Thirty-two issuers defaulted globally in 2005, having an impact on bonds worth a total of $29 billion. With huge volumes of credit default swaps now written against these bonds, how and when recovery rates are determined is crucial. There is an urgent need for the market to establish a settlement standard that can minimize any price and recovery rate manipulation in the most efficient manner. The Isda protocol in May amended existing index-related contracts from physical to cash settlement but most single-name CDS are still settled physically and the difference between the two processes creates recovery basis risk.
The scramble to find bonds to achieve physical settlement of CDS contracts often results in a short squeeze, which triggers an artificial price spike. In Delphi’s case this inflated the bond price by 24% just before auction as the firm had $27.1 billion of outstanding CDS against notional outstanding bonds of just $2 billion. And Dana Corp’s bankruptcy in March resulted in another squeeze as $20 billion of CDS chased $2 billion of bonds.
Cash settlement of single-name CDS will not overcome this manipulation, it will just make settlement more orderly. Alternative solutions fall into two broad camps: net physical settlement via an auction and net physical settlement using a central repository of trades. Both try to avoid price manipulation by netting transactions to reduce the need to buy bonds – the former crosses contracts to produce open interest and the second uses the central repository to calculate open exposure following which participants can decide whether to cash settle or physically settle. Establishment of such a platform could be spurred by the need to have a clearing and settlement process before the proposed trading of index futures can take place [see CDS futures: Exchange-traded contracts set to attract new client base, Euromoney April 2006].
So much for the how, but timing – the point at which recovery rates are determined – is equally contentious. At the moment, the standard for most contracts is that the dealer has a 30-day to 60-day window to deliver bonds – and can clearly choose the timing to achieve the lowest recovery rate. Thus the protection buyer has an option that the protection seller does not. The obvious solution to this is for valuation periods to be shortened.
The final recovery price from an index auction and from settlement of a single-name CDS can be very different. Concern over this risk will grow as the credit cycle turns and more defaults take place. Investors therefore need to separate recovery risk from default risk, and the best way to do this is by a fixed recovery swap, or recovery lock. The recovery swaps market is very thin at the moment and populated almost entirely by auto names. But as long as distressed debt funds and principal finance desks are happy to step up and buy this risk, expect to see growing use of fixed recovery swaps in the CDS space.
