Corporate borrowing costs have been going up. They are about to rise even more as Citigroup, Credit Suisse Link Loans to Swaps.

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.

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.

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.

“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.

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.

“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.”

Illogical Flaw In Rates

Scores of corporations have credit lines at prices based on the idea those credit lines would never be tapped, clearly a ridiculous idea. Indeed, corporations tapping those lines is one of the reasons for the last spike up in M3.

So if and when corporations want access to those credit lines(as they do now) the risk on those lines was hugely underpriced. This situation is being rectified, and it is going to further pressure corporations that have not secured enough long term financing.

Expect corporate bonds rates to keep rising on account of rising default risk, even as the Fed tries to provide liquidity by cutting the Fed Funds Rate. Rising corporate bond default risk, is not a favorable environment for equities.

Mike “Mish” Shedlock
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