Links to CDS measures growing common in bank credit deals (Westlaw Business)

By Guest Contributor
January 11, 2011

The American International Group (AIG) building is seen in New York, March 24, 2009. REUTERS/Shannon StapletonBy Erik Krusch

Jan. 10 (Westlaw Business) –  Credit terms are loosening, but lenders are still after their proverbial pound of flesh. Consider AIG and AT&T’s recent credit agreements, which link each loan’s interest rate to the corporations’ credit default swaps (CDS). Lenders are also insulating themselves from risk with London Interbank Offered Rate (LIBOR) floors, such as the one undergirding healthcare technology company MedAssets’ recent term loan. In a similar vein, bankers installed an original issue discount (OID) in construction materials maker Armstrong World Industries’ recent term loan. Lenders are doing their due diligence and weighing risks in order to concoct the right mix of interest rate terms in hopes of protecting their capital going forward.

High yield borrowers are basking in the glow of a revitalized credit market, with even covenant-lite loans and equity cures making comebacks. Lenders do not, however, have quite as short a memory as it might seem. Changes to interest rate definitions demanded by banks in the wake of the credit crisis are becoming the market standard. Chief among these lender protecting, and potentially return-on-capital juicing, interest-related terms are: the linking of CDS to interest rates, LIBOR floors, and OID.

CDSs are derivatives that pay out, similar to insurance, if a “credit event” (ratings downgrades, events of default) on a debt instrument. During the credit crisis, lenders were hit with a rash of borrowers drawing down their revolving lending agreements. These lines of credit are often low margin loans for banks and are essentially viewed as emergency capital by borrowers. The problem now, from many banks’ perspective, is that they were required to pay out funds at low rates under agreements negotiated during sunnier days. As a result, these once-bitten bankers are now not shy about biting back and are insisting that newly negotiated credit agreements link the loan’s interest rate to the borrower’s CDS. This linkage would likely drive up a company’s cost capital during individual episodes of distress or during a general financial crisis.

Several companies’ recent credit agreements illustrate this link between interest rates and a firm’s CDS – and none more ironically than AIG’s two recent $1.5 billion revolving credit facilities. AIG has been ensconced in the smothering embrace of the U.S. government ever since the lender required a massive recapitalization, which was due in no small part to the soured CDS trades entered into by AIG Financial Products. AIG’s recent agreements define “Applicable Rate” as meaning:

…for any day, a per annum percentage equal to: (a) (subject to the proviso at the end of this definition), (i) with respect to any ABR Loan, the applicable Credit Default Swap Spread minus 1.00% (provided that such percentage for purposes of this clause (a)(i) shall in no event be less than 0%) and (ii) with respect to any Eurodollar Loan, the applicable Credit Default Swap Spread; and (b) with respect to ticking fees or commitment fees pursuant to Section 2.09(a) or (b), respectively, the Applicable Fee Rate; provided that, for any day from and after the Commitment Termination Date with respect to Loans that are converted to term loans pursuant to Section 2.01(b), the applicable Credit Default Swap Spread for any Type of Loan shall be equal to the applicable Maximum CDS Spread.

Other recent credit agreements tying borrowers’ CDS measures to the interest rate include Altria and Boeing’s $600 million and $2.38 billion deals, respectively.

Another credit crisis induced change designed to protect lenders is the addition of a LIBOR floor to the base rate definition of many loans. LIBOR is a daily reference rate based on the quoted eurodollar interest rate that large banks are willing to lend to each other at. LIBOR is often the base rate, meaning the applicable interest rate on a corporate loan is LIBOR plus a contractual defined spread, for corporate loans. During financial crisis, interest rates, including LIBOR, often plummet. LIBOR floors prevent corporate loans that reference LIBOR as a base rate measure from dropping below a contractually defined minimum – even if LIBOR drops precipitously.

LIBOR floors were not unheard of prior to the credit crisis, but the financial maelstrom unleashed a deluge credit terms with these provisions. Aircraft parts maker TransDigm, for example, recently priced a $1.55 billion term loan with a 1.5% LIBOR Floor. Earlier this year, MedAssets priced a $635 million term loan and Warner Chilcott marketed a $1.02 billion term loan B facility with1.50% and 2.25% LIBOR floors, respectively. Notably, LIBOR floors seem to be declining from the precipitous heights they reached during the credit crisis. Canada’s Precision Drilling Corp, for example, recently amended its December 23, 2008 $1.2 billion term loan’s LIBOR floor from to 1.75% from 3.25%. The salient factor of today’s LIBOR floors is that they have outlasted the credit crisis and lenders do not seem ready to part with these provisions.

OIDs are another lender protecting feature of credit agreements that are out lasting the credit crisis. An OID means that a borrower receives less than the face value of the loan. Interest and commitment fees are, however, calculated on the face value of the loan and the borrower must repay the full face value of the loan at maturity. These discounts have the effect of compensating lenders for risk by juicing their returns. One example of a recent and disclosed OID is Armstrong World Industries’ $550 million term loan B, which carried a .5% discount. Oil and gas contractor Willbros’ recent $300 million term loan came with a much deeper 6% OID. Despite Wilbros’ drastic discount, it does seem that OIDs are generally not as steep today as they were during and in the immediate aftermath of the credit crisis.

Lenders may be returning to the market, but they are insisting on a variety of terms to protect their capital. Linking interest rates to borrowers’ CDS, LIBOR floors, and OIDs are requirements that bankers are drafting into credit to protect their interests and juice their returners. The use of any or none of these terms could be appropriate in a given loan negotiation. In the midst of negotiations, lenders will need to carefully weigh their options in light of the specific risks that each loan presents. Borrowers, meanwhile, should be aware of the strategic use of these provisions when negotiating new or amended loan agreements.

(This article is part of Westlaw Business’ 2010 Credit Terms Series, which highlights common, though sometimes contentious, terms that companies and attorneys are turning to as they modify existing credit arrangements or negotiate new deals. To browse all articles in the series, please click here.

The article was originally published by Westlaw Business Currents (currents.westlawbusiness.com), a ThomsonReuters publication. Westlaw Business Currents delivers lawyer-authored content and Westlaw Business source documents together with Reuters news to keep you informed of the latest developments in your areas of interest. Available online and delivered directly to your desktop, Westlaw Business Currents provides you with the news and timely analysis you need to stay on top of current trends and maintain a competitive edge for your organization and your clients.)

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This loan structure is extremely dangerous because 81.68% of single name CDS transactions in the live trade warehouse at DTCC are dealer-dealer trades. Only one reference name in the world has averaged more than 10 non-dealer trades per day over the 77 weeks ended December 30, 2011. As a result, the dealer-lenders have near complete control over the base rate on the loan.

Posted by dvandeventer | Report as abusive

Clearly the maxim that common sense is uncommon remains true as does the proposition that risk in its various manifestations is discounted by the “it won’t happen to me” sense of expectation. Even if all actors do not have agreed upon objective probability distributions for rare events it does not mean that we should either understate or ignore such uncertainty. The CFOs and treasurers signing off on these covenants are taking a big gamble.

Posted by Arijit_Banik | Report as abusive