Banks link loan to CDS

It’s a new move in the credit market. Some banks including Citi and Credit Suisse are tying corporate loan rates to credit- default swaps. It’s reported that Nestle, the biggest food producer, and Nokia, the largest mobile-phone maker and at least other four companies agreed on banks’ demand to link the interest rate on their credit line to the CDS.

The inclusion of the CDS shows that banks are shifting away from setting loan pricing by relying on debt ratings and Libor. This move may leave companies exposed to fluctuations in derivative instruments that not tightly regulated by government.

This transformation is partly due to the concerns that Libor may not truly reflect borrowing costs helped bring about the change. Earlier this year, widespread suspicion arose that a number of banks had been understating the interest rates they were paying, particularly for 3-month money, and that official Libor rates had therefore been falling short of actual rates in the market place. At times the gap was believed to be as high as 30 bps. While millions of borrowers have clearly been better off as a result of the understatement, this small difference translates into billions of dollars collectively for those on the wrong side of the contracts.

Though collusion between the banks was suggested, a less blameworthy reason is more likely. Individual banks were apparently scared of being seen to be paying too much for their loans, fearing that this might spark off questions about their creditworthiness and lead to bigger problems, such as those suffered by Northern Rock and Bear Stearns.

Banks are also seeking to shift from a reliance on credit ratings amid concern Moody's Investors Service and S&P have been too slow to act when credit quality deteriorates.

It also could be regarded as a self-saving measure by banks. It wasn't long ago that banks were basically giving away credit. That could be major reason we're in the problem today. And those days are gone.