By Michelle Sierra
NEW YORK, July 18 (LPC) - Market-based pricing is disappearing in US investment grade lending as Credit Default Swaps (CDS) become a less relevant measurement of risk, and lenders feel less need to buy protection against the loans as top companies continue to perform in a stable economy.
The practice was introduced after the 2008 financial crisis when several blue-chip companies drew down on revolving credit facilities, shocking banks that had charged minimal interest margins on the assumption that the loans would remain undrawn.
Market-based pricing was endorsed by banks such as JP Morgan and Bank of America Merrill Lynch and was designed to make significantly low pricing on investment grade loans more dynamic.
The practice linked loan pricing to real-time risk using bond and CDS trading levels, rather than slower-moving credit ratings.
If borrowers drew down on multi-billion dollar credit lines, the link to CDS rates would boost the drawn cost of the loan to better compensate banks for their risk.
“During the credit crisis, the risk of lending to all these companies was higher, and banks were borrowing at rates higher than the rates they got paid to lend,” a banker said. “So the bank market came up with market-based pricing as a way to be better compensated for the market volatility.”
CDS are usually bought by banks and other investors as protection against a company’s risk and negative credit events.
Years of relative market stability and falling CDS activity have, however, reduced banks’ interest in buying protection. CDS trading desks have closed or been restructured and CDS levels for investment grade companies have tightened so much that they have become almost irrelevant metrics of risk.
Outstanding notional amounts of CDS contracts fell noticeably, from US$61.2trn at the end of 2007 to US$9.4trn 10 years later, according to a Bank for International Settlements’ research report.
“Because fewer people buy CDS, especially of these highly rated companies, CDS stopped being considered such an adequate representation of risk,” the banker said.
Some highly rated US companies, including biopharmaceutical company Bristol-Myers Squibb, refiner Motiva Enterprises and broadcaster CBS, have already dropped CDS-based pricing on multi-billion dollar loans.
Bristol-Myers signed revolving credit facilities totaling US$3bn due 2024 in January. The financings replaced existing 364-day facilities that included CDS-based pricing and were due to mature on July 2023, according to Refinitiv LPC data.
CIT’S FAUX PAS
Market-based pricing was introduced after financial holding company CIT Group drew the ire of its lenders by drawing down on its US$7.3bn revolving credit line at the height of the financial crisis rather than continuing to access funds in the Commercial Paper (CP) market.
CIT’s commercial paper program became more expensive than the drawn cost of its revolving credit, so the firm chose to draw down on its loan, successfully arbitraging costs between both markets.
Companies use revolving credit facilities as backstop financing in case short-term CP lines fail to roll over, and are able to draw down, repay and re-borrow at will.
CIT eventually filed for Chapter 11 bankruptcy protection in November 2009, but its decision created a precedent that investment grade bankers came to dread.
Although market-based pricing was designed to protect banks, its disappearance late in the credit cycle when another crisis could follow is not worrying, bankers said.
The bank market has changed in the decade since the crisis. International banks have adhered to the Basel II and III agreements put in place by the Basel Committee on Banking Supervision in response to the financial crisis. The measures aimed to strengthen the regulation, supervision and risk management of banks.
US investment grade loan pricing has also widened with average drawn spreads of 62.5bp over Libor for the highest investment grade rating of Triple A, compared to 10bp over Libor in 2008, according to the first banker.
“If we have another crisis people would still be under water but not to the extent at which they were during the credit crisis,” the first banker said. (Reporting by Michelle Sierra. Editing by Tessa Walsh and Kristen Haunss)