Central Banks Are Destroying Traditional Risk Spread Methodologies

According to a recent regulatory filing, Ohio-based First Energy Corp. (FE) has agreed to link interest rates on its $300 million credit line to the cost of Libor, plus a spread of 3 percentage points over Libor, plus the sum of the spread on credit default swaps for both First Energy and the lending bank, Credit Suisse (CS). The effective rate of 6% over Libor for First Energy is simply an answer to the total chaos in corporate risk spreads caused by the Federal Reserve Bank's commercial paper facility, by strenuous efforts by central banks in Europe and Asia to force down Libor rates and by governments guaranteeing inter-bank lending and, in certain instances, wholesale loans and bond issues.

Besides First Energy, Nestle (NSRGY.PK) and Nokia (NOK) have reportedly succumbed to demands by banks to align total spreads payable on loans with relevant credit default swaps rates; Citigroup (C) is structuring the Nestle standby credit. In fact, a growing number of bankers are now convinced that the recent misalignments in the corporate risk-spread matrix now demand an entirely separate (and dangerous, in the view of some observers) approach to pricing yields over benchmark rates.

Triple-A rated General Electric (GE), for example, is now able to sell its commercial paper to the Fed at the overnight indexed swap (OIS) level plus 100 basis points, a good 180 basis points below Libor. At the same time, GE's longer-maturity bonds are being traded at spreads which are fully consistent with the lower end of the investment-grade spectrum, around 350-400 basis points over treasuries. While GE is borrowing cheap (and short) around 1.70% from the Fed, a default swap-driven banking credit line would cost GE a minimum of 5 percentage points over Libor, or 8%.

The objective of the central banks may well be to encourage corporate lending, by injecting liquidity and lowering rates. But actions like the fixing of spreads (over OIS) by the Fed and the guaranteeing of inter-bank loans by the governments in Europe and Asia have had a direct, destructive influence on the traditional balance between credit ratings and yields, particularly in an environment where credit quality is being scrutinized from the prism of a prolonged and painful recession through 2009.

Therefore the logical shift towards pricing loans within the credit default swap framework in order to achieve as risk-neutral a lending profile as is possible today. Obviously, if the credit default methodology gains momentum, borrowing costs for businesses will rise significantly since there is widespread acknowledgment that all asset classes must be subject to comprehensive revaluations at this juncture. Imagine the impact on the housing market if mortgage loan providers are obliged to link their securitizations to credit default swaps!

In view of the highly fluid state of the existing counterparty risk matrix, the impact of a potentially seismic shift in credit spread methodologies on interest rate and currency swaps is still unclear, though the cost of far-forward foreign exchange contracts to buy dollars and Euros (against most emerging market currencies) has increased substantially last month. But it is certain that major (and sophisticated) international banks are going to ignore the guidelines on the relationship between benchmark rates, credit ratings and risk spreads established by central bank interventions, and proceed along a safer though more complex and less-travelled path.

Stock position: Short GE.

Comments

[investor88]

A very informative article which goes beyond slogans like declining TED spread and declining LIBOR as evidence of credit easing due to all the govt injection of capital, guarantees and liquidity. This article is a wake up call that credit is still tight.

2008 Nov 02 08:26 AM

[sr9web]

This article paints a very grim picture indeed...

2008 Nov 02 02:11 PM

[Augustus]

The Fed and Paulson have really screwed up the credit market pricing. In the rush to provide credit for various good purposes, they have driven the uninsured borrowers out of the market - or made borrowing unaffordable for them. It was not too bad if they had stopped at the GSE bailouts and guarantees. When they have now made the facility available for commerical paper of selected issuers they have ruined the rates for the rest. Banks have to lend money to borrowers. They also should have to do their own credit evaluation and pricing. The Fed has now guaranteed the loans to some very large borrowers, screwing many of the smaller ones which may really be much more credit worthy. It is a version of the "good money driving out bad" principle at work.

2008 Nov 02 06:10 PM

[Redman]

A very good article. Despite the so-called "dangers' of this new methodology..you gotta do what you gotta do! There would be no reason for this if the banks had kept their collective eye on the ball in the first place! These above 'normal' rates companies are paying now are a direct result of a pricing mechanism that didn't/doesn't work in any environment. The market (bonds, stocks, Libor, etc.) are trying, albeit lamely, to re-price what they think is the current value for instruments that they and the banks invented and possibly never really understood! Who ever thought that home values would collapse? Certainly not those who invented and marketed these products! Hence the neurosis surrounding the current atmosphere. If we are to survive this crisis then the steps being taken ( and remember, these are short-term steps) will have to be accepted as they are until the de-leveraging process works itself out.

2008 Nov 03 08:32 AM

[flow5]

a very literate commentary. but I don't understand why banks would borrow in the Euro-dollar system, which is unregulated (no legal reserves, only "prudential" or liquidity reserves) which has been allowed by the governments and central bankers to create trillions of new inter-national units of account. this deluge of international money has imposed excessive inflationary pressures on prices (e.g., housing, etc.).

2008 Nov 03 09:04 AM