We often hear from clients, and especially prospects, that, when hedging interest rate risk, their lending bank can’t understand why an independent hedge advisor is necessary. The bank’s state that, by law, they’re required to provide the “mid-market” and then add their spread (fee) . Click to read our related report, “Dodd-Frank and the Illusion of Transparency”
Why, the lending bank asks, should a borrower engage an outside independent hedge advisor? The bank’s reasoning being that all the advisor is going to do is negotiate pricing. Why, the bank explains, spend money on an advisor who doesn’t understand the lender-borrower relationship? To combat the advisor’s involvement, the bank will offer to lower the derivative fees to offset any advisory fees due to the likely long-standing lender-borrower relationship. Such an offer begs the question: Does that imply the bank might not be so accommodating the next time the client wants a new loan? Keep in mind, interest rate derivatives are one of the most profitable products a bank offers, and any bank’s offer to reduce its fees to dissuade the borrower from using an independent advisor should set off alarm bells in a borrower’s mind.
What you don’t know and why an independent advisor is necessary when hedging interest rate risk:
1) Is the bank’s spread over or under “mid-market” appropriate?
2) Do the terms of the hedge match the underlying exposure?
3) Are you over or under-hedged?
4) Is the trade fairly priced?
5) Does the ISDA agreement match the terms of the underlying loan? The ISDA is the most overlooked document the hedger is asked to sign. A non-negotiated ISDA is always in the bank’s favor, and is negotiable, regardless of what the bank is telling you.
6) Do the economics of the hedge match what was agreed to? An additional month can add 20% or more to the cost of the hedge.
7) 5 decimal places on the swap rate or 4? Doesn’t seem like a big deal, but it is.
8) What curve is being used to value the bid or offer of the price of the hedge? Different curves often generate very different valuation results.
9) Most companies, not-for-profits, Native American Tribes, Family offices, REITs, Private Equity firms, and real estate developers use independent advisors to ensure fair pricing, spread over mid-market, ISDA terms, and accuracy. Do they know something you don’t?
10) Some of the firms we deal with are Fortune 500 companies. They should have the ability to price a derivative internally, but are rarely able to determine the bank’s cost of a given hedge. Why? In our experience, the corporate CFO or Treasurer and the pricing system they’re using come close, but not close enough to determining the bank’s actual cost of offering the hedge. A pricing system is only a worthwhile investment if the operator knows how to use it.
11) Companies often lease a pricing system with “live” feeds of current interest rate indices. What happens if the lights go out or the live feeds don’t make sense? What is the contingency plan?
13) Our firm was asked by a client recently to verify if their interest rate swap matched the parameters of the underlying loan. After reviewing the loan terms and the swap economics, there was a huge discrepancy in the valuation between what the bank calculated and our calculation. To clarify, our firm wasn’t engaged to advise on the swap. As a direct result of our involvement, the company was able to negotiate a refund of over $300k because of the mismatch. This client was lucky because the relationship with the bank overshadowed the loss. Technically, the hedger was obligated to the swap contract. This was a unique situation because the client had significant assets with the bank. Keep in mind the bank made the mistake, however if it wasn’t for the relationship, the hedger would legally be liable.
Ask yourself, do I really know how to manage interest rate risk?
Am I getting sound advice from my banker? Good question, but why not have an independent advisor double check hedge pricing and structure based on your – and not the bank’s – specific goals and objectives. Have an independent third party verify if the fees the bank is charging match the credit risk they’re taking.
Our firm has an excellent relationship with banks, and our philosophy is to work together with your lender, legal, and credit advisors.
Why would a bank dissuade you from using an independent advisor when the disclaimers in their hedge presentations, hedge agreements and trade confirmations recommend it? The following are samples of disclaimers from banks we see on a daily basis:
You should conduct a thorough and independent evaluation of the financial, tax, accounting, legal and regulatory characteristics, consequences, costs and risks of the transaction in light of your particular circumstances, based upon the advice of your own financial, legal, tax, accounting, and other professional advisors.
Counterparty should conduct a thorough and independent review (either itself or with such advisers as it deems appropriate) of the legal, tax and accounting aspects of any proposed transaction in light of its particular circumstances.
You are solely responsible for making your own independent appraisal of, and investigation into the products, investments and transactions referred to in this document…
You will be exercising your independent judgment and relying upon your own professional advisors that you deem necessary to evaluate such Swap, trading strategy, recommendation, disclosure or information, including financial, tax, legal and accounting advisors. You will not enter into any Swap or trading strategy unless you or your professional advisors are capable of evaluating such Swap, trading strategy, recommendation, disclosures and information and making trading decisions, and if you have answered “Yes” to the “Capable Persons Policy” question in respect of yourself on the Customer Questionnaire, then you further represent that, prior to entering into such Swap or trading strategy, you will have complied in good faith with written policies and procedures that are reasonably designed to ensure that the persons responsible for making such evaluations and trading decisions are capable of doing so.
We speak from experience. In our decades in the capital markets hedging interest rate risk, if one of us were to become a real estate developer, we would never enter into a derivative transaction without independent advice.
Current Interest Rates