30 10 08 CDS Insanity
Lest you be lulled to sleep by the daily 400+ point swings in the DJIA, word comes yesterday of new insanity in the capital markets. Bloomberg is reporting that Credit Suisse and Citi are now using credit default swap rates to determine rates on corporate loans. Yes, there were reports of unidentified pigs flying over NYC last night. So now future loan agreements will have rates decided not as a spread to LIBOR based on a firms credit rating and a thorough analysis of its balance sheet by bank loan officers but on the whims of an illiquid derivative market which is prone to bouts of extreme panic.How does this all work? Cited in the Bloomberg report is the case of FirstEnergy:
FirstEnergy, with utilities in Ohio, Pennsylvania and New Jersey, agreed this month to link interest rates on a $300 million credit line to the cost of Libor as well as the sum of the spread on its default swaps and those of Credit Suisse, according to a regulatory filing. Loans from the Zurich-based bank would require total interest payments of about 6 percentage points over Libor if the power company draws on the bank line, according to regulatory filings and Bloomberg data. That's almost 14 times the spread on a $2.75 billion credit line the company negotiated in 2006.So not only is the rate dependent upon their own 'rating' in the CDS market, it is also dependent upon how the market views the default risk of Credit Suisse. What kind of nonsense is this? The borrower should pay more because the market thinks the lender more likely to default?
The utility would pay Libor plus 3 percentage points to draw on the line, according to company filings. Based on yesterday's levels, FirstEnergy would be charged an additional 1.70 percentage points, reflecting the levels of its credit- default swaps, and another 1.35 percent to account for the bank's own spread, according to Scilla. Pricing on the loan will change as Libor and the swap spreads on Credit Suisse or FirstEnergy move. Source: Bloomberg.com
The game here seems to be the banks wanting to appear to provide a credit facility, while in fact, offering nothing. As the only time most firms need these lines are in times of economic or market turmoil, CDS spreads are likely to have increased dramatically for both the borrower and lender. As an example of the former, consider what happened to many insurance companies at the beginning of October. Not only did the CDS rates for Hartford, Metlife and Lincoln National blow up to 500 bp, they went to trading on an upfront basis requiring prepayment of from 500 to 1100 bp. Those rates are now down dramatically, though still at elevated levels of 300-400 bp. "Normal" might be measured in the 10s of basis points. Would any of these companies have been able to draw on these lines at the start of October? This realization has led a number of companies, such as Nestle, to demand caps be in place in exchange for accepting these new terms.
This move to using CDS as the basis for loan terms will also open another Pandora's box of speculation in CDS contracts. There is already a perception that CDS have been misused by speculators who were short equity to help force bankruptcies by driving up the cost of funding for a company to impossible levels. Having revolving loan agreements also tied to CDS will remove the last fire wall against this type of activity, perhaps even opening the door for another company to push a competitor under. It really is shocking that after the near meltdown of the capital markets this fall that we should move deeper into the unknown while the original fires are not yet out.
Copyright 2004-2008 by Gedanken Experiment (previously Rant Street) except as otherwise noted. Our terms of use are as follows: Content on Gedanken Experiment may not be indexed, cached, reproduced or syndicated in any manner by any party whose purpose is to provide such an index, cache, reproduction or syndication of our content for a monetary fee or other consideration to their clients, customers or users. Content on Gedanken Experiment may not be copied, reproduced, republished, indexed, cached, uploaded, posted , transmitted, framed or distributed in any way, without the prior written permission of Gedanken Experiment, except that a) user may download, display, or print one copy of the materials on any single computer solely for user's use; b) user may briefly quote or excerpt for use in a review or criticism for purposes of illustration or comment or as part of a news report as per fair use guidelines of www.copyright.gov; c) internet search engines which provide the public the ability to search online content at no charge (free) may index and cache content from Gedanken Experiment which is not explicitly blocked by robots.txt; in case (a), (b) and (c) above user agrees to keep intact all copyright, trademark, and other proprietary notices of both Gedanken Experiment and any other third parties mentioned in our content. Modification of the materials or use of the materials for any other purpose is a violation of Gedanken Experiment's, its affiliates', or its third-party information providers' copyrights and other proprietary rights. Nothing contained herein shall be construed as conferring by implication, estoppel, or otherwise, any license or right under any copyright, patent, trademark, or other proprietary interest of Gedanken Experiment, its affiliates, or any third party, except as expressly set forth herein. 02-13-2007