With the ever-growing popularity of partial risk guarantees in emerging markets, Fitch has quite fittingly completed a study that provides insight into the recovery rates of defaulted loans in Mexico, thus providing somewhat of a guideline as to how much partial risk insurance is needed to benefit a structured transaction.

While the study was completed in Mexico, according to Greg Kabance, an analyst at Fitch, it provides an indication of how loans are performing in other emerging markets. "While creditors rights will vary across countries, this information gives us an estimate of what recovery rates might be in other countries and therefore we know how large a partial risk guarantee needs to be in order to get some benefit," said Kabance.

The study analyzed 120 defaulted loans and bonds and found that the recovery rates in present value terms were 40% for unsecured debt and 47% for secured debt. Unlike the default rates in the United States, the unsecured and the secured percentages are quite close. "In the U.S. it's much different; it's usually 80% [secured] and 40% for unsecured but the creditors' rights under the old bankruptcy security law were quite weak," said Kabance. "Due to the long drawn out bankruptcy process and weak creditor rights, the benefits of being a secured creditor was much lower compared to the United States. The new bankruptcy law should help increase that overall recovery rate for creditors and especially secured creditors."

The old Mexican bankruptcy law, enacted in 1943, did not provide adequate protections that creditors needed to seize and collect outstanding debts on a timely basis. The new law, enacted in May 2000, is intended to improve the economic and social value of a firm during financial distress.

Fitch expects that the new law will improve creditors' rates however, it may be at the expense of the unsecured creditors. "The 40% recovery rate for unsecured creditors might actually drop," said Kabance. "But the overall pie will increase because the law is better. The secured creditors are positioned to benefit more and that might be to the detriment of unsecured creditors."

Additional study findings

The study is based on the old law since there are less than 20 deals that abide by the new law. Since Fitch is unclear as to how the unsecured creditors will be affected by the new law, and given that the study is small, Fitch is being conservative by using 30% as a base as opposed to the actual 40%.

The study also found that the loans being sold to vulture funds are probably making money. "People were buying distressed debt portfolio's at prices just over 20% so the data we saw shows that recovery rates are higher than 20% so they must be making pretty decent money," said Kabance.

Additionally, the rating agency was pleasantly surprised by the 40% recovery rate on unsecured debt. "That's good," said Kabance. "That's on par with the United States and we actually, historically, thought it would be a lot lower than what the results actually were."

According to Kabance, this is the first study of its kind and therefore, the company was previously attempting to take a conservative stance by assuming that the rates were lower than the U.S. The results of this study were also consistent with a CDO study previously conducted by Fitch, which proved that defaulted bonds within CDOs and recovery rates within emerging market debt were just as high, if not higher, than U.S. debt.

On the negative side of the study, Kabance noted that only 70 of the total loans analyzed were resolved, while another 50 were still in the bankruptcy process. Therefore, according to Kabance, the recovery rates on the unresolved loans are going to be quite low.

All in all, the study has allowed Fitch to understand what recovery rates should be and how much partial risk guarantee is needed in order to benefit a transaction.

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