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Lower Risk with Derivatives (July 28, 2006)

Location: Washington, D.C.
Author: Ellen J. Silverman
Date: Friday, July 28, 2006

Alan Greenspan has always favored derivatives since they provide capital to help companies avert a credit crunch and reduce risks by making financial markets resilient to shocks. At a time when oil prices are above $70 a barrel and more than two dozen central banks have raised interest rates since May, derivatives are allowing companies to borrow a record $607 billion and obtain relatively cheap financing.

By bundling more than 10 percent of that lending into so-called collateralized debt obligations (CDOs), bankers are able to provide more cash to companies. Defaults fell to the lowest level since 1997 as sales of CDOs rose 63 percent to $177 billion in the first half, according to the Bond Market Association. Derivatives "help explain why the default rate has remained this low as long as it has," said David Hamilton, director of default research at Moody's Investors Service.

Eastman Kodak and cable-television operator Charter Communications, which both reported losses of more than $1.6 billion over the past six quarters, had an easier time raising money because of CDOs. Kodak got $2.7 billion in loans in October, including $1.2 billion that paid 2.25 percentage points above the benchmark London interbank offered rate. As recently as three years ago, borrowers with similar ratings had to pay an interest margin of more than three percentage points above the dollar London interbank offered rate or Libor. The company was able to borrow even after Moody's lowered its ratings three times since the beginning of 2005 in part because its debt and credit-default swaps are contained in more than 150 CDOs, according to CreditSights, a New York-based bond research firm. Access to capital means that Kodak has more time to return to profitability.

Jeffrey Rosenberg, head of credit strategy in New York at Banc of America Securities, said, "The broader implications of all of this from a fundamental point of view is to provide an extension of the time that corporations have to access capital at very attractive rates." The additional lending, he added, "has helped postpone the increase in default rates." Sales of CDOs totaled $249 billion last year, up from $157 billion in 2004, according to the Bond Market Association. Corporate-bond yield spreads would have widened 0.03 percentage point to 0.05 percentage point more since May without demand from the instruments, according to Edward Marrinan, head of North American credit strategy at J.P. Morgan Securities. Based on the $5 trillion corporate-bond market, investors have been spared $2.5 billion in losses. CDOs have "helped limit the damage," Marrinan said.

In the case of Charter Communications, access to capital helped it weather a cash shortage. Charter's 2005 earnings of $1.9 billion were not enough to pay $1.5 billion of interest and $1.1 billion of capital expenses, according to the bond research firm Gimme Credit Publications. In September Charter persuaded investors to exchange $6.8 billion of debt at a discount for new bonds with longer maturities to improve its "financial flexibility." "Charter is a great example of a life-extension deal," said Raymond Kennedy, head of the high-yield debt group at Pacific Investment Management.

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