Copyright 2008, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Financial Services, November 2008
A new trend is developing in the pricing of corporate loans which has the potential to have a major impact on the cost of credit for borrowers and the way in which that cost of credit is calculated. There have been several recent occurrences of loans being priced on a margin that is linked to the cost to purchase protection under a credit default swap (CDS) for the related borrower and, in one reported case, to the cost of protection of the lender as the reference entity under a CDS. Based on published reports and SEC filings, variations of these new arrangements have been agreed to by several large corporations, such as FirstEnergy Corp., and NiSource Inc. and by household names such as Nestlé and Nokia.
This approach is a departure from the established practice of pricing corporate loans according to a grid formula that is referenced to either a leverage ratio or a credit rating for the applicable borrower. The purpose of the change is to ensure that the lenders receive an amount as compensation for extending a corporate loan which better reflects the entire risk being taken in making the loan. However, the new approach also raises concerns for borrowers, such as the fact that there is a variation in CDS spreads even for corporations that have the same credit rating. The new approach also indicates an interesting shift by lenders in their approach to pricing and in their assessment of credit risk.
In late September 2008, NiSource Inc. agreed with a syndicate of large banks led by Barclays Bank PLC, to a new revolving credit agreement reflecting loan pricing based on a floating rate or LIBOR plus a spread tied to the daily average of the five-year CDS mid-rate spread price for a CDS referencing one of its subsidiaries, NiSource Finance Corp. The pricing is to be provided by the "Quotation Agency", Markit Group Limited. NiSource was successful in negotiating a cap on the CDS spread, thus lessening the impact that the CDS spread would have on its loan pricing. Given that the pricing for CDS protection can swing by several hundred basis points, particularly in times of financial distress, the cap was a valuable feature for the borrower. Indeed, without such a cap, the borrower could – at the time of its greatest need (i.e., during or just prior to a default) – see its cost of borrowing increase dramatically, with increases significantly in excess of amounts typically provided for in a pricing grid linked solely to a change in credit rating or leverage.
The recent agreement between FirstEnergy Corp and Credit Suisse goes further than the NiSource arrangement in that there is no cap on the CDS spread component of the loan pricing. More importantly, the spread is based on a rate that also factors in the CDS pricing for Credit Suisse itself, i.e., the borrower's cost of borrowing will increase not only if the "market" values its credit as riskier, but also if the borrower's lender is seen as an increased credit risk. This no doubt is an effort by the lender to ensure that its return from the borrower best reflects the lender's own perceived cost of funds from time to time. Thus, even when financially healthy, a borrower under this arrangement can have its cost of borrowing increase if the lender, for example, ran into difficulty – an interesting risk for treasurers to contemplate and to hedge against. It may also give borrowers increased concern as to the identity and creditworthiness of any syndicate members that are having their CDS pricing factored into the borrower's loan pricing.
As with the NiSource facility, the independent organization, Markit Group Limited, is to act as the Quotation Agency. The difficulty with such an arrangement is that Markit Group Limited is merely an information provider, and only aggregates and disseminates the information it receives from market participants. Whereas the LIBOR market has an established set of procedures and is monitored by the British Bankers Association, the pricing of a CDS is more opaque and is arguably more prone to trading influences unrelated to the creditworthiness of the reference entity. In addition, in the credit rating agency model of loan pricing, the rating agency publishes its results for all to see and is held directly accountable for its analysis.
This new CDS model for corporate loan pricing is related to the gyrations in the credit market, including those that have been occurring with respect to the LIBOR market, and is a tip of the hat to the CDS market, which has long proven to be a leading indicator of loan and institutional defaults, much like it was of buyout activity during the seemingly long-forgotten days of corporate buyouts. However, it may also reflect a lessening of respect for the formalized credit rating process, or a least a view that such process lags (rather than leads) the market and is subject in any event to borrower influence (see The Relationship Between Credit Default Swap Spreads, Bond Yields, and Credit Rating Announcements by John Hull, Mirela Predescu and Alan White, Journal of Banking & Finance, Volume 28, Issue 11, November 2004, where the authors conclude that the CDS market anticipates negative announcements by ratings agencies).
It could also be argued that pricing based on risk analysis and credit decisions is, to some extent, being shifted to the marketplace, and at least partly away from the credit departments of lenders. Of course, to the extent that lenders control matters such as the reference CDS obligation, the amount or existence of any cap on increase, the timing of recalculations, and other like variables, then lenders will continue to have access to several credit assessment tools to better reflect and improve their credit risk objectives and to fine-tune pricing matters.
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