## _wp0962

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---

### The Use (and Abuse) of CDS Spreads During Distress — Introduction
- CDS spreads are a function of the probability of default/distress (p) and the recovery value (r), where both p and r are jointly stochastic.
- Standard modeling practice assumes r constant (usually at 20 to 40 percent).
- When CDS spreads are high, using a constant r can misstate implied default probabilities.
- The cheapest-to-deliver (CTD) bond is a practical proxy for a stochastic recovery value during distress.

### Recent distress in financial institutions — empirical findings
- Fixed-recovery models (e.g., r = 40 percent) rely solely on CDS spreads and ignore CTD bond prices; this can yield default probabilities that are too low until default is imminent.
- CTD bond-price signals can precede or diverge from CDS-spread signals because:
  - CDS markets can be dominated by fast-moving hedge funds while cash bond markets can be dominated by buy-and-hold real-money investors.
  - Cash bond markets can be illiquid during distress so cash bond prices may not immediately reflect changing default risk; however, in some episodes (e.g., Lehman) cash bond prices collapsed before CDS spreads rose, producing a positive basis during distress.
- Empirical markers and cut-offs used in analysis:
  - Distressed bond price ‘cut off’ used: below 95% of par.
  - Lehman’s CTD 2034 bond traded well below par (text notes cash bond prices collapsed to around 20 cents; Box 1 notes the CTD 2030 dipped as low as 14 cents to the dollar in intra-day trading).
- Case comparisons:
  - Landsbanki and Washington Mutual: probability of default calculated with fixed recovery rate predicts too low a PoD relative to PoD using stochastic recovery (CTD proxy); stochastic PoD was higher and more volatile well ahead of the default event.
  - Lehman Brothers: cash bond prices collapsed before CDS spreads rose; reliance on CTD would have given earlier warning than CDS spreads with fixed r.
  - Washington Mutual was an exception with a much higher recovery rate because it was acquired by JPMorgan Chase.

### Key quantitative outcomes (ISDA auction / settlement recovery rates)
- CDS Settlements Determined Under the ISDA Cash Opt-in Protocol — Recovery Rate:
  - Lehman Brothers 10/10/2008 8.625
  - Washington Mutual 10/23/2008 57.000
  - Landsbanki 11/04/2008 1.250
  - Ecuador 1/14/2009 31.375
- Box 1 (Ecuador) additional numeric notes:
  - The auction recovery rate was described in the Box as set at 31.75 (Box text).
  - The CTD bond used in analysis: 2030 bond (empirically the cheapest bond); the 2015 bond was also acceptable delivery and was priced higher.
  - Footnote: the CTD bond, the 2030 bond, dipped as low as 14 cents to the dollar in intra-day trading (day-end prices used in analysis).

### Policy implications and recommendations
- Surveillance and monitoring:
  - Financial surveillance should use a flexible armory of tools; models should incorporate stochastic recovery value (CTD-based signals) especially during distress episodes.
  - Using constant recovery values alone in distress situations can ignore important information from CTD prices and yield extracted default probabilities that may be too low.
  - Incorporate CTD-derived stochastic recovery methodology into monitoring systems for institutions, sectors, and sovereigns in distress (cash-settlement ISDA protocol makes CTD relevant for many widely traded reference entities).
- Risk management for financial institutions:
  - Institutions that use fixed recovery assumptions could have a false sense of security and be surprised by outsized losses, which can generate knock-on (systemic) losses across other institutions.
  - To avoid underestimating losses, institutions and supervisors should model recovery value as stochastic and use CTD bond-price signals when available.
- Interpretation of elevated distress signals:
  - Elevated distress probabilities derived from stochastic-r models should not be dismissed as false alarms even if some distressed entities do not ultimately default; these are meaningful signals of elevated distress.
- Broader modeling considerations:
  - The stochastic-recovery methodology can and perhaps should be applied beyond financial institutions to other sectors and sovereigns in distress (see Ecuador example).
  - Models of conditional PoD, joint PoD, distance to distress, and joint default dependence have generally held recovery value constant (in the range of 20–40); this practice risks understating probabilities of default when recoveries fall.

### Recovery swaps and market infrastructure (Appendix summary)
- CDS settlement and CTD delivery mechanics:
  - In cash-settlement auctions, the auction-determined recovery rate becomes the effective recovery metric for many CDS contracts when physical delivery is impractical.
  - Protection sellers who receive CTD bonds may prefer to avoid holding distressed assets; they can enter recovery swaps (aka recovery locks) to “lock in” a recovery rate prior to or during a restructuring.
- Recovery swap market features:
  - Recovery swaps trade on the debt of about 70 companies.
  - These contracts were barely traded in 2006 but are now worth well over $10 billion as more companies fail to repay debts.
  - Recovery swaps enable an investor to exchange a preset fixed rate for the actual amount received by bondholders after a default; mark-to-market changes will affect CDS pricing and implied PoD because the CTD may be lower or higher than the recovery lock.

