Fitch suggests increasing post-bankruptcy waiting period for CDS valuation to better reflect credit risk

By Caroline Salls

Pittsburgh, March 15 - Increasing the waiting period to conduct ISDA protocol auctions following bankruptcy will produce recoveries that better reflect fundamental credit risk, according to a Fitch Ratings report that examined Delphi Corp. and recent ISDA CDS Index protocols.

The report updates Fitch's report on best practices in a credit default swap valuation procedure that promote equitable settlement prices to both protection buyers and sellers, and indicates that the waiting period to start the valuation process should be increased to 45 days from 28 days.

The report also suggests including a minimum of five bidders in the auction, excluding the valuation agent.

"The explosive growth in the over $12 trillion credit derivatives market makes it inevitable that credit events will occur in the future where the notional CDS exceeds the outstanding par amount of cash bonds, eliminating physical delivery as a practical settlement option," Fitch's Kevin Kendra said in the report.

"As such, continued use of the ISDA CDS index protocols to settle index and single-name CDS are advantageous to the market.

"While the ISDA protocol auctions are typically held 28 days following bankruptcy, our research indicates that increasing the length of the process to 45 days will minimize the impact of technical factors and produce recoveries that better reflect fundamental credit risk."

In a recent Fitch case study, the ISDA auction protocol for Delphi yielded a settlement price of 63.375 at 27 days after the Delphi bankruptcy.

However, Fitch's Shaun Baddeley said in the report, "This price contrasts with the average Delphi recovery of 53.5% seen in the Fitch-rated synthetic CDO universe. These recoveries were received on average 58 days following the bankruptcy date."

Fitch said its case study is based on 99 final valuations on Delphi, which ranged from 40% to 63%, highlighting the lack of standardization and transparency in the settlement process.

Final valuations on Delphi in 53 synthetic CDOs are still outstanding, however recently received valuations more closely represent the average recovery than the ISDA protocol price.

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