If you're unfamiliar with credit derivatives, it's time to get acquainted, as bank are using these financial instruments more often.
Credit derivatives — or swaps — make it possible for banks to limit their credit exposure without selling the loans they want to keep on their balance sheets. In addition to participating in loan syndicates that share the risk of the company's debt, lenders are increasingly arranging to buy credit derivatives on borrowers through insurers.
According to the International Swaps and Derivatives Association, the credit-derivatives market had reached $2.15 trillion by the end of last year. In the most common of these arrangements, the purchase of a credit-default swap, the buyer pays a premium (expressed as basis points on the notional amount) to a counterparty, which guarantees payment of par value if the specified company defaults on its bonds or bank debt.
Some argue that the proliferation of credit derivatives will reduce the cost of capital, if only because they encourage more lending by banks. But at this point, it is hard to tell, because the credit-derivatives market is not as deep or transparent as the secondary bond market.
No wonder many treasurers do not give the credit-derivatives market nearly as much attention as the bond market. "Bond spreads tell me potential credit concerns before anything else, because [the bond market is] a very active and transparent market," says John Blahnik, treasurer of Delphi Corp., which has about $2 billion of bonds outstanding.
Nevertheless, he and other finance executives acknowledge that they are keeping closer tabs on credit derivatives these days. Blahnik himself monitors the market on a weekly basis by asking his banks for data; another treasurer of a major corporation says that about twice a week she obtains pricing data from about six banks on five-year default swaps.
Why watch? However difficult they are to discern, price fluctuations in credit derivatives affect bond and loan prices. And banks' use of these instruments can influence their relationships with borrowers. Not only could they conceivably alter a bank's willingness to lend, but critics warn that credit derivatives can also encourage the disclosure of information that could hurt borrowers' interests.
Appetite for Loans
One basic question is whether banks' use of credit derivatives — either as buyers to hedge exposures or as sellers to acquire an exposure and earn premiums — will make them more or less willing to lend. Proponents contend that the ability to buy protection has increased banks' appetite for loan origination. "By reducing risk capital, banks are able to free up capacity to accommodate additional business," says Blythe Masters, managing director of JP Morgan Chase in New York.
Fitch Ratings study released last spring provides some evidence for that view. The agency found that as of the third quarter of 2002, the global banking system had in essence transferred $97 billion of credit risk — the notional amount of protection purchased in buying a credit derivative — out of the industry. Partly because of that risk transfer, the report stated, "bank asset quality has remained relatively solid in the face of record corporate defaults and a sharp deterioration in recovery values." The bottom line, says Robert Grossman, chief credit officer at Fitch, is that the use of credit derivatives "allows banks to originate more" loans.
The mere fact that a bank is more inclined to keep a company's debt on its balance sheet thanks to credit derivatives is welcome news for finance executives, since it gives companies more confidence that banks won't abandon them during tough times. One Fortune 500 treasurer, who asked not to be identified, says he prefers to work with institutions that hold on to his company's debt. When planning to renew a loan arrangement, the treasurer asks the company's commercial banks whether they are keeping the debt on the balance sheet. "And we say, We don't want you to sell it," he says. "We are direct. We say, 'We want you to hold the position.' " But he's content to see the banks hedge a small portion of the risk through credit swaps.
The treasurer has a similar message for the investment banks with which he deals. Since they do not have the balance-sheet capacity to maintain 100 percent exposure to loans they make, they sell the loan or hedge much or all of it. "We'd rather have them hedge," the treasurer says.
The Flip Side
But if buying derivatives increases banks' lending capacity, what does the selling of these instruments imply? A growing number of banks have been selling derivatives through their trading desks to increase their exposure to corporate credits. While finance executives may welcome the extra commitment such activity reflects, it's clearly possible that the banks may end up substituting such sales for loans. That's because the premiums they can earn by selling credit derivatives may be far more profitable than the interest they earn on loans.
In fact, credit derivatives' prices are higher than loan rates, indicating that loan rates are priced below market. And banks have not raised rates on high-credit-quality loans toward the market price at all. In large part, that's because banks traditionally make loans to large companies at below-market rates as a loss leader to obtain other, fee-paying business. But, says Lisa Watkinson, New York-based executive director at Morgan Stanley, "we're starting to see fairer pricing of bank loans" at higher-risk corporations.
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