BOX 1: THE LESSONS OF DELPHI CASE AND RECOVERY RATE PRODUCTS

The economic fallout caused by the bankruptcy of Delphi did not result from inappropriate risk management and speculation, but reflected inefficiencies in the microstructure of derivative markets at the time of settlement.4 When doubts about Delphi's creditworthiness emerged, the prospect of a shortage of deliverable debt increased the price (and reduced the attendant average recovery rate) of CDS-based credit protection beyond the level that might have otherwise been justified by the expected repayment from debt resolution (implied by rating agencies' estimates of Delphi's ultimate recovery rate or settlement prices of comparable firms). Higher transaction costs incurred by scarcity of collateral deterred trading of physical delivery CDS contracts (for lack of demand), because protection buyers would have had to settle contracts on overpriced collateral, thereby discounting their recovery value implied by par value compensation through the CDS contract. Cash settled CDS contracts would not have implied such recovery risk.

Sellers of credit protection via CDS contracts are constantly exposed to recovery risk, while protection buyers are faced indirectly with recovery rate risk if the underlying asset (or a surrogate cheapest-to-deliver (CTD) asset) trades above the fair market price (suggested by the projected recovery rate) due to limited asset diversity when market liquidity is poor.

Several products permit investors to hedge recovery risk separately from default risk in derivative contracts. As opposed to a plain vanilla CDS contract, where the protection seller is exposed to recovery rate risk upon default of the underlying reference asset, a fixed recovery rate CDS, for instance, eliminates the uncertainty on the recovery rate by fixing a specific recovery value over the maturity of the CDS contract. After a credit event, the protection buyer is entitled to a cash settlement equal to 100 minus the pre-specified, fixed recovery rate. Recovery CDS with a fixed recovery rate set to zero are referred to as zero recovery CDS. Such products could serve as pricing benchmarks in the wake of a credit event, fostering a more efficient settlement process.

A recovery lock is a cash-neutral forward contract that fixes the recovery rate irrespective of the settlement price of the underlying reference asset. In practice, a recovery lock is structured by means of two opposite trades on the same reference entity. Protection sellers hedge themselves against recovery rate risk of their long position in a plain vanilla CDS by purchasing protection through a fixed recovery CDS. If the implicit recovery rate of the conventional CDS contract concurs with the fixed recovery rate, the premium payments on the transactions wash out and net to zero. In this case, if the reference entity defaults, the protection buyer of the fixed recovery CDS delivers the defaulted debt to the recovery seller and receives compensation equal to 100 minus the pre-specified, fixed recovery rate, which, in turn, pays off the compensation claim under the issued plain vanilla CDS contract. If the premium payments of the two trades differ, for example the actual recovery of the underlying asset drops below the fixed recovery rate at the time of default, the protection buyer reinvests higher premium income from the short position of a plain vanilla contract into fixed recovery rate protection on a larger notional value.