Default Recovery Swaps

With Bank of America flipflopping on whether the appointment of a car czar constitutes an event of default for CDS purposes, Alea, who found the flip-flop, also finds a new default derivative product: the Default Recovery Swap. These things aren’t a way of buying up assets on the cheap, but they do imply, at least to me, that equity-market valuations might yet have a long way to fall.

The DRS is an interesting concept: let’s say that Archie buys a DRS from Bertie, based on a GM recovery value of 7 cents. Then if GM defaults, Bertie will pay Archie 7 cents, while Archie will pay Bertie whatever the recovery value on GM debt is, as decided at the end of the default auction. (Details of how that works here.) Of course, the DRS is cash-settled, so if the actual recovery is 11 cents, then Archie ends up paying Bertie 4 cents — while if the actual recovery is 2 cents, then Bertie pays Archie 5 cents.

Default Recovery Swaps have become increasingly attractive in recent months, as recovery rates have plunged. In a normal world, recovery rates are generally quite high: after the equity holders have been wiped out, there’s quite a lot of assets for bondholders to split between them. But in a chaotic world like today’s, lots of firms are going bust and selling assets into a market where no one has the money to buy them:

“One would expect much lower recovery rates as default rates soar,” Diane Vazza, head of S&P’s global fixed income research group, said in an e-mail…

S&P cited an “inverse correlation” between defaults and investor recoveries in a February 2007 report.

When default rates are less than 2 percent, more than half of defaulted debt recovers more than 70 percent of face value, according to the rating company.

When defaults are greater than 8 percent, more than half such debt recovers less than 40 percent, S&P estimated…

“Nobody thought about hedging the recovery rate” when default rates were low and recoveries stable, said Philip Gisdakis, a Munich-based credit strategist at UniCredit SpA.

“Typically, investors thought recovery rates for financial companies should be in the range of 80 to 85 percent,” Gisdakis said. “With Lehman below 10 percent and with other financials at very low recovery rates, that’s something that is completely new.”

Even non-financials are trading at very low recovery rates: DRS on Tribune, for instance, were trading at about 7 cents before the default was announced — more or less where it’s trading today. But according to the official default petition, Tribune has $7.60 billion in assets and $12.97 billion in liabilities — which, if you could convert those assets easily into cash, would amount to a recovery value of 59 cents on the dollar. Or, to put it another way, as far as Tribune’s bondholders are concerned, that nominal $7.6 billion of assets — which includes, I believe, the Chicago Cubs — can in fact easily be sold only for less than $1 billion.

What does this mean for equity-market valuations? I think it means that if you’re looking to pick up cheap assets, you’re much better putting your money to work buying bits and pieces of bankrupt companies — possibly by buying up their senior debt post-default — than you are buying stocks. While Tobin’s Q might be below 1, stock-market price-to-asset-value ratios are nowhere near as low as what we’re seeing right now in the distressed-debt market. As a result, we might have to see distressed-debt prices rise quite a bit before the smart money starts moving back into equities.

Update: RobertB makes a good point about Tribune in the comments: it has $8 billion of secured debt. Whenever a company has secured debt, the unsecured debt, even if it carries the name "senior", becomes a leveraged play and can easily go to zero — as seems to be the case here.

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