An unusual provision in JP Morgan’s 2023 European leveraged finance SRT deal Valeria explains the low initial recovery price related to French IT contractor Atos.

SRT deals hedge a portion of a bank’s loan book by transferring junior risk to investors through credit protection instruments. But determining the level of losses which investors bear can be difficult, and the restructuring of Atos, a common obligor in the SRT programmes of several banks, underlines the complexities.

The JP Morgan deal is understood to have determined higher losses than other deals referencing Atos, because of an unusual deal provision which sourced pricing through auction processes. Different SRT transactions may have also referenced different parts of the Atos capital structure.

The JP Morgan deal placed the public CDS auction, run by the EMEA Credit Determinations Committee, as the starting point for specifying recoveries, rather than beginning with realised losses, projected losses, sale price or other workout-based mechanics.

The deal documents are private and the SRT recovery level may have been modified from the public auction pricing outcome. See here for a more detailed discussion of different settlement mechanics in SRT deals.

A public CDS auction is designed to match recoveries to the “cheapest to deliver” instrument, which will often be an unsecured or subordinated bond, while the bank loans or revolvers typically referenced by SRT transactions will usually recover more.

JP Morgan Chase is a member of the EMEA Credit Determinations Committee. As a major CDS dealer JP Morgan Securities took part in the public auction. The Term Loan and RCF were used as deliverable obligations for the CDS auction, alongside the unsecured bonds. The €900m RCF agreement was added to the list of deliverable obligations for the purpose of the CDS auction on 30 August 2024.

Under the terms of the RCF and Term Loan, a lender could transfer the instrument, provided that the amount transferred was at least €10m, according to the updated auction settlement terms on 3 October 2024.

In a CDS auction, dealers first make an initial market, then submit requests for physical settlement on either bid or offer side, which adjust the initial market based on revealed demand during the auction.

JP Morgan Securities offered €15.3m for physical settlement at the auction. Barclays offered €19m, BNP Paribas offered €5.4m, and Merrill Lynch offered €1m, with no physical settlement on the bid side.

The recovery price in the CDS auction was thus 3 cents, adjusted from the 7.875 cent initial market, per the 9 October 2024 CDS auction results.

This method gives transparency in settlement, because results and auction dynamics are publicly available. But it isn’t perfect. Historically, several CDS auction process, such as those for Hovnavian, Norske Skog or Codere have seen funds exploit auction mechanics to deliver or reduce a payout on their derivative positions.

JP Morgan was not involved in these manipulations and there is no suggestion that it benefitted from the possibility that a fund could manipulate CDS auction mechanics.

SRT transactions sometimes use a credit default swap as a legal mechanism to transfer the risk, and may also use CDS default definitions from ISDA, the governing body for CDS documentation. But that doesn’t imply any link to the CDS auction process, and SRT documentation is generally bespoke to each deal.

The CDS legal structure has also fallen out of favour, with most deals in Europe now based on a financial guarantee.

Using a public CDS auction to determine prices is unusual, with most transactions hewing closely to a bank’s actual recoveries and workout process (though with plenty of detailed variation).

But the public CDS method does give transparency, and may be appealing to investors doing relative value or basis trades with SRT, single name CDS and credit index tranches, because it reduces the risk of variation through different settlement mechanics.

SRT investors in deals with this structure also benefit from the chances that an auction will run through all dealer markets and deliver a 100 price, as happened in Europcar.

In the past, some SRT transactions have included provisions giving investors a “first look” at any underlying loan obligations put up for sale by the bank issuing the SRT.

Because Valeria was not done with a single investor, even if an investor had wanted to purchase the loan, there would have needed to be a mechanism for other investors to bid as well.

The SRT was issued by a special purpose vehicle.

JP Morgan declined to comment.