What Is a Credit Linked Note?

A credit linked note is any security carrying the risk of default on a loan. This may sound confusing, but it can be easily described in a four-step process. The process starts when a lending institution issues a loan. It ends when an investor purchases a security that is actually a derivative of the loan. If all goes well, each party along the way will make money in the process.

Step 1: A Loan Is Made

The first step in the creation of a credit linked note (CLN) is the issuance of credit. This may be any type of loan, but it is typically a large loan such as a business loan or mortgage. Once the lending institution has issued a loan, it has two options. The first is to sit back and wait for the borrower to repay the loan in order to profit. The second is to pass the loan onto another institution, freeing up cash for yet another loan, and potentially earning more in the process

Step 3: The Loan Is Sold

If the bank decides to pursue the second option, it begins by shopping the loan to different trusts or special purpose companies (SPCs). Typically, the bank must pay an annual fee to these institutions in exchange for the risk it is passing on. It must also disclose any risks associated with this loan. For example, if the loan is subprime, the lender should share this information with an SPC. This gives the SPC an idea of how likely it is for the borrower to default, and the SPC can decide accordingly whether to purchase the loan.

Step 2: A Special Purpose Company Divides up the Loan

If the SPC purchases the loan, it will also want to divide up the risk by selling it to another investor. Instead of selling the loan as one entity, though, the SPC will divide the loan into multiple parts. Each of these parts can become its own security. Similarly, each of these parts could potentially be bundled up with other loan parts or other types of securities. The resulting product carries some risk of the original loan, but if all has gone well, at least part of the risk has been countered through divvying up the loan.

Step 3: Investors Purchase the Divvied up Loan

Investors purchase the divvied up loan in the form of a security. Over the life of the CLN, the investor receives a coupon rate. If the original loan is repaid, the investor also receives par value of the security back in return at the end of the loan's life time. If a default occurs, however, the investor receives back only a discounted risk premium on the purchase. The SPC loses money as well, and this may be charged back to the original lender depending on the structure of the CLN and how many times it has been divided up. If the loan is divided up into a high number of packages, and the other loans in these packages go into default as well, all parties will lose money. 

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