Standard loan agreements need to adopt transferability mechanisms as part of their standard documentation in order to bring the market liquidity that is a prerequisite for shifting large quantities of credit risk, for example through credit derivatives. Charles Smithson, partner at Rutter Associates in New York, explained that at present standard loan documentation assumes loans to be non-transferable.
Market liquidity, be it in bonds or loans, allows for credit risks to be transferred to another party, however, at present the only debt instrument with a liquid market is investment-grade bonds, Smithson argued. Credit-default swaps allow borrowed money, which includes bonds and loans, to be delivered after a credit event.
Syndicated loans and bilateral loans have limited transferability in the secondary market and as such the ability to value their underlying credit risks remains a large challenge for portfolio managers looking to manage in risk their loan portfolios, he said. Loans embedded with options, such as the right of a borrower to prepay or to draw down on the committment, create the most difficulties in detemining their asset value, he said.
