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Tying Loan Interest Rates to Borrowers’ CDS Spreads

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Tying Loan Interest Rates to Borrowers’ CDS Spreads

Federal Reserve Board,

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Resisting a bargain is hard, but cheaper corporate loans may have hidden costs.

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7

Qualities

  • Controversial
  • Analytical
  • Scientific

Recommendation

The search for greater efficiency in finance is a hallmark of the past few decades. But a good engineer knows that a little bit of friction can keep a system from spiraling out of control. Economists Ivan T. Ivanov, João A.C. Santos and Thu Vo investigate the effects of a recent financial innovation – corporate loan pricing tied to credit default swaps (CDS). Though offering cheaper capital, CDS-linked loans may undermine some of the main stabilizers of the economy. getAbstract recommends this provocative, though technically challenging, investigation into the broader impacts of CDS-linked loans to bankers and corporate finance executives.

Summary

Economic research makes a strong case for banks’ monitoring of the businesses to which they lend. The proprietary information banks obtain before agreeing to extend credit and during the life of loans complements other sources of data on the health and profitability of enterprises. In 2008, banks began offering corporate loans and lines of credit with variable interest rates using market-based pricing tied to credit default swaps (CDS) or CDS indexes (CDX). Loans tied to CDS spreads reflect the day-to-day risk profile of a borrower, since the CDS spread represents...

About the Authors

Ivan T. Ivanov is an economist at the Federal Reserve Board of Governors. João A.C. Santos is an economist at the New York Federal Reserve Bank. Thu Vo is a researcher at the Amherst Securities Group.

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