The bankruptcy filing of troubled auto parts supplier Delphi Corp. late last year is known as the largest corporate credit event to rattle the credit default swap market to date - with more than $20 billion in total notional exposure. That makes the way in which the Delphi-linked CDS trades were settled a lesson for future evaluation procedures for a number of market participants. And while the $12 trillion - and growing - credit default swap market is expected to require a heavier reliance on an optional International Swaps and Derivatives Association's method for settling CDS index trades, events such as the Delphi bankruptcy last year illustrated that substantial price differences exist between bonds valued using the protocol and those using other settlement methods, primarily because prices were determined under the index protocol method some 40 days sooner on average.
"A big event like this lets us observe how the market really works," said Kevin Kendra, a senior director at Fitch Ratings. Last year broke the record for the number and total notional balance of credit events called during any 12-month cycle on record, according to Fitch. Delphi's filing alone accounted for 78% of the credit events by number and 92% by notional balance. This year has begun with a string of difficulties for the U.S. auto industry, most recently resulting in the bankruptcy filing of auto parts supplier Dana Corp. Similarly, a potential General Motors Corp. bankruptcy filing could represent the largest corporate credit event to hit the U.S. market.
Along with ISDA's release of pay-as-you-go and physical settlement options for CDS trades referencing structured finance assets, the association has also unveiled a so-far lightly used method for settling covered index trades; it allows for cash settlement and uses a minimum of five dealers to determine a bond's market value. Last year, the auctions took place an average of 28 days following corporate bankruptcies and incorporated bids from between six and 15 dealers. While Fitch for one is promoting the use of the protocol going forward, the rating agency's analysts say at least 45 days should pass in order for the auction price to reflect a fair market value.
For example, four weeks after Delphi's Oct. 8 bankruptcy filing, 15 dealers participating in the index protocol auction settled on a price of 63.4% - meanwhile, those trades which were settled outside of the protocol resulted in an unweighted average 53.5% recovery rate. The 53.5% recovery rate was priced an average 58 days following the credit event, compared with the 27-day window that passed prior to the index protocol auction. The rating agency tracked 99 final Delphi valuations, which ranged from 40% to 63% recovery rates. The average length of time of the valuation period last year was 61 to 80 days, according to Fitch, while a number of credit events settled as far out as 120 days.
Bond pricing immediately following a corporate bankruptcy is often heavily influenced by market technicals, thus prompting many to wait a longer period of time prior to settling a trade. In Delphi's case, because of the sheer volume of CDS trades that needed to be settled using the physical settlement procedure - which requires the actual purchase and delivery of the underling cash bond referenced in the trade - a number of opportunists crowded in to buy its bonds immediately following the Chapter 11 bankruptcy filing. The buyers purchased the bonds at a discount and then pumped up the price, effectively creating a "short squeeze" and temporarily raising the market price of the bonds, according to Kendra.
"We suspect that there was a lot of short-term money hoping to make a gain off of Delphi bonds," Kendra said, "Delphi's bond prices were going down, down, down, and then there was this uptick."
The temporary increase in Delphi bond prices affected about 7% of the trades that had settled using ISDA's index protocol method by inflating recovery rates. At least a handful of CDO managers that had used the index trades as a hedge went as far as changing existing documentation in order to settle the Delphi credit event using the ISDA protocol and eliminate basis risk.
All new credit events last year were called due to bankruptcy, and 87.2% of all credit events from 2000 through 2005 were also prompted by bankruptcy; 8.8% were called due to restructuring and 3.4% during the years were called due to failure to pay, according to Fitch. But, as an increasing number of synthetic CDOs referencing such assets as ABS, MBS, emerging market debt and CDOs enter the market, a broader range of credit events are anticipated.
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