Markets in everything, as Marginal Revolution might put it.
We’ll start with a problem that might not be hugely on the market’s mind right now, but is getting ever closer:
How much would investors recover if (when, dear reader) Greece, Ireland or Portugal default and restructure their debt?
More to the point, how certain would any recovery figure be? The tail risk is no longer whether they restructure. It’s how much (or how little) they’ll offer after.
The problem is this: restructuring any one of these sovereigns will prove larger and far more complicated than the previous record-holders, Argentina ($82.2bn of debt defaulted, 2001) and Russia ($72.7bn, 1998), combined. Greece’s outstanding debt sits at circa $430bn, Ireland comes in at $145bn, Portugal at $289bn. There are all sorts of additional tail risks attached. You can imagine a scenario of writing down all three at the same time, with all the damage that could cause to those exposed. This could happen through a domino effect, for example, or if all three countries left the euro at the same time. Who knows, really. Tail risk, innit.
At any rate, even if the market could digest the periphery defaults one at a time, it’s a lot of debt, much of which is parcelled around embarrassingly vulnerable areas of the European banking system. More broadly, sovereigns can really burn creditors if they are so minded. There’s no easy access to collateral (these days anyway), nor judicial remedies, nor anywhere to hide within a single-tier capital structure. This is to say nothing of the potential time-lag between default and actual restructuring that can also confound investors.
Here’s a Moody’s chart from a 2008 report, which shows how sovereign recovery rates can markedly differ both from country to country, and between default and restructuring:
Note how the most indebted sovereigns, Argentina and Russia, ended up offering investors the least even at the exchange stage. Not coincidentally, let’s consider a peripheral example de nos jours…
Greek ten-year government bonds currently trade around 65 cents to the euro — which would burn holders horribly if these numbers were crystallised in a real haircut.
But more than a few observers argue Greece will end up having to go much further and write down its debt by two-thirds in order to achieve a sustainable debt path. This extra third won’t simply burn investors: it will carbonise them.
What to do?
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Return of the recovery lock
Now, not only bondholders per se could be in trouble here, but also CDS buyers delivering bonds to sellers following default – with the sellers paying bonds’ par values back to buyers in addition to taking this delivery.
Way o’ the world in CDS markets, of course.
The problem is that credit default swaps are bit misnamed. Having evolved into excellent products for investors taking positions on movement in credit spreads (including, via CDS options, spread volatility), CDS are quite static on pricing the expected recovery of value from assets after a default, when they are auctioned off.
Standard CDS contracts include a 40 per cent recovery assumption — irrespective of the credit they reference — for pricing purposes, and this convention only really changes once the credit becomes truly distressed. Investors’ eventual recovery is not decided until the auction at default. Perhaps not great for recovery tail risk, as in the sovereign examples above. (Really not great for any tail risk when you want hard and fast recovery rate information.)
Hence the market for recovery rate products.
We first covered this market over two years ago, if you want to catch up.
It’s firstly possible to write a fixed-recovery CDS, which is pretty self-explanatory, and secondly to combine this with a normal CDS in a recovery swap – which is not. Come default, counter-parties can exchange payout difference between recoveries, but investors taking part in the swap have to buy one CDS and sell another (very complicated, this) while sellers in the swaps may receive bonds of any maturity at default. This might be tricky for some trades.
However, in their European Capital Alpha note, Barclays Capital analysts recently noted a contrast in how recovery locks function, that seems technical but is significant.
By contrast a recovery lock specifies what can be delivered, and fixes the reference price of the underlying bond, BarCap point out. It’s important to note that the terminology reverses here. Buyers of recovery locks are effectively selling CDS and vice versa. If physical settlement is chosen in the credit auction, buyers receive the bond and pay out the fixed price. In cash settlement, it’s a case again of pocketing the difference between the auction’s recovery price and the price as fixed, BarCap say.
Accordingly you can see why you might ‘sell’ recovery by seeking a certain price to lock if you’re bearish and think a credit’s post-default prospects will come in under that level, and vice versa.
There’s a fuller explanation of all three product types on page 47 of this 2006 BIS report, or click the box to enlarge:
You’d probably not want your mum (or AIGFP) to trade them. For example, while recovery locks might dispense with mark-to-market volatility in underlying bonds, investors remain exposed to losses from marking recovery lock quotes to market.
