Explanation of Credit Linked Notes

A credit linked note is a credit derivative that pays investors based on payment of a debt. There are four parties involved in order for a credit linked note (CLN) to come into being: the borrower, the lender, a trust and an investor. The borrower takes a loan from a lender. The lender engages in a default swap with a trust. The trust sells the default swap to an investor. This eliminates the need for an insurer on the loan, but all the parties will stand to lose if the borrower actually defaults. 

Credit Default Swap Model

The first step is for a lender to set up a credit default swap with the trust. The lender or dealer agrees to pay a trust an annual fee. This fee can be passed onto investors to engage them in the opportunity. The fee is paid in exchange for a service rendered. That service is like insurance on the loan; if the borrower defaults, the trust will pay the lender whatever amount it fails to recover on the debt.

Credit Linked Note Model

The trust can do this because it has funding from investors. They play a crucial role in allowing the trust to operate. It could not simply agree to pay lenders in the case of a default if it was not funded with a large amount of capital. The trust earns this capital by taking on money from investors. They earn a sum equal to the par value of the loan plus the annual fee provided by the dealer if the borrower repays the debt. However, if the "specified event" occurs (i.e., the borrower defaults), the investors lose everything. The trust has no obligation to repay the investors the sum. They are repaid only the recovery rate plus a small annual fee.

Problems with Credit Linked Notes

CLNs work well if borrowers are creditworthy. In a market of creditworthy borrowers, very few will default, leaving the investor with plenty of opportunities to make money in exchange for only a few losses. However, in a market of borrowers who are not creditworthy, the situation rapidly changes. This is what occurred prior to the credit market crash of 2007. Too many borrowers were not qualified for their loans, and lenders sold the default swaps as if the borrowers were in good standing. The default swaps were bought up by trusts and investors who were essentially duped into believing they were purchasing a valuable asset.

Systemic Risk

The term systemic risk is often applied to credit linked notes. Often, the lender does not issue one credit default swap per loan. Instead, the loan can be broken up into small pieces, resulting in multiple swaps and multiple CLNs. This means one default can lead to small losses across multiple trusts. As long as the losses are small, the risk is negligible. However, when losses are large, the risk is amplified in this scenario. Systemic risk due to heavy investment in credit linked notes is a key reason many investors, including large institutions, lost large sums in the credit crash.

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