What Are Loan Credit Swaps?
A loan credit risk swap (LCCS) is a form of credit derivative where the credit risk of an underlying loan is traded between two participants. The structure of a loan credit risk swap is quite similar to that of a typical credit default swaps (CDS) except that only the underlying reference asset is exchanged, rather than any kind of corporate debt. A normal CDS would be used to supply financial leverage against any given bond or other financial instrument; however, a LCCS gives credit risk flexibility to a company or investor. It allows a company to borrow money at confirmed interest rate without needing to secure the loan at the full market value.
A normal CDS uses two sources to provide financial leverage: debt and equity. Financing credit risk swap uses the equity because the way to obtain financial leverage, while providing another identical financial risk to the borrower (in this instance, the financial threat of not making payments is substituted for the credit threat of not paying a payment). The borrower could refinance the underlying collateral to secure a lump sum of cash. In this manner, a normal CDS would allow a company to obtain additional funds to fund its business activities.
Another type of LCCS may be the syndicated secured loans. In a typical syndicated secured loan, the borrower is given a reference obligation. This obligation represents the interest that will be put on the loan if the borrower is unable to pay. In this manner, the borrower's credit risk is reduced (since he or she is still obligated to pay the interest rate).
The underlying assets in loan credit swaps are usually the ones that are of low value (i.e., assets that have high trading values but low market value). Thus, the borrower who has chosen to take part in the swaps can obtain some level of flexibility from her or his credit exposure. However, in order for loan credit swaps to be effective, both the borrower and the lending company should be well-advised regarding their credit exposure and how big is their potential losses. Some investors who be a part of these swaps take advantage of the lower capital requirement imposed by LCCS. Once the lender's required deposit (the collateral) is greater than the money that the borrower has on hand, the borrower has the ability to benefit from this lower deposit requirement.
The risks involved in LCCS come from the type of the transactions themselves. For instance, in a normal credit default swap, the interest applied to the loan will undoubtedly be determined by an economic index. In LCCS, the reference obligation serves because the economic index. When this occurs, the borrower will be subjected to risk of interest rate fluctuations, that could prove negative to the lending company if they are struggling to pay their interest obligations.
The other risk connected with LCCS is that the larger the loan that is involved, the more potentially negative the implications can be for the lender. Because of this when the total of most loan amounts are larger than the amount of funds that a bank can safely lend out at any given time, they are forced to pass the negative impact of the larger amount of funding to the borrowers of their loan. On ezcash related note, if the borrower were to default on the loan, the lender would still be protected as the defaulted loan was registered as a secured debt against the borrower's home. With this kind of collateral, it is needed for borrowers to be careful about how much of the loan they could pay off each month.