An emerging type of derivative product may enable lenders to increase returns and the availability of credit while decreasing systemic risk. These products, known as credit derivatives, address a core function of banking - extending credit.

Credit derivatives unbundle and replicate the credit attributes of a debt instrument and allow a lender to transfer (for a price) certain customized credit risks to other parties. While new and innovative, they are actually extensions of the concepts underlying such traditional products as loan participations and standby letters of credit.

An adage of the prudent lender is to avoid having too many eggs in one basket. Bank lending limits add the force of law to such principles. Still, most lenders do not actively manage their loan portfolios, opting for a "buy and hold" strategy after a loan is funded. Loan sales are still relatively illiquid.

Standby letters of credit, guarantees, and risk participations are occasionally used to back up weaker credits. In such cases, the lender focuses on the credit of the guarantor rather than the borrower.

Credit derivatives such as "credit default swaps" and "total return swaps" may be useful in allowing lenders to continuously adjust their credit exposures. Alternatively, these swaps may be embedded in structured notes. In each of these products, a third party assumes, in whole or in part, the risk of a default of the borrower. The lender still owns the loan but has direct recourse against the swap counterparty.

The concept is the same as a standby letter of credit but is more flexible.

Some may avoid "swaps" in the belief that they are inherently too complex. In fact, the concept is simple. A swap is a bilateral contract in which both parties agree to do something at a predetermined time. In this sense, "swap" is wishes of the parties. The basic swap documentation is standardized.

The price of credit can be broken down into three components. (1) the cost of funds (usually Libor or some variation), (2) administrative costs (overhead and the out-of-pocket costs of making a loan), and (3) the risk premium, which depends on the creditworthiness of the debtor.

In a credit default swap, the risk of default is unbundled from the other attributes of a loan. A third party essentially guaranties all or part of a loan for a time period that may or may not coincide with the maturity. The lender makes a payment (or a series of payments) to the third party much like a premium. In exchange, the third party agrees to pay the losses (determined according to an agreed-upon formula) the lender suffers because of the debtor's default.

The formula is often based on the mark-to-market decline in the borrower's other debt obligations of equal standing, a so-called "reference security." Of course, the value of such a commitment depends on the credit of the third party. The lender retains ownership of the loan and all interest rate risks and rewards. The third party normally has no contingent ownership rights or rights of subrogation in the underlying loan if a default occurs.

A variation of this product is a credit default basket in which default exposure to several borrowers is assumed by the third party. Payout is normally limited to the first default to occur. Therefore, the likelihood of default correlation of the names in the basket is taken into account in the pricing as the lender is receiving protection for only the first default.

A total return swap is a synthetic loan sale for a period that may or may not coincide with the term of the loan. The seller funds the buyer's position but the buyer acquires all of the economic attributes of a loan, including all interest payments, principle payments (including risk of default), fee income, and the economic rewards and risks of a mark to market of the loan. The economic performance for the buyer is similar to that of a reverse repurchase agreement.

Pricing depends on a number of factors with the credit of each of the borrower and the third party obviously being the most critical, along with supply and demand. Demand will depend upon the speed with which this market, now in its infancy, develops. At this point in the credit cycle, lenders seem to be more concerned about booking assets than risk diversification. This may change when the economy weakens.

A party taking on credit risk will do so only if it believes it understands the particular risk being acquired. Therefore, credit default swaps will be limited to credits for which there is sufficient market information.

The decision to acquire risk will depend primarily upon the perceived attractiveness of the price.

For example, if the fee earned on a credit default swap is 50 basis pints of the amount of the credit (the "notional amount") at a time when the interest rate on loans for similarly rated credits is 40 basis points above Libor, a third party may decide the credit default swap to be more attractive for the same risk profile than a direct loan purchase (proving Walter Wriston's observation that even traditional banking is risk intermediation).

Other benefits of a credit default swap include customized maturities and less use of the balance sheet.

These basic building blocks can be modified in any way the parties choose. As with other over-the-counter derivatives, their appeal is in the flexibility. A lender entering into these swaps will have the same risk diversification motivations as a lender syndicating a credit, but these products may allow more customized solutions.

A lender might desire default protection for only a certain period of the loan, for example, the introduction of a new product by the borrower. Conversely, a lender may accept a greater degree of risk at the beginning of a loan and then later wish to take profits on the higher spread it negotiated when the loan had a riskier profile.

Traditional loan sales present certain relationship issues. Borrowers are concerned about a new bank having rights against them while lenders are concerned about participants taking over their lead roles. Swaps may lessen these concerns as there is no direct relationship between the borrower and the third party.

Credit derivatives may allow debt portfolios to continuously rebalance their risk profiles and utilize the risk diversification principles of modern portfolio theory. The fact that a third party desires additional risk is evidence that the other side of risk is reward.

Risk is not a toxic waste to be disposed of. Too little risk means no chance of gain. A risk avoided is also a possible gain avoided. The credit derivatives may also attract participants other than banks to the commercial loan market, increasing liquidity and the availability of credit.

A number of regulatory issues need to be resolved before the credit derivatives market can reach its potential. For example, the treatment under bank lending limits needs to be resolved. It would seem that credit default swaps should be viewed as funded loans, as are standby letters of credit.

If so, this logical corollary is that the lending bank should be considered to have made a loan only the extent of the notional amount not subject to a swap. Put differently, there should not be a double counting.

Under risk-based capital rules, exposures to depository institutions have a lower capital charge than unsecured exposure to corporations. It would seem that the capital charges of a credit to a corporation should be reduced to that of a depository institution to the extent another depository institution has assumed the default risk. Additional ambiguities may exist under the Commodity Exchange Act and state insurance and gaming laws.

The regulatory system must recognize the risk-reducing benefits of these products if they are to be used to their full economic benefit.

Mr. Karol in a partner in the New York law firm of Carter, Ledyard & Milburn.

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