CreditSights: CDS put recoveries under pressure

July 17, 2009

In a CreditSights report published today, analyst Atish Kakodkar notes that recoveries on defaulted debt are “proving to be extremely low” in this latest cycle (no link).  He blames…

  • lack of debtor-in-possession (DIP) financing, which forces more debt workouts via straight Chapter 7 Liquidation instead of Chapter 11 Reorganization.
  • weak debt covenants, which allow busted debtors to operate longer than during previous cycles.  This means they burn through more cash before their creditors have a chance for recovery.
  • “empty creditors,” who’ve a bigger incentive to force borrowers into bankruptcy than to workout debts in a way that might keep companies operating.

So far in 2009 there have been 46 default auctions, 25 for senior unsecured CDS and 21 for LCDS.  That compares to 11 and 2 respectively for all of last year….

Average recoveries in 2009 “have dropped precipitously in 2009 compared to prior years and should face continued downward pressure as defaults proliferate.”

In 2009, senior unsecured CDS recovery has averaged just over 13% [i.e. 13¢ on the dollar], ranging from a low of 1.5% to a high of 32%.  June was a particularly harsh month with the five CDS auction recoveries averaging only 9.5%.  This compares to an average recovery of about 40% observed in prior years…

…the 19 (first lien) LCDS auction recoveries in 2009 have averaged about 48% with relatively large standard deviation of about 33%…

With average recoveries touching new lows in 2009, we believe recovery assumptions in trading and risk management models are likely to be seriously questioned in coming months.

Also interesting are his comments regarding “empty creditors,” holders of troubled bonds who are hedged with CDS.

….bankruptcy may be a more attractive option than solvency for these creditors if they also hold relatively large amounts of CDS making their economic interest quite different from that of a regular creditor.

He notes the recent case of McClatchy.  The ailing newspaper publisher recently offered cash, 33¢ on the dollar, for its bonds maturing in 2011.  Though that price is much higher than where the bonds now trade, only 2% of holders tendered their bonds in the exchange.

According to our analyst, the vast majority of bondholders appear to be in a position to profit from a default of McClatchy through purchases of CDS protection….

…companies that may have been able to restructure in order to remain afloat (in the absence of CDS) may now be pushed into bankruptcy sooner and at a faster pace….


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Caveat: I’m new to this.
If the issuer of the CDS made 100% the bondholder and took actual possession of the bond when the Company first went into bankruptcy, wouldn’t this solve the conflict of interest? The new holder of the bond (the former issuer of the CDS) would act in good faith in the reorganization process. What am I missing?

Posted by Charlie Lefaux | Report as abusive

Given the slack in the economy I would argue its better for the economy in general to have fewer workouts and more liquidations. Why keep a Chrysler or Circuit City around when their competitors are hurting anyway. We have to rationalize our economy again. So, to this very small extent, I salute those creditors who hold CDS against their soured investments and opt to liquidate the debtor.

Posted by sangellone | Report as abusive