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 (CSGN:VX). 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 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 (NESN:VX) and Nokia (NOL:US) 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 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.
