Collateral, Collateral Everywhere

IDSA has been trumpeting the increased use of collateral in derivative transactions, which is said to reduce the systemic risk associated with derivatives. An article in today’s Financial Times notes that non-financial users of derivatives are concerned that the Administration’s regulatory plan will increase costs by requiring all parties to at least partially collateralize their positions.

The effects of all this collateral on the bankruptcy system are little discussed. But given the flagrantly broad safe harbor provisions currently in the Bankruptcy Code, more collateralized derivatives means more of the debtor’s assets will leak out of the bankruptcy system.

Traditionally the U.S. has had higher recovery rates on unsecured debt than other developed economies, a phenomenon I’ve often attributed to the well-developed reorganization system. But the increased use of security interests, not only in the derivative context but also with regard to second lien financing, means that this probably will be changing.

Indeed, the unsecured creditors of both GM and Chrysler may receive very little recovery if they are not lucky enough to be critical parts of the new forms of these companies.  Indeed, I'd expect that the Chrysler unsecured creditors who are "left behind" will receive nothing, given that the senior secured lenders will remain only partially paid after application of the sale proceeds.

All this as the Financial Times also reports that individual investors are rushing into high yield debt mutual funds.

Comments

[lmclark]

weren't many of the CDS's out there already "collateralized"? And weren't the repos essentially collateralized (since they are functionally the same as security interests)? Am I missing something here?

[Stephen Lubben]

Prior to Lehman, the use of collateral largely depended on the credit rating of the parties. And often the collateral was not "bilateral." For example, a hedge fund entering into a CDS transaction with Lehman would have posted collateral, because there was an inbalance in credit ratings. And, of course, there was no risk that Lehman would default . . . Non-financial parties apparently "collatealized" their obligations by reducing the availability of the bank lines -- which, of course, is not really collateral at all.

[Lawrence D. Loeb]

Stephen:

As I pointed out in my blog post on the DIP market (http://blog.lawrencedloeb.com/2009/04/why-doesnt-anybody-want-to-take-dip.html), there was an increase in the use of bank debt over the last few years. This has occurred, in no small part, because of the ability to securitize those loans and recycle the capital. Banks were able to generate origination fees and service fees on more loans than ever before given the market's appetite for securitized products.

Since most of these loans were first lien, second lien, or third lien, there are few assets at distressed companies that do not have liens against them. The increase in securitized loans in the capital structure has led to lower recoveries for both the secured and unsecured lenders. The secured lenders have had a reduced return (particularly second and third lien) due to the larger share of assets being secured by lenders and by depreciation in the value of those secured assets (leading many secured loans to have significant unsecured portions in bankruptcy). The unsecureds have not, as in the past, been able to realize any value from assets that were unsecured or with values in excess of their liens.

Given the reduced appetite for CLOs, I expect that, in the future, capital structures will return to more classic structures that include unsecured tranches as a larger share of the capital structure. This should, in turn, lead to recoveries in future bankruptcies/distressed exchanges that are more consistent with history.

[Stephen Lubben]

I think this is a good point about the likely long-term trend; although the derivatives part of still cuts the other direction, it is not likely to be as significant as the issue of leveraged loans.

[Adam Levitin]

Isn't one of the big lessons from the mortgage crisis that collateral does not guarantee repayment? Collateral value is not guaranteed. No matter how much one wants to will away credit risk, it will always exist, as long as there are counterparties.