None of this is to suggest offhand that recovery products are sinisterly exotic, or uncontrollably sophisticated, however — compared to abuse of normal CDS.
And none of this is to say recovery locks are at all new, either. Originating in the mid-2000s, recovery products went mainstream during the financial crisis. Even Lex noticed them. This isn’t really a surprise, given there are often sectors of the economy where the size of defaults is hard to guess. Think of the current “retail recession” in the UK, for example (indeed it appears from BarCap’s note that Dixons is a name traded relatively often at the moment, with recoveries around 35-40 quoted) or bond insurers during the subprime crisis. The changing applications of recovery locks for corporate names is worth another post entirely.
We hadn’t really heard of locking sovereigns before, however, and it’s locks’ bond-specific and hedging characteristics that are intriguing here.
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Locking up sovereigns
Until BarCap’s Arup Ghosh made this enticing observation in the European Credit Alpha note:
While traditionally viewed as a product for high yielding names, recovery locks are becoming increasingly popular as a tail risk hedge across other asset classes including sovereigns…
And here’s a chart from BarCap to give a flavour of those sovereign trades:
You can see how all five peripheral names have broken the standard recovery rate, and therefore traders have been in the business of wishing to price actual plausible recoveries. While it’s likely to be expected that more could be recovered from Italy than Greece for example, all of the quotes seem quite harsh versus what the bonds typically tell us.
What’s even more striking is how markets have priced recovery rates over time in peripheral names. Markit’s Lisa Pollack dug into the recovery locks market for us, producing this brilliant graph of composite recoveries for Greece CDS 2010-2011:
(Composite recoveries, of which a 5-day rolling average is plotted here for Greece, offer some insight into recovery lock prices – but do not always correspond so well, Pollack says.)
As you can see, the theoretical 40 per cent recovery rate died for Greece sometime on April 22, 2010. Traders’ first real-world estimates of post-default recoveries are actually above this level but circa early June (when Spain’s CDS curve inverted and the euro was getting trashed) a rout began. Greece remains below 50.
Anyway, those are some details on prices. What do investors want from these products? BarCap points out three uses which interest us for their possible applications to sovereigns.
Hedge 1 – Tail risk protection: Buy a (e.g. Greek) bond and sell a recovery lock to limit haircut risk. BarCap explains further:
Hedge maximum loss on bonds: bondholders can use recovery locks as a cheap tail risk hedge. Pairing a recovery lock with the underlying bond allows investors to hedge the worst-case scenario of a very low recovery on the bond following default. As there are no coupon payments on the hedge, this is a costless way of hedging default risk for bondholders…
Oops — we forgot this point above. This is another interesting aspect of recovery locks that almost makes them seem tailor-made for sovereign restructuring. With zero cost to maintain the trade, recovery locks can be put on for years. Even naked purchases of ridiculously cheap eurozone sovereign CDS 2005-2010 involved some money upfront. And, with the bailouts, we do expect that it could take years to sort out restructuring for the periphery.
Hedge 2 – Sell CDS and sell a recovery lock, thus limiting losses on paying out par values and taking delivery of bonds.
Hedge 3 – A naked buyer of CDS can buy a recovery lock in order to specify the potential payout in a cash settlement post-default.
All of which might lead some observers to think ‘Great, more hedges ,’ but others, ‘Great, more false senses of security’. We leave it to you decide, although if you’re interested in ‘Create Your Own Leverage’ problems in financial markets, it is well worth looking into recovery locks in any case.
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A dry footnote
One last tricky bit: there are good reasons to sell recovery locks, especially around sovereign risk. But who’s buying?
Pollack tells us that quotes on sovereigns tend to be infrequent and given by few dealers, and that bid-ask spreads remain wide. Peripheral CDS (and bonds) have become illiquid but the one-way attractions of recovery locks may have already hampered this product in 2008, too.
Annoyingly we can’t find so much as an estimate of current recovery lock trading volume to see what’s changed, but will keep looking.
What is clear though — as ‘sovereign default’ and ‘tail risk’ become ever more entwined, we’re not expecting recovery swaps and locks to fade away.
Related links:
It’s swaps all the way down - FT Alphaville (2008)
Guest post: Quanto-fied, a sovereign CDS tale – FT Alphaville
Quanto CDS flows return – IFR
Costs of sovereign default – Bank of England (2006)