Compromising Positions

Will credit derivatives encourage more lending, or will they harm the interests of borrowers?

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.

What’s more, the use of swaps can increase the spread over Treasury bond yields at which a company’s own issues trade at any given moment. How? Unlike bonds, credit-default swaps give investors the ability to easily take either a short or long position on a company’s credit. When an investor buys a credit-default swap, the purchase expresses a negative view of a company’s credit and, therefore, effectively shorts it. If the company defaults, the investor will be paid par value for the amount of credit hedged.

Conversely, when an investor sells a credit-default swap, it is taking a long position on a company’s likelihood of defaulting. But the resultant increase in trading could produce wider variations in spreads, raising a company’s cost of funding. Traders claim that because credit derivatives give investors the chance to take either a long or short view on a company’s credit, there can be more volatility in bond-spread movements.

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