A Credit Default Swap (CDS) is an instrument designed to transfer the credit exposure of fixed income products between parties. A CDS is also referred to as a credit derivative contract, where the purchaser of the swap makes payments up until the maturity date of a contract. Payments are made to the seller of the swap. In return, the seller agrees to pay off a third party debt if this party defaults on the loan. A CDS is considered insurance against non-payment. A buyer of a CDS might be speculating on the possibility that the third party will indeed default.
The protection buyer, protection seller and the third party are the parties involved in a CDS agreement. In this case, Charles Bank International (CBI) is the protection buyer, First American Bank (FAB) is the protection seller and CapEx Unlimited (CEU) is the third party who is borrowing the loan from CBI.(Refer to Appendix-Figure 1)
The reason why CBI would benefit is because in case CEU defaults on the loan, FAB would give out a guaranteed payment to CBI. In terms of lending to CEU, if the new loan of $50million is added to the existing loan, this would put CBI over its credit exposure limit. However, rejecting the loan could hinder the relationship ties between CBI and CEU. Thus, a CDS would help CBI reduce its credit risk as well as maintain a good relationship with CEU as the loan could be given out with a lower risk weight age added to it. The chances of FAB and CEU defaulting at the same time is quite low as FAB is a highly rated entity and so if CEU defaults on the loan there is some guarantee that FAB would pay it.
As for CEU, they could now exceed the limit and take the loan even though they are not aware of the CDS agreement. This could ensure that they could carry on with their expansion and need not be in a position to secure the loan from other sources. Lastly, FAB could now improve relationships with CBI and also receive a fee from CBI for the CDS. This fee could be beneficial as it is quite high and chances of CEU defaulting is substantially low as they have already been a loyal customer of CBI for more than 5 years. This means that they would be receiving a fee but might not have to pay a sum as CEU is very unlikely to default.
Next, whether FAB should hold on to the CDS depends on its tolerance for risk and the returns of CDS. The benefit of keeping the credit risk for FAB is the semi-annual payment. On the other hand, this comes at a cost of setting aside capital to cushion the extra credit risk that it undertakes. Thus, if the benefit exceeds the costs or if the returns is higher for keeping the risk, then FAB ought to hold on to the CDS. If FAB is better off selling the risk to another party, as stated in the case, they can pass it on to low-rated banks or a hedge fund by creating another CDS. However in the event that CEU defaults on the swap, there is a high likelihood of these banks with low credit ratings defaulting at the same time. This can be mitigated through the use of collaterals requested by FAB. However, this is not realistic as it would not be something that a CDS seller would want to do.
Thus, the group believes that the most viable solution is issuing a credit–linked note (CLN). Risk is transferred from FAB to investors through a note and cash is paid to FAB upfront. The transferring of risk would see FAB passing on the semiannual fee it gets to the CLN investors. However, the key benefit is that if CEU defaults, FAB is not obliged to repay the full value of the notes. This alternative is feasible for both parties as not only is it less risky than a CDS for FAB, investors also gain through a higher payment. In conclusion FAB should transfer the risk away using CLN.
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