Posting growth figures over the last four years that have shown upward momentum, the credit default swap market is obviously of increasing interest to institutional investors. Yet in 2003 a record number of credit events occurred impacting the synthetic CDO space, despite a rosier economic picture in both the U.S. and Europe. Have market participants matured enough to avoid these pitfalls?
That answer can depend on how much time is built into soliciting bids for settlements or digesting recovery data.
In a case study on the soft credit event of British Energy, Fitch Ratings found that the balance sheet struggles of the U.K.'s largest electricity generator (beginning in 3Q02) triggered 29 credit events in mostly European synthetic CDOs. The period between the first and last event called - about 300 days - was the longest of any reference entity triggering credit events to date.
Interestingly, as it panned out, market participants that called early [Nov. 28, 2002] realized an average recovery of 41.4% but those that waited another few months [March 24, 2003] realized an average recovery of 64.2%, according to Fitch data.
"Recoveries varied significantly depending on when you called your recovery on the credit event," said Shin Yukawa, associate director, Fitch. Yukawa also noted differences in recoveries by the type of event called. (Credit events can be triggered by bankruptcy, failure to pay, restructuring and moratorium.) In the case of British Energy, recoveries on credit events due to restructurings fared better than the ones deemed for bankruptcy. By Sept. 24, 2003, three credit events were called for restructurings, which logged an average annual recovery of 91.8%.
Looking at broader figures from 2003, Fitch analysts found recoveries tended to be higher when the valuation process lasted between 20 to 60 days or 100 to 180 days. Those completed between 60 to 100 days produced below-average recoveries.Yukawa chalks that up to the fact that most credit events appear to settle during that time period, creating a logjam resulting in broker dealers providing lower bids.
"It's the effects of supply and demand," Yukawa said. "You're going to experience an oversupply of bid requests if you have a lot of credit events settling around the same time."
And based on its findings, Fitch is encouraging synthetic CDO investors to obtain at least five bids per credit, regardless if that includes the calculation agent or not, utilizes the highest of highest valuation method, and conducts multiple valuation rounds.
An update on global
credit events
Fitch Ratings hammered out an interesting piece of research last week that delved into credit events in global synthetic CDOs, releasing its Year-End 2003 Update.
Despite recovery from the recession, a record number of credit events - 96 (involving 19 reference entities) - were recorded in 2003, translating into $402.8 million (709.0 million) in notional exposures. But setting such a seemingly negative record doesn't actually reflect the undercurrent of the market.
"The number of deals that held a [reference entity] was much greater than in prior years," said Jill Zelter, managing director, Fitch, of the activity in 2003. "So the number of credit events was higher despite the fact that the actual number of defaulted companies might have been lower than prior years," she explained.
"In 2001, you had a lot more unique names triggering [credit events] for that year and a less number of credit events per name," added Yukawa. With the market's growth, a single reference entity isn't just in one or two deals, but can be packed into multiple types of CDOs.
Reference entities
Both Yukawa and Zelter felt investors need to be more aware of the increasing level of overlap of underlying names in synthetic CDOs transactions, particularly in the wake of the growth of CDOs of CDOs.
When it came to analyzing credit event data from 2003, not surprisingly the overwhelming majority of reference entities having credit events were those with highly speculative ratings - 91.9% were rated triple-C plus or below - or those whose ratings were withdrawn, Fitch analysts found.
Credit events due to restructuring increased over 2002, 35.4% in 2003 versus 6.0% in 2002. However, bankruptcy and failure to pay accounted for the majority of credit events at 64.6%. In 2002,they accounted for 91.7%.
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