The WSJ says that banks are shortening the terms of their revolving credits and tying the interest rate to CDS spreads. The first move makes sense, the second still shows they haven’t committed to fundamental credit analysis.

Now, lenders are cutting the length of many commitments to less than a year. They are charging higher fees for the lines of credit, known as revolvers. And instead of promising an interest rate determined mainly by the company’s credit rating, banks will now charge more if the cost of insuring the company’s debt against default is higher.

It never made any sense to extend revolving credit to even the best credits for more than a year or at most eighteen months. There’s just too many things that can go wrong beyond that time horizon and locking in long term lending commitments was just a bet on the proverbial tree growing to the sky.

Substituting swap spreads for credit ratings is just an extension of the original bad idea of substituting credit ratings for fundamental in-house credit analysis. The sole purpose of this approach is to insulate management from liability. In the event of a loss this approach provides the defense that management relied on independent third party analysis of the risk and therefore bears no responsibility for the loss.

Swap spreads are not necessarily indicative of credit risk. They are indicative of profit expectations. One of my favorite and more rational blogs, Deus Ex Macchiato, put it rather well:

The answer is that it does not matter (much). Most CDS trading is about views on the spread, not views on default. People buy CDS on the US government because they think the spread will widen and they can close out at a profit, not because they think that default is likely. Therefore the CDS market often tells you rather little about default: what it tells you about is market participants expectations of spread movements. CDS spreads go out when there are more buyers of protection than sellers. That is the only reason spreads move. Any connection between CDS spread movements and expectations of default is a modeling assumption, and one that is particularly dubious at the moment.

I’ve no idea how the banks are going to be persuaded to abandon their fascination with models and third party analysis of credit risk. Somehow, though, it has to come about.