When Banks Stop Underwriting

Citigroup (C) and Credit Suisse (CS) are so damaged by the financial crisis, it seems, that they've given up underwriting loans to their biggest and most valuable corporate clients, including Nestle and Nokia. Instead, they're linking those loans to the companies' CDS spreads. This is not a good idea, as Sam Jones notes:

Banks are supposed to be arbitrary lenders, in the sense that they perform, in-house, the necessary due diligence on on the creditworthiness of a company, and lend to that company accordingly.

Tying rates to CDS, though, is effectively outsourcing opinions of the creditworthiness of a company to the market. Indeed, it's more of the same "outsourced" due diligence from banks that in part inflated the '00-'07 debt bubble in the first place.

I've never been particularly impressed by arguments which say that indexing is a bad idea because if everybody did it, there wouldn't be any price-setters. But this is a clear case of where that kind of an argument works. Banks have more and better information about borrowers than anybody else, they should be the price-setters. If they let the market decide, on the basis of worse information than the banks themselves have, they're making the whole edifice less robust.

Note that the problem here is one of who's doing the underwriting, and is not anything related to CDS: The banks could easily have used bond spreads instead, if they were liquid enough. Which is why I hate Bloomberg's lede:

Citigroup Inc. and Credit Suisse Group AG are among banks tying corporate loan rates to credit-default swaps, raising borrowing costs and exposing companies to derivatives accused of crippling the financial system.

Clearly, the "derivatives accused of crippling the financial system" meme is not one which is going to go away. Even when it has very little place in a story such as this.

Comments

[RiskAverseA...:]

No, the "derivatives accused of crippling the financial system meme is not one which is going to go away." In fact, you might even find a Republic one day soon wake up and declare war on the Empire where the greater bulk of these things originate...

2008 Oct 30 11:11 AM

[Andy Abraham:]

The Derivative time bomb is getting closer to exploding..when we will learn from our mistakes... This is the real problem...greed and arrogance...

Andy Abraham

2008 Oct 30 12:24 PM

[IanB:]

Sadly, the moneycenter banks started giving up underwriting a decade ago when they switched the spreads on their loans from covenant-based to ratings-based. The same though occurred to me then - aren't the banks supposed to keep track of the health of their borrowers?

It was also interesting to note that the new pricing on some loans includes LIBOR plus the SUM of the spreads on the borrower's and the lender's CDS - now the borrower is paying for a downgrade of the lender's credit. Nice.

2008 Oct 30 03:59 PM

[Smarty_Pants:]

What difference does it make in the end? If the loan goes bad the Treasury will have the FED print the money to cover the loss.

It's all good. (Note: Heavy Sarcasm intended.)

2008 Oct 30 04:23 PM

[James Wilson:]

Well give Citi another choice. The companys want high dividens on their Money Market CD'S but want to pay a low interest rate on loans and run high debt to cash ratios !
With the amount of credit large corporations demand they are luck anyone answers the phones actually. Demanding great rates on their CD'S while taking all the time they can to pay thier bills. Their accounts payable departments well vesred with the Check is in the mail routine.
MS and Goldman get CITI backing then say sell them short. Tell the businesses that need CITI's fiancing or under writing to go see Goldmans or MS. lol
Goldman and MS are just praying the short sellers don;t come after them big time lol.

2008 Oct 31 10:13 AM

[Tom Jacobs:]

First off, banks have historically used these loans and lines as loss leaders with the internal argument that getting at the rest of the wallet requires using the balance sheet to get in the door. The regulatory differences between commercial and investment banks regarding how these were booked used to dramatically favor the commercial banks (obviously not an issue anymore). Thus, the development of the CDS market provided a means for those within commercial banks trying to impose some discipline on the large corporate loan business to provide an external metric as opposed to asset swapping illiquid bond spreads. Tying to CDS while as you say somewhat removes the monitoring function, is it really believable that loan officers really have much in the way of unique private information on the large companies which have active CDS markets like Nokia? I don't think so.

On the evils of derivatives arguments it just gets worse and worse. Just because Warren Buffet blew his due diligence on General Re:

"When we purchased Gen Re, it came with General Re Securities, a derivatives dealer that Charlie and I didn’t want, judging it to be dangerous. We failed in our attempts to sell the operation, however, and are now terminating it.

But closing down a derivatives business is easier said than done. It will be a great many years before we are totally out of this operation (though we reduce our exposure daily). In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit. In either industry, once you write a contract – which may require a large payment decades later – you are usually stuck with it. True, there are methods by which the risk can be laid off with others. But most strategies of that kind leave you with residual liability."

(from:

www.myprops.org/conten.../

we are now saddled with the endless doom and gloom over products that are great for clients when they reach commodity status but always cause problems when banks first develop them since clients are so easily convinced to pay a lot for something they don't need unlike the rest of human experience with the sales process. The misrepresentation by all of these ignorant pundits is really sickening.

2008 Oct 31 10:15 AM