Lenders are increasingly using credit default swaps to gain exposure to investment-grade loans, forgoing traditional participation in the primary market. Selling protection essentially gives the seller the same credit risk as direct participation in the loan, but the premium on the protection far outweighs the skinny pricing on investment-grade loans. Banks hurt by recent events in the investment-grade market are now looking at the same risk with better return, and LIBOR plus 12.5 basis points just doesn't add up.
"Over the last month, the levels for swaps has gone way out," said one bank loan portfolio manager. But pricing on the loans has stayed artificially low, as banks compete for relationship, he added. The credit default swap market is therefore acting as a "synthetic secondary market," allowing investors to evaluate whether to participate on credits based on a relative-value tool.
Some investment-grade loans are feeling the pinch. AT&T, for instance, is struggling with a new $4 billion roll-over credit. It is a CP backstop priced at LIBOR plus 12.5 basis points and fully drawn at LIBOR plus 1%. However, a bank could sell credit protection at 4 3/4 -5 1/4 % over LIBOR. One banker asked, "So why buy a $100 million piece of the loan likely paying 12.5 basis points, when you can sell the credit protection and get a much higher spread? Both provide exposure to the credit, but one pays a lot more."
One point underscored by the increase in use of credit default swaps is that relationship lenders are getting a good look at how their participation is valued in the open market. Michael Rushmore, ceo of LoanX, a loan pricing service, said "Bankers price the corporate loan product in the context of the entire client relationship." But credit default protection tells banks, if there were no relationship factors, here is the way other investors price the risk, he explained.
As more banks walk away from lending relationships that do not generate additional business, selling credit default protection becomes more popular. But lending to get ancillary business is still a crucial factor in the loan market, said one banker. Some banks are finding a way round the problem of skinny pricing and the need to participate on the loan. "Many banks are starting to consider selling credit protection as a means to fund their hedges and diversify their credit portfolios," said Steve Bennett, senior v.p. of credit portfolio management at CIBC World Markets.
Bank of Nova Scotia has a policy of small participation on loans to satisfy relationship needs, but it also sells credit protection at the far more profitable rates. Furthermore, there is a growing demand for the product. "The commercial banks are definitely becoming more active [buyers] after the recent defaults," Bennett said. "They are seeing the positive results of active portfolio management, and bank management is asking, 'Why are we not hedging?'"