Tying Loan Rates to Borrowers’ CDS Spreads February 10, 2014 at 8:23 pm

João Santos blogs about an interesting paper on Liberty Street Economics.

The development of the CDS market has provided banks both with a new way to manage their credit risk and with observable information on borrowers’ default risk. While banks do not seem to use the CDS market extensively to lay off credit risk, it appears that they are relying on information from the CDS market in their lending business. We find that since early 2008 banks have increasingly extended loans to corporations with interest rate spreads tied to the borrower’s CDS spread (or to a CDX index) over the life of the loan, a practice referred to as market-based pricing… We find that the difference between the actual and the hypothetical fixed-rate spread over the life of loan is always negative for loans priced off the CDS market, confirming that market-based pricing has lowered the cost of bank credit.

We know that CDS spreads dramatically over-state the probability of default, but clearly old fashioned bank lending spreads over-stated it even more. I do worry that this approach risks pushing the borrower into default as their spreads blows out, too – whether or not that blow out was caused by a change in fundamentals.

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