‘You’re very clever, young man, very clever,’ said the old lady. ‘But it’s turtles all the way down!’
Introducing CRSs, that’s credit recovery swaps, sometimes known as default recovery swaps, or, in basic terms, swaps to insure your swaps. They’re a booming business, according to a Bloomberg article out today:
Credit-recovery swaps are trading on the debt of about 70 companies, including automaker General Motors Corp. and bond- insurer MBIA Inc. That’s up from 40 during the summer, according to Mikhail Foux, a strategist at Citigroup in New York.
The contracts, barely traded in 2006, are now worth about $10 billion as more companies fail to repay debts, Foux said. Also known as recovery locks, the agreements are bought as insurance by sellers of credit-default swaps, such as banks, hedge funds and insurers.
The basic idea here is that CRS buyers agree to exchange a pre-agreed fixed rate for what bondholders get after a credit event with a CRS seller. If the actual recovery rate is lower than the price agreed, the CRS seller wins. If it’s higher the CRS-buyer wins.
Creditflux explains the dynamics in a bit more detail:
In a recovery swap two counterparties agree, in effect, to swap recovery rates following a credit event. In the case of a physically settled recovery swap the recovery buyer agrees to buy defaulted bonds from the recovery seller at the ’strike’ rate - say, 40%. The recovery buyer is fixing the price at which it buys the defaulted bonds and is therefore long recovery rates, because it will benefit if the actual recovery rate is higher than the strike rate. The recovery seller wants the real recovery rate to be lower than 40% and is therefore short recovery rates.
A CRS-seller could thus have have bought a CRS to ensure, for example, a 20 per cent recovery rate on Lehman debt, three days before the bank’s bankruptcy, Foux tells us. The seller would have ended up getting 11.375 cents on the dollar from the CDR, instead of the final recovery rate of 8.625 cents (20 - 8.625 = 11.375).
No wonder then, that banks like Citigroup, Goldman Sachs et al are peddling the instruments, according to Bloomberg.
What’s more surprising is that there would be enough people long on defaults to match them.
Perhaps that’s why the instruments, which have been around since roughly 2003 despite what the Bloomberg article says, have yet to really take off.
In the Bloomberg story we’re told, for instance, that the International Swaps and Derivatives Association doesn’t keep records of the size of the market because no one has yet asked them to. The market’s simply not big enough — especially when you consider that the CDS market stood at something like $60,000bn at the end of 2007. $10bn is small beer by that measure.
There’s also a difficulty in setting an actual strike price that will appeal to investors. From Bloomberg, again:
Recovery swaps aren’t traded heavily because bid-offer spreads “remain wide,” Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California said in an e-mail. That means it’s hard to find a price that satisfies traders on both sides of a deal.
Add to that the fact that CDRs, by their very nature, are sold on companies that have usually seen their CDS spreads widen, indicating more protection-buying than protection-selling, and you have the potential for a very one-way bet.
Related links:
Citigroup peddles default-recovery swaps as bankruptcies soar - FT Alphaville
Turtles all the way down - Wikipedia
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