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US CREDIT-ResCap swaps imply 72 percent default risk
Tue Nov 20, 2007 3:06pm EST
By Karen Brettell
NEW YORK, Nov 20 (Reuters) - Credit derivative traders are pricing in a 72
percent chance that Residential Capital, the second-largest independent U.S.
mortgage lender, will default on its debt within one year as its losses
mount, raising questions over how long its owners will support it.
Recovery swaps, the contracts used to hedge or bet on how much principal
bondholders will recover in the event a company defaults on its debt, have
also been active on ResCap, the mortgage unit of GMAC Financial Services.
"The market has shifted from a 'when' to an 'if' situation with ResCap as
their exposures to some of the now-defaulted builders and the increasing
chance that GMAC/Cerberus lets them go becomes increasingly likely," said
Tim Backshall, chief derivative strategist at independent research firm
Credit Derivative Research LLC.
Private equity firm Cerberus Capital Management LP [CBS.UL] owns a large
stake in GMAC.
Swaps are also implying a 54 percent chance the lender will default before
June 2008, Backshall said.
ResCap earlier this month posted a $2.6 billion loss for the third quarter,
which in turn led to a $1.6 billion loss at GMAC, the finance company once
controlled by General Motors Corp. (GM.N: Quote, Profile, Research).
During the third quarter GMAC injected $1 billion into ResCap. Doubts,
however, are now being raised over how long GMAC and Cerberus will be
willing to support the mortgage lender, which has lost money for four
straight quarters.
Last November, GM sold 51 percent of GMAC to a group led by Cerberus.
The cost to insure ResCap's debt for one year is around 39.5 percent the sum
insured as an upfront payment, or $3.95 million to insure $10 million in
debt. Five-year protection costs are 42 percent the sum insured upfront, in
addition to annual payments of 500 basis points.
"ResCap is trading on recovery expectations and recovery swaps are currently
at around 44 percent," Backshall said, adding that this expectation may be
too high.
"Recovery expectations are very hard to predict but judging from the known
losses, write-downs on its land option contracts, and extrapolating the
unknown losses in the business lending portfolio, recovery could be
significantly less," he said.
Risky tranche trades based on the previous series of the investment grade
credit derivative index, which includes ResCap, have also been driven wider
as investors buy protection against the possible default by the lender,
analysts at Barclays Capital said in a report.
Tranched trades take exposure to benchmark credit derivative indexes at
different levels of leverage with the riskiest portions, known as the equity
tranches, taking the first loss on any defaults.
ResCap was included in the previous series of the investment grade index,
before it was downgraded into junk territory.
Buying protection on equity tranches based on the previous series on the
index would profit if ResCap defaults and its bonds recover 40 percent or
less, Barclays said.
If a default occurs three months or more after the trade is put on, however,
the cost of carrying the position may erase potential gains, the bank said.
Tue Nov 20, 2007 3:06pm EST
By Karen Brettell
NEW YORK, Nov 20 (Reuters) - Credit derivative traders are pricing in a 72
percent chance that Residential Capital, the second-largest independent U.S.
mortgage lender, will default on its debt within one year as its losses
mount, raising questions over how long its owners will support it.
Recovery swaps, the contracts used to hedge or bet on how much principal
bondholders will recover in the event a company defaults on its debt, have
also been active on ResCap, the mortgage unit of GMAC Financial Services.
"The market has shifted from a 'when' to an 'if' situation with ResCap as
their exposures to some of the now-defaulted builders and the increasing
chance that GMAC/Cerberus lets them go becomes increasingly likely," said
Tim Backshall, chief derivative strategist at independent research firm
Credit Derivative Research LLC.
Private equity firm Cerberus Capital Management LP [CBS.UL] owns a large
stake in GMAC.
Swaps are also implying a 54 percent chance the lender will default before
June 2008, Backshall said.
ResCap earlier this month posted a $2.6 billion loss for the third quarter,
which in turn led to a $1.6 billion loss at GMAC, the finance company once
controlled by General Motors Corp. (GM.N: Quote, Profile, Research).
During the third quarter GMAC injected $1 billion into ResCap. Doubts,
however, are now being raised over how long GMAC and Cerberus will be
willing to support the mortgage lender, which has lost money for four
straight quarters.
Last November, GM sold 51 percent of GMAC to a group led by Cerberus.
The cost to insure ResCap's debt for one year is around 39.5 percent the sum
insured as an upfront payment, or $3.95 million to insure $10 million in
debt. Five-year protection costs are 42 percent the sum insured upfront, in
addition to annual payments of 500 basis points.
"ResCap is trading on recovery expectations and recovery swaps are currently
at around 44 percent," Backshall said, adding that this expectation may be
too high.
"Recovery expectations are very hard to predict but judging from the known
losses, write-downs on its land option contracts, and extrapolating the
unknown losses in the business lending portfolio, recovery could be
significantly less," he said.
Risky tranche trades based on the previous series of the investment grade
credit derivative index, which includes ResCap, have also been driven wider
as investors buy protection against the possible default by the lender,
analysts at Barclays Capital said in a report.
Tranched trades take exposure to benchmark credit derivative indexes at
different levels of leverage with the riskiest portions, known as the equity
tranches, taking the first loss on any defaults.
ResCap was included in the previous series of the investment grade index,
before it was downgraded into junk territory.
Buying protection on equity tranches based on the previous series on the
index would profit if ResCap defaults and its bonds recover 40 percent or
less, Barclays said.
If a default occurs three months or more after the trade is put on, however,
the cost of carrying the position may erase potential gains, the bank said.
