WHAT EXACTLY ARE Loan Credit Swaps?
A loan credit risk swap (LCCS) is really a form of credit derivative where in fact 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 standard credit default swaps (CDS) except that only the underlying reference asset is exchanged, rather than any kind of corporate debt. A standard CDS would be used to provide financial leverage against any given bond or other financial instrument; however, a LCCS gives credit risk flexibility to an organization or investor. It allows an organization to borrow money at a given 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. A loan credit risk swap uses the equity because the way to obtain 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 secure a lump sum of cash. In this manner, a normal CDS allows a company to obtain additional funds to invest in its business activities.
Another type of LCCS may be the syndicated secured loans. In an average syndicated secured loan, the borrower is given a reference obligation. This obligation represents the interest rate that will be applied to the loan if the borrower struggles to pay. In this way, the borrower's credit risk is reduced (since they're 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 which have high trading values but low market value). Thus, the borrower who has chosen to take part in the swaps should be able to obtain some quantity of flexibility from his or her credit exposure. However, to ensure ezcash swaps to work, both the borrower and the lender should be well-advised regarding their credit exposure and the size of their potential losses. Some investors who be a part of these swaps take advantage of the lower capital requirement imposed by LCCS. When 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 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 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 fluctuations, that could prove negative to the lending company if they are unable to pay their interest obligations.
The other risk connected with LCCS is that the bigger the loan that is involved, the more potentially negative the implications could be for the lender. Which means that when the total of all loan amounts are bigger than the amount of funds that a bank can safely lend out at any given time, they're forced to pass the negative impact of this larger amount of funding through to the borrowers of their loan. On a related note, if the borrower were to default on their loan, the lender would be protected because the defaulted loan was registered as a secured debt against the borrower's home. With this type of collateral, it is needed for borrowers to be cautious about how much of the loan they are able to pay off each month.