What Are Loan Credit Swaps?
A loan credit risk swap (LCCS) is really a form of credit derivative where the credit risk of an underlying loan is traded between two participants. The structure of financing credit risk swap is quite similar to that of a typical credit default swaps (CDS) except that only the underlying reference asset is exchanged, instead of any sort of corporate debt. Post information 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. ezcash allows an organization to borrow money at a given interest rate without having to secure the loan at the full market value.
A standard CDS uses two sources to supply financial leverage: debt and equity. A loan credit risk swap uses the equity because the source of financial leverage, while providing a second identical financial risk to the borrower (in this instance, the financial risk of not making payments is substituted for the credit risk of not paying a payment). The borrower could refinance the underlying collateral to obtain a lump sum of cash. In this way, a normal CDS would allow a company to obtain more funds to fund its business activities.
Another type of LCCS is the syndicated secured loans. In a typical syndicated secured loan, the borrower is given a reference obligation. This obligation represents the interest rate that will be put on the loan if the borrower struggles to pay. In this way, the borrower's credit risk is reduced (since he or she is still obligated to cover the interest rate).
The underlying assets in loan credit swaps are usually those 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 his or her credit exposure. However, in order for loan credit swaps to work, 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 take part in these swaps take advantage of the lower capital requirement imposed by LCCS. Once the lender's required deposit (the collateral) is greater than the amount of money that the borrower has on hand, the borrower has the capacity to reap the benefits of this lower deposit requirement.
The risks involved with LCCS come from the nature of the transactions themselves. For example, in a normal credit default swap, the interest rate applied to the loan will be dependant on 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 lender if they are unable to pay their interest obligations.
The other risk associated with LCCS is that the larger the loan that's involved, the more potentially negative the implications can be for the lender. This means that 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 a related note, if the borrower were to default on their loan, the lender would still be protected as the defaulted loan was registered as a secured debt against the borrower's home. With this type of collateral, it becomes necessary for borrowers to be cautious about how much of the loan they could pay off each month.