### Section 2 — Changing recovery rates
- Many credit-default contracts written early this year assumed a 40 percent recovery rate in pricing deals.
- The October 10, 2008 derivative industry auction on bankrupt Lehman Brothers Holdings Inc.’s credit-default swaps set a value of 8.625 cents on the dollar for Lehman debt, according to Creditfixings.com.
- A credit-default derivative seller could have bought a recovery lock to ensure a 20 percent recovery rate on Lehman debt three days before the firm’s September 15 bankruptcy.
- The seller would thus have received 11.375 cents on the dollar from the recovery contract.
- Typical investor assumptions for recovery rates on financial institutions were in the range of 75 to 85 percent.
- Lehman’s recovery was below 10 percent; with other financials at very low recovery rates, signals from CDS spreads using 40 percent recovery models can be misleading.
- Moody’s indicates that corporate default rates in this cycle will likely match or exceed the peak levels reached in the previous two U.S. recessions.
- S&P cited an “inverse correlation” between defaults and investor recoveries:
  - When default rates are less than 2 percent, more than half of defaulted debt recovers more than 70 percent of face value.
  - When defaults are greater than 8 percent, more than half such debt recovers less than 40 percent, S&P estimated.

### Section 2 — Market practices and instruments
- Specifics about recovery-lock contracts are not generally available because they are made privately and do not trade on an exchange; also bid-ask spreads are high.
- The contracts date back to 2005, when a Fitch Ratings report said investors were starting to use them to lock in returns after defaults.
- ISDA established standard documents for deals in 2006.
- The New York-based trade group does not keep records on the size of the market.
- There is limited demand for hedging the recovery rate when default rates are low and recoveries stable.
- Physical delivery is allowed within the context of ISDA protocol if it suits the CDS investor (see Ecuador box).

*Source: The Use (and Abuse) of CDS Spreads During Distress, Manmohan Singh and Carolyne Spackman, WP/09/62 (IMF Working Paper, March 2009).*

### Section 1

### The Use (and Abuse) of CDS Spreads During Distress

### Introduction
- Credit Default Swap spreads are a leading indicator of distress; CDS spreads are a function of the probability of default/distress (p) and the recovery value (r), where both p and r are jointly stochastic.
- Standard modeling practice assumes r constant (usually at 20 to 40 percent).
- When CDS spreads are high, using a constant r can misstate implied default probabilities.
- The cheapest-to-deliver (CTD) bond is a practical proxy for a stochastic recovery value during distress.

### Recent distress in financial institutions — empirical findings
- Fixed-recovery models (e.g., r = 40 percent) rely solely on CDS spreads and ignore CTD bond prices; this can yield default probabilities that are too low until default is imminent.
- CTD bond-price signals can precede or diverge from CDS-spread signals because:
  - CDS markets can be dominated by fast-moving hedge funds while cash bond markets can be dominated by buy-and-hold real-money investors.
  - Cash bond markets can be illiquid during distress so cash bond prices may not immediately reflect changing default risk — however, in some episodes (e.g., Lehman) cash bond prices collapsed before CDS spreads rose, producing a positive basis during distress.
- Empirical markers and cut-offs used in analysis:
  - Distressed bond price ‘cut off’ used: below 95% of par.
  - Lehman’s CTD 2034 bond traded well below par (text notes cash bond prices collapsed to around 20 cents; Box 1 notes the CTD 2030 dipped as low as 14 cents to the dollar in intra-day trading).
- Case comparisons:
  - Landsbanki and Washington Mutual: probability of default calculated with fixed recovery rate predicts too low a PoD relative to PoD using stochastic recovery (CTD proxy); stochastic PoD was higher and more volatile well ahead of the default event.
  - Lehman Brothers: unusual scenario where cash bond prices collapsed before CDS spreads rose; reliance on CTD would have given earlier warning than CDS spreads with fixed r.
  - Washington Mutual was an exception with a much higher recovery rate because it was acquired by JPMorgan Chase.

