Moody's claims documentation affects recovery values

Recovery values assigned to a single reference entity in credit derivatives contracts are inconsistent, partly due to a lack of standardised valuation documents, according to Moody’s Investors Service.

Moody's research indicates there have been instances where different recovery amounts have been assigned to a single reference entity following the occurrence of a credit event. Lack of uniform and comprehensive documentation of the valuation process for cash settlements of credit default swaps is a significant reason for this inconsistency.

Moody's believes the reporting of the valuation process should be standardised to bring about greater consistency of settlement prices in cash-settled synthetic securities and a set of standardised valuation notices should accompany each declared credit event.

Such measures should include: limiting valuation obligation characteristics to avoid the use of particularly illiquid instruments; setting at least one 'fall-back' valuation date if the minimum of two bids is not available on the first valuation date; soliciting, at each valuation date, five dealers unaffiliated with the calculation agent and with one another so as to minimise the risk of moral hazard; and recording and reporting the valuation process in a standardised form.

“The increased transparency resulting from the adoption of these notices should contribute to a narrowing of the range of recoveries assigned to a given reference obligation upon settlement of a declared credit event,” Moody’s said.