Opinion

Felix Salmon

When companies short their own securities

By Felix Salmon
August 10, 2009

BusinessWeek has an interesting article about CDS-linked lines of credit, where the cost varies in line with the borrower’s CDS spreads:

The lenders stress that the new products give them extra protection against default. But for companies, the opposite may be true. Managers now must deal with two layers of volatility—both short-term interest rates and credit default swaps, whose prices can spike for reasons outside their control.

Making matters more difficult for corporate borrowers: high fees. Banks are raising their rates for credit lines across the board—but the new CDS-based credit lines cost far more than the old lines. FedEx could end up paying $1.9 million to $3.6 million a month if it decides to tap a new line from JPMorgan and Bank of America. On its previous line with JPMorgan, FedEx would have paid about $540,000.

Companies the size of FedEx can easily hedge their interest-rate risk, using rate swaps. But how can they hedge their own credit risk? There’s only one way of doing that: by buying credit protection on themselves — the bond-market equivalent of shorting your own stock. That might be legal, but it’s certainly not pleasant.

(Via Chittum)

Comments
9 comments so far | RSS Comments RSS

I could be off on this, but I don’t think any dealer would sell a company CDS on itself. Am I wrong?

Posted by ab | Report as abusive
 

…plus i think these would be procyclical: credit deterioriation leads to higher interest rate risk.

 

As a more substantial comment, do you really think this is inappropriate? Really no reason to think that credit ratings-based rates (which are common) are more appropriate than CDS-based rates. Unless you think the Agencies’ performance recently instills a lot of confidence.

Posted by ab | Report as abusive
 

These are mostly standby/CP backstop lines that are not meant to be drawn. The pricing link to the CDS is usually used now in an attempt to protect the bank because these facilities tend to be drawn only when something has gone wrong, either with the company or with the market, and it is tough to set the loan pricing in advance to cover such scenarios. These facilities are also now more costly because they were usually ridiculously underpriced before, in the order of a few bp over Libor, which in a drawn scenario would go nowhere near to covering the bank’s cost of lending and credit costs. Banks got pretty burned on these when they were drawn last year.

 

Felix –

Could this be a way for CDSs to justify their existence?

It seems that it can be stabilizing for a company to buy insurance on itself. If I buy Aflac, as the duck explains to me, I will get paid if I get hurt and miss income. This would seem helpful for people and companies alike.

The point is of course moot since CDS contracts are barely contracts at all while the jokesters that play in them need not have the ability to pay.

In San Francisco in 1907 at least they were rebuilding in a much better way. Watching our collective impotence is really depressing.

Posted by Dan | Report as abusive
 

A CDS-linked line of credit would appear at first glance to be a product with similar correlation risk properties to a soluble umbrella.

Posted by dsquared | Report as abusive
 

@dsquared

I still don’t understand how this is worse than a ratings-based interest rate. Do you think it is? Or are you just pointing out that any credit-linked rate is procyclical?

Posted by ab | Report as abusive
 

Companies in business today, and individuals who involve themselves in the finance sector have a sizable challenge and must exercise diligence and evidence based practice, in order to monitor and forecast future needs without the high risk of exposure that was very much part of the 1990′s.

Posted by AlbertSparks | Report as abusive
 

This is not a solution, it’s suicidal. It’s like jumping into a bottomless pit of debts and loans with eyes wide open.

Posted by simoniddings | Report as abusive
 

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