### Key quantitative outcomes (ISDA auction / settlement recovery rates)
- Table 1: CDS Settlements Determined Under the ISDA Cash Opt-in Protocol — Recovery Rate
  - Lehman Brothers 10/10/2008 8.625
  - Washington Mutual 10/23/2008 57.000
  - Landsbanki 11/04/2008 1.250
  - Ecuador 1/14/2009 31.375

- Box 1 (Ecuador) additional numeric notes:
  - The auction recovery rate was described in the Box as set at 31.75 (Box text).
  - The CTD bond used in analysis: 2030 bond (empirically the cheapest bond); the 2015 bond was also acceptable delivery and was priced higher.
  - Footnote: the CTD bond, the 2030 bond, dipped as low as 14 cents to the dollar in intra-day trading (day-end prices used in analysis).

### Policy implications and recommendations
- Surveillance and monitoring:
  - Financial surveillance should use a flexible armory of tools; models should incorporate stochastic recovery value (CTD-based signals) especially during distress episodes.
  - Using constant recovery values alone in distress situations can ignore important information from CTD prices and yield extracted default probabilities that may be too low.
  - Incorporate CTD-derived stochastic recovery methodology into monitoring systems for institutions, sectors, and sovereigns in distress (cash-settlement ISDA protocol makes CTD relevant for many widely traded reference entities).
- Risk management for financial institutions:
  - Institutions that use fixed recovery assumptions could have a false sense of security and be surprised by outsized losses, which can generate knock-on (systemic) losses across other institutions.
  - To avoid underestimating losses, institutions and supervisors should model recovery value as stochastic and use CTD bond-price signals when available.
- Interpretation of elevated distress signals:
  - Elevated distress probabilities derived from stochastic-r models should not be dismissed as false alarms even if some distressed entities do not ultimately default; these are meaningful signals of elevated distress.
- Broader modeling considerations:
  - The stochastic-recovery methodology can and perhaps should be applied beyond financial institutions to other sectors and sovereigns in distress (see Ecuador example).
  - Models of conditional PoD, joint PoD, distance to distress, and joint default dependence have generally held recovery value constant (in the range of 20–40); this practice risks understating probabilities of default when recoveries fall.

### Recovery swaps and market infrastructure (Appendix summary)
- CDS settlement and CTD delivery mechanics:
  - In cash-settlement auctions, the auction-determined recovery rate becomes the effective recovery metric for many CDS contracts when physical delivery is impractical.
  - Protection sellers who receive CTD bonds may prefer to avoid holding distressed assets; they can enter recovery swaps (aka recovery locks) to “lock in” a recovery rate prior to or during a restructuring.
- Recovery swap market features:
  - Recovery swaps trade on the debt of about 70 companies.
  - These contracts were barely traded in 2006 but are now worth well over $10 billion as more companies fail to repay debts.
  - Recovery swaps enable an investor to exchange a preset fixed rate for the actual amount received by bondholders after a default; mark-to-market changes will affect CDS pricing and implied PoD because the CTD may be lower or higher than the recovery lock.

*Source: The Use (and Abuse) of CDS Spreads During Distress, Manmohan Singh and Carolyne Spackman, WP/09/62 (IMF Working Paper, March 2009).*

### Section 2

### Section 2

### Changing recovery rates
- Many credit-default contracts written early this year assumed a 40 percent recovery rate in pricing deals.
- The October 10, 2008 derivative industry auction on bankrupt Lehman Brothers Holdings Inc.’s credit-default swaps set a value of 8.625 cents on the dollar for Lehman debt, according to Creditfixings.com.
- A credit-default derivative seller could have bought a recovery lock to ensure a 20 percent recovery rate on Lehman debt three days before the firm’s September 15 bankruptcy.
- The seller would thus have received 11.375 cents on the dollar from the recovery contract.
- Typical investor assumptions for recovery rates on financial institutions were in the range of 75 to 85 percent.
- Lehman’s recovery was below 10 percent; with other financials at very low recovery rates, signals from CDS spreads using 40 percent recovery models can be misleading.
- Moody’s indicates that corporate default rates in this cycle will likely match or exceed the peak levels reached in the previous two U.S. recessions.
- S&P cited an “inverse correlation” between defaults and investor recoveries:
  - When default rates are less than 2 percent, more than half of defaulted debt recovers more than 70 percent of face value.
  - When defaults are greater than 8 percent, more than half such debt recovers less than 40 percent, S&P estimated.

### Market practices and instruments
- Specifics about recovery-lock contracts are not generally available because they are made privately and do not trade on an exchange; also bid-ask spreads are high.
- The contracts date back to 2005, when a Fitch Ratings report said investors were starting to use them to lock in returns after defaults.
- ISDA established standard documents for deals in 2006.
- The New York-based trade group does not keep records on the size of the market.
- There is limited demand for hedging the recovery rate when default rates are low and recoveries stable.
- Physical delivery is allowed within the context of ISDA protocol if it suits the CDS investor (see Ecuador box).

*Source: _wp0962 - Section 2*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0962.pdf_