Standard & Poor's annual default recovery survey, released last week, painted a grim picture for holders of defaulted loans.

As a result of the record defaults of 2002, recovery rates - both in terms of ultimate recovery and trading price recovery - have fallen to record lows, and things are not likely to improve this year either. Bank loans achieved a 72% settlement value at time of emergence in 2002, compared with 73.6% in 2001.

In fact, recovery rates have been on the decline since 1995 (with the exception of 2000, when there was a small increase), the year in which S&P began to track them. Last year's decline dragged the cumulative average from 1998 to 2002 down to 81.6%.

It isn't just ultimate recovery rates that are on the decline: trading price recovery rates have experienced a similar, if not more dramatic decline. The average trading price for defaulted bank loans dropped to 53 cents on the dollar last year, versus 57 in 2001, while for defaulted bonds the price was even lower, at 21 cents in 2002 against 24 the previous year.

Economy, Telecoms, Vintage to Blame

When it comes to loan quality, the investment community has often been all too quick to point an accusing finger at banks. This time around, though, many banks have been more stringent in their lending, and have made an effort to keep credit quality at a higher level.

"The reduced ultimate recovery does not seem to be the result of lower quality bank debt or any other type of questionable structuring, but rather the result of lower asset values for restructured assets," said Roger Bos, associate with Risk Solutions, S&P's risk management unit that administers and analyzes the LossStats database. "That the recent bank debt recovery results are only 8% to 10% below the 15-year mean is a result of banks continuing to structure debt better by getting higher quality collateral, having more debt contractually subordinated to their position, adjusting covenants, and reducing commitment levels earlier in the process."

The continuing decline in loan recovery rates is largely a consequence of the meltdown of the telecommunications industry. By mid-2002, the telecom industry accounted for 35% of the dollar-weighted defaults waiting to emerge. With most bankruptcies taking 18 months to unfold, there remains a large supply of distressed assets, which will in turn continue to depress prices.

The weakening economic environment, which has led to huge increases in the number of downgrades and defaults in all asset classes, also depressed loan recovery rates, as did "vintage" deals, put together in the good times, when lenders gave little thought to the amount of leverage they used.

"It is similar to a rodent being digested and working its way through the body of a snake," said Michael Rushmore, CEO of LoanX. "The deals being worked though now are largely from 1998 and 1999, which tended to be more highly levered and concentrated in industries with lower asset support - a deadly combination."

Rushmore believes that recovery rates will eventually take a positive turn, even if it isn't this year.

"Deals from 2000 and onward that do go through a workout process will have been better structured, supported by more equity and better collateral," he said. "That in turn will produce higher recovery rates."

In the meantime, market participants could actually use the low recovery rates to their advantage, Rushmore said.

"Low relative recovery rates for the asset class will not reduce the attractiveness of the distressed loans to the sophisticated investors who use highly disciplined approaches to the development of their bid levels," he said.

In fact, the less predictable recovery rates may in fact lead to greater involvement of more risk-tolerant distressed loan investors, including hedge funds, who will thrive in an environment of a larger standard deviation in those recovery rates, he said.

In any case, loan investors are better off than their bondholder counterparts: while the recovery rates for bonds improved slightly from 2001's record low of 22.1%, the percentage for 2002 was 28%, well below the 1988-2002 average of 46%.

Fitch Ratings is in the process of putting together its report on recovery rates, but preliminary results show recovery rates for loans at 71% of par, compared to 35% for bonds, through the first half of 2002.

The trouble is that while the amount of debt subordinated to bank debt - the debt cushion - has increased over the past five years, thus providing increased security for loan investors, the same trend has negatively impacted senior unsecured bonds, which have had their debt cushion whittled away as more bank debt is issued above them and less subordinated debt below.

"The ability of secured debt holders to grab whatever collateral a company possesses has caused unsecured bond recovery rates to fall through the floor," Bos said.

As for loan recoveries, "the rapid pace at which companies are emerging from bankruptcy, as well as the bottoming out of the senior unsecured bond's ultimate recovery rate, provides hope that next year's results will not be significantly worse than 2002 and that results should improve in 2004," Bos forecasts.

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