate to question models, but don't always question the inputs of those models - it's important for investors not to simply plug in a number without questioning it."

According to Kamakura Corporation chairman and ceo Donald van Deventer, the major concern regarding market convention for CDS recovery rates is its simplicity. "Expected loss is assumed to account for 100% of the spread, whereas in reality the price represents the intersection of supply and demand," he explains.

Indeed, 45 other variables - in addition to the five-year default probability - are statistically significant in predicting CDS levels, notes van Deventer. The Kamakura Risk Information Services public firm default probability service addresses the relationship between default probabilities and CDS quotes in order to help clients correctly measure 'plus alpha' or even 'negative alpha' performance opportunities in the credit markets.

Among the factors that affect recovery rate calculations are the size of the underlying company (because it influences the size of the spread) and its jurisdiction (Japanese companies, for example, typically have narrower spreads due to the country's 'main bank' system and Japanese institutional investor preference for Japanese counterparties). Another issue is that bond spreads and CDS spreads aren't equal, even if the tenor matches, because of the greater liquidity in synthetic markets. Consequently, there can be significant difference in implied recovery rates between CDS and the underlying bonds in either direction if the liquidity differential isn't correctly taken into account.

Three implied spread functions - for bid prices, offered prices and traded prices - employed by Kamakura explain 80%-83% of the variation in CDS quotes over the 500,000 observations in its database. These implied spreads allow clients to clearly see how much of the current default swap quote is the default probability, how much is the normal premium to the default probability and how much of the CDS spread is unexplained - representing either an arbitrage opportunity or something special that isn't captured by historical patterns of movements between default probabilities and credit spreads.

One CDS trader agrees that the standard 40% recovery rate underestimates the downside from a long credit perspective. However, he points out, this only holds when calculating the NPV of contracts that trade spread running.

"Once the market moves to trading points up front, the assumed recovery rate has no bearing on the NPV of the trade. Consequently, I'd imagine that accurate recovery rates are more relevant for clients who need to monitor existing risk rather than clients who are putting on new risk," the trader says.

The move to trading in points upfront is expected to reduce the number of players in the CDS market as some won't want or be able to offer cash upfront, thereby increasing spreads (since there will be fewer providers of credit protection). But van Deventer suggests that the new contracts will complicate the task of calculating recovery rates even further, due to the change in the history of spreads, exactly as the change in the ISDA default definition to 'modified' and then 'modified modified' has had a statistically measurable impact on CDS spreads.

Pricing Partners is nonetheless seeing interest in providing an independent opinion on recovery rates by backing out the figure based on the underlying bond. "If a credit event occurs, the buyer of protection typically receives the underlying bond, so logically if the bond is trading at below a 40% recovery rate they'll receive less than 40%. Consequently, by analysing both related instruments, it is possible to back out a more appropriate implied recovery rate," explains Benhamou.

For example, backing out CDS recoveries from the bond market for distressed names can lead to recovery rates as low as 5%-15%. For first-to-default baskets, lowering the recovery rate can reduce valuation prices by 20%. Van Deventer says that it is hard to generalise about the impact of inaccurate recovery rates on P&L because it depends on where a counterparty sits in the capital structure, the priority of payments and whether the underlying entity is subject to government interference.

One alternative to backing out a recovery rate from the underlying is to use historical analysis. However, it is difficult for many market participants to access the appropriate data.

01/04/2009