Wednesday, October 29, 2008

Citigroup, Credit Suisse Link Loans to Swaps in Shift

(Bloomberg) Citigroup Inc. and Credit Suisse Group AG are among banks tying corporate loan rates to credit- default swaps, raising borrowing costs and exposing companies to derivatives accused of crippling the financial system.

Nestle SA, the biggest food producer, Nokia Oyj, the largest mobile-phone maker, FirstEnergy Corp., the Ohio-based owner of electric utilities, and at least three other companies bowed to banks' demands to link the interest rate on credit lines to the swaps, which are used to bet on borrowers' likelihood of default.

Banks are toughening terms following $678 billion in writedowns and losses, rising funding costs and a jump in companies drawing on lines they'd already negotiated. Before markets seized up this year, most rates on $6 trillion of revolving loans were based on a borrower's debt rating and priced at an amount over the London interbank offered rate.

``We want banks to be able to provide credit and liquidity to a company like ourselves and they're only going to be willing to do that if they feel it has market pricing built into it,'' Randy Scilla, FirstEnergy's assistant treasurer, said in a phone interview from Akron, Ohio.

Companies such as FirstEnergy may have little choice but to accept the new terms. Banks arranged $603 billion of loans in the U.S. this year through yesterday, down from $1.73 trillion in 2007, according to data compiled by Bloomberg. Even a plan by U.S. Treasury Secretary Henry Paulson to buy $250 billion of shares in financial companies as part of a global injection of $3 trillion into capital markets may not be enough to stem the lending decline.

`That's Crazy'

The inclusion of the swaps shows that banks are shifting away from setting loan pricing by relying on debt ratings and Libor, a benchmark rate that is set each day in London by tallying the cost of 16 banks to borrow from each other. Three- month Libor, the typical benchmark for loans, rose to 4.82 percent on Oct. 10, the highest this year, as markets froze. The rate was set at 3.42 percent today.

The move to swap-based pricing may leave companies exposed to fluctuations in instruments that aren't listed on government- regulated exchanges.

``That's crazy,'' said Lynn Tilton, chief executive officer of $6 billion private-equity firm Patriarch Partners in New York, which loans or lends money to more than 70 companies. ``This will accelerate the downward spiral of market prices and raise borrowing costs to unsustainable levels.''


The default swaps were created so bondholders and banks could buy protection against a borrower's inability to repay debts. The market ballooned to more than $60 trillion in the last decade as investors used the instruments to bet on companies. The Securities and Exchange Commission is probing allegations trading helped create a panic that caused the collapse of Lehman Brothers Holdings Inc.

FirstEnergy, with utilities in Ohio, Pennsylvania and New Jersey, agreed this month to link interest rates on a $300 million credit line to the cost of Libor as well as the sum of the spread on its default swaps and those of Credit Suisse, according to a regulatory filing.

Loans from the Zurich-based bank would require total interest payments of about 6 percentage points over Libor if the power company draws on the bank line, according to regulatory filings and Bloomberg data. That's almost 14 times the spread on a $2.75 billion credit line the company negotiated in 2006.

`Unprecedented Times'

The utility would pay Libor plus 3 percentage points to draw on the line, according to company filings. Based on yesterday's levels, FirstEnergy would be charged an additional 1.70 percentage points, reflecting the levels of its credit- default swaps, and another 1.35 percent to account for the bank's own spread, according to Scilla.

Pricing on the loan will change as Libor and the swap spreads on Credit Suisse or FirstEnergy move.

Spreads on FirstEnergy's default swaps reached a record high of 1.80 percentage points on Oct. 20, up from 0.48 percentage points a year ago and 0.12 percentage points in February 2007, according to CMA Datavision. Credit Suisse's have risen threefold since December.

``We're in unprecedented times right now,'' Scilla said. FirstEnergy doesn't anticipate needing to borrow from the line, he said.

Swings in credit-default swap prices can be more pronounced than a company's perceived nonpayment risk would suggest, said John Grout, policy and technical director at the U.K.'s Association of Corporate Treasurers in London.

Cap Included

Some companies, including Nestle, convinced banks to include a cap on the level of its swaps.

The Vevey, Switzerland-based company is seeking to refinance 6 billion euros ($7.7 billion) of debt, according to bankers familiar with the discussions. It wants to set up a backup for a commercial-paper program that's ``not intended'' to be drawn down, said Roddy Child-Villiers, head of investor relations. The debt will be linked to a percentage of the company's default swaps.

Nokia is also paying a spread over Libor based on its derivatives, according to Arja Suominen, a Helsinki, Finland- based spokeswoman.

Credit lines were once seen mainly as emergency funds to be tapped as a last resort. Since markets tightened last year, at least 36 companies hurt by the slowing economy and an inability to tap commercial paper or bond markets have borrowed $30 billion on previously negotiated lines, according to Pacific Investment Management Co. in Newport Beach, California.

`Illogical Flaw'

``Historically there's been an illogical flaw in the price of revolving credit facilities and backstop loans in particular, they were priced very cheaply as they were never meant to be drawn down,'' said David Slade, head of European leveraged finance at Credit Suisse in London. ``But now, in the current environment, these lines are being used and banks need to be properly recompensed.''

Goodyear Tire & Rubber Co., the largest U.S. tiremaker, drew $600 million from its credit line last month after it couldn't gain access to $360 million of cash in a money market fund. The Akron, Ohio-based company, rated BB- by and Standard & Poor's, is paying 1.25 percentage points more than Libor, or 4.72 percentage points. It would pay about 12 percentage points if it were to negotiate a new loan today, based on the average of similarly rated companies in an S&P index. Spokesman Keith Price declined to comment.


Concerns that Libor may not truly reflect borrowing costs helped bring about the change. The rate came under scrutiny as the debt-market seizure deepened. Some lenders may have provided numbers to the British Bankers' Association that underestimated their cost of funds, the Bank for International Settlements in Basel, Switzerland, said in March. The BBA said on April 16 that any member deliberately understating rates would be banned.

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.

The push for the change is coming as the U.S. government and New York Attorney General Andrew Cuomo investigate whether the swaps were manipulated by short sellers to spread false rumors about financial companies. People who sell short hope to profit by repurchasing the securities later at a lower price and returning them to the holder.

``We're going through a transformation right now with regard to pricing of credit,'' FirstEnergy's Scilla said. ``It wasn't long ago that banks were basically giving away credit. That could be part of the reason we're in the problem we're in today. And those days are gone.''

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