How CDS Protection Can Finance a Corporate Loan
Summary
The document discusses ways credit default swaps may connect to corporate funding, while distinguishing a protection-selling income strategy from a specific financing structure. In the described historical deal, one bank lent to a young corporation at a high spread, while another bank paid an upfront amount to buy credit protection referencing that borrower. If the borrower defaulted, the lender would owe a much larger payment under the protection contract; if not, the protection buyer received no repayment of its upfront fee. The lender used that cash to help fund its loan, while increasing its overall exposure to the borrower’s credit.
The account says the arrangement referenced a private company with little public debt, making a similar transaction difficult to arrange under current conditions. It presents the structure as an unusual case rather than a standard funding technique, and gives no detailed legal, accounting, or risk analysis. A separate answer mentions CDS as a possible income strategy when selling protection on bonds, but does not explain its financing mechanics.
Key ideas
- A bank can use an upfront CDS premium received from a protection buyer to help fund a corporate loan.
- The protection seller takes on additional credit exposure beyond its direct loan to the borrower.
- The described contract paid out on borrower default and provided no repayment to the protection buyer if no default occurred.
- The example involved a private borrower with limited publicly traded debt, which constrained the reference contract.
- Selling protection on bonds is also described as a possible income strategy, with limited detail.
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Full text
# CDS for Funding # CDS for Funding I was wondering if anyone is familiar with how credit default swaps can be used for corp funding and financing. I came across an old case where a bank created a funding structure for a client (asset manager). However, I'm not familiar with how this takes place. Any insight on the above would be greatly appreciated. Thank you, Faisal ## Answer by DataAdventurer (score 1, accepted) https://quant.stackexchange.com/a/34908 I'm not sure if I understood your question right. What is a CDS? "agreement that the seller of the CDS will compensate the buyer [...] in the event of a loan default [...]. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller [...]" https://en.wikipedia.org/wiki/Credit_default_swap How this could be used? The Investmentbank could have helped the Asset Manager to sell the protection against the default of a bond or a basket of bonds, as an income generating strategy. ## Answer by Dimitri Vulis (score 1) https://quant.stackexchange.com/a/85625 I saw one unique deal in the early 2000s. Perhaps you saw the reference to the same deal. Background: Young corporation X did not have any publicly traded stock or bonds, wanted capital. Bank Y emphatically did not want to lend to X. Bank Z was willing to lend to X. The deal: Bank Z lent some money to X, charging L+700 interest, to be repaid in 5 to 7 years. Bank Y bought (naked) CDS protection from bank Z, referencing X. It was structured as zero-coupon, zero-recovery. Might have been phrased as letter of credit (LOC). Please note that today it would be very difficult to trade any CDS/LOC referencing a private entity with no bonds and hardly any loans, but back then it sometimes happened. The meaning of the deal: Y paid a large upfront fee to bank Z, the only cash flow. If X defaulted on the loan from Z, then Z would pay lots more money to Y, but if X did not default, then Y would get nothing at all. Z was long X's credit - creating a much larger credit exposure than the loan alone. Z used the money from Y to fund the loan to X. Y was short X's credit, called this a hedge for their other long credit exposures. Note that Y's actions might have made more sense if Y had previously been long X's credit, and wanted to offset that, but this was not the case. The aftermath: X used the capital wisely, grew much larger and healthier. It now issues IG bonds, trading around S+150. X was grateful to Z for believing in them when they were little, and has a good business relationship with Z. Bank Y was mad! Bank Y threatened to sue everybody, but did not. Everyone familiar with the story did not feel like doing something similar ever again. ## Answer by Moomin (score 0) https://quant.stackexchange.com/a/85623 From an accounting perspective, CDS spreads provide a market-observable proxy for funding costs, ensuring FVA reflects the "exit price" required under fair value measurement standards like IFRS 13. The application of CDS spread ensures that financial statements accurately capture the impact of an entity’s own credit risk on its marginal borrowing costs for uncollateralized derivative positions. Regarding hedging, CDS serves as a liquid instrument to offset P&L volatility, allowing banks to neutralize the funding risk tied to fluctuations in their institutional credit spreads.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.