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Leveraged loans are booming. Now a new type of derivative could provide greater access to bank lending for junk-rated borrowers

Among the hottest markets in recent years has been that for non-investment-grade corporate loans. Last year companies issued $480 billion of these obligations, commonly called leveraged loans, up from $295 billion in 2005, according to Standard & Poor's. Fueling the growth are a boom in private equity buyouts and increasing demand from investors starved for yield by low interest rates. Now a new wrinkle on leveraged loans stands to help the market expand even more quickly: the development of derivatives called leveraged credit default swaps, or LCDSs.

Wall Street firms dreamed up the instrument two years ago as a way for loan portfolio managers to hedge credit risk. (Standard credit default swaps aren't the right tool for the job because they're linked to high-yield bonds, which are unsecured and therefore more expensive to hedge than leveraged loans.) In July banks and other market participants finally standardized the documentation and other rules necessary to officially launch LCDS trading. Since then contracts on about 200 loans have begun to trade and the notional value of outstanding LCDSs has grown to $40 billion, according to derivatives pricing service Markit Group.

The instruments function like insurance: Holders of loans can buy protection against borrowers defaulting. The sellers of protection -- typically, hedge funds -- receive monthly premium payments from buyers and pledge to pay them a set sum if the underlying loan defaults. Sellers take possession of the buyer's portion of the loan after a default.

Some banks are starting to use LCDSs to limit risk on the loans they underwrite. Banks are particularly interested in using the instruments to hedge their exposure to revolving credit lines, which are harder to place with outside investors because they lack a liquid secondary market. Banks thus wind up holding bigger portions of revolvers on their balance sheets and need to hedge that exposure.

LCDSs played a part in the mammoth $23 billion financing package completed last month for Ford Motor Co. Dozens of banks that were part of an underwriting group led by Citigroup, JPMorgan Chase & Co. and Goldman, Sachs & Co. bought hundreds of millions of dollars of credit protection to offset risk associated with the five-year revolving portion of the financing, say bankers and others with knowledge of the transaction. Ford had originally planned to secure $8 billion in revolving credit, but increased that part of the deal to $11.5 billion because of strong demand driven in part by the LCDS protection.

"Loan CDSs have helped make the market as a whole more efficient," says Andrew O'Brien, head of leveraged finance at JPMorgan.

The Ford deal highlights an important potential benefit for borrowers, related to the expansion of LCDSs. Because they now have the ability to hedge more precisely the risk of holding leveraged loans on their books, banks may extend more credit to speculative-grade companies.

"You will see situations with larger companies where underwriters are a little more aggressive," predicts Daniel Toscano, head of senior debt capital markets for Deutsche Bank in New York.

The cushion provided by LCDSs could even help banks continue to arrange big loans for corporations and private equity firms if investor demand for those obligations shrinks. Today the leveraged loan market is extremely liquid, thanks to a record-low default rate of 1.3 percent for 2006, according to S&P. But the ratings agency projects that defaults will increase to 3 percent in 2007 because of slowing economic growth. That, in turn, could dampen demand for leveraged loans.

The development of leveraged-loan default swaps "has diversified the loan investor base," says Lisa Watkinson, global head of structured products at Lehman Brothers and an early architect of the new product. "The ability to have an effective, true, clean hedge is very important."

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