Interest Rate Swaps: 10 Myths and Misconceptions

The professionals at Derivative Logic have over 100 + years of combined capital market experience on the trading floors of major derivative dealers. During our countless discussions with clients from a myriad of industries over the years, we came up with a list of the most common misunderstandings about interest rate swaps.

1: “The Bank is betting against me”

We hear this all the time. The fact is the bank is mainly interested in earning fee income by marking up the swap rate, not making bets. Think of it in this way: Is your stockbroker making a bet against you if they sell you a stock or bond? They make their money by charging a commission to execute the purchase or sale of the security.

2: “When unwinding a swap, the negative termination value is another way for the bank to make money”

Part of this is true. When you pay off your floating-rate bank loan and simultaneously terminate your swap before its maturity and the swap rate is higher than current swap term rates, then you are going to have to write a check to get out of the interest rate swap. The bid/offer spread from mid-market is set by the bank and there is no rule as to how many basis points from mid they can add when quoting a termination value. The bank has the opportunity to quote a value based on a subjective spread and then sell the position at a more favorable spread from mid-market.

The same is true if a swap’s termination value is positive and they are paying you to unwind it; they may pay you less than it’s worth. However, if the swap value is negative and terminated because of a default at fair market value, it is a real loss to the bank. The bank does have risk as a counterparty to the swap in the event of a default and the termination value is negative. What is a fair swap fee/spread for the risk the bank is assuming in the event of a default?

3: “The bank is earning more in interest because I have to write a check every month on the swap”

What if the bank was paying you because your fixed rate is lower than SOFR, does that mean the bank is losing money? No. Simply put, if you are paying the bank on the swap, the bank has hedged the position, and the payments net out.

4: “The ISDA is non-negotiable”

This is partially true. The swap contract between you and the bank is called an ISDA Agreement and comes in two parts: 1) The Master Agreement and 2) the Schedule. While the ISDA Master Agreement isn’t negotiated – it’s sort of like a Webster’s dictionary for derivatives – the Schedule should be, but often times is not because most borrowers are not aware they can negotiate the Schedule.

The Schedule is where the agreement gets “customized” to include language that protects the borrower and should match the language in the loan agreement. If the bank ever tells you the ISDA isn’t negotiable, is “standard” or “boiler plate”, a siren should go off in your mind. You always have an opportunity to negotiate the Schedule and level the contractual playing field. Is it worth the effort? Absolutely, as banks typically offer ISDA agreements that, out of the box, are overwhelmingly in their favor.

5: “Derivatives are risky”

You may recall Warren Buffet’s quote “Derivatives are financial weapons of mass destruction.” While certainly noteworthy, Mr. Buffet wasn’t referring to a borrower executing a derivative to manage interest rate risk when he made that statement. Employing a swap to fix a floating rate loan is no riskier than a fixed rate loan that includes make-whole provisions and/or pre-payment penalties.

Your risk is simply opportunity risk – you may have been better off floating or structuring a hedge that actually increases interest rate risk rather than mitigating exposure to unfavorable changes in interest rates. One of the main reasons it is important to seek independent advice. Among other benefits, interest rate swaps offer the hedger flexibility – a key feature in today’s economy – to diversify their floating rate debt by hedging an amount less than their full loan obligation or for a shorter term than the loan term.

In fact, for many borrowers, we would venture to say that a traditional fixed-rate loan can be riskier than a floating-rate loan fixed with a swap.

6: “Swap rates are transparent; one can easily get a swap rate by searching the internet”

Highly traded securities are very transparent in terms of bid/offer and the broker doesn’t mark up the price, they just charge a commission.

Anyone can access live market pricing on securities traded on an exchange. The swap market isn’t transparent because the swap rate is determined by numerous factors such as term, amortization schedule, and notional. There is no exchange for customized hedges and that is why a swap executed with a bank is an Over-the-Counter (“OTC”) transaction.

The reason a swap is a derivative is because the value is derived from futures contracts.
Interest rate futures contracts are traded on an exchange, however the notional on the contract is standardized to be $2,500 for a term of 90 days and settling on the 3rd Wednesday of the month. To hedge on the exchange is tricky because the contracts aren’t going to match the terms of the loan. Trading in the futures market can also subject the hedger to margin calls.

Dodd-Frank (Wall Street Reform and Consumer Protection Act) regulations were enacted on July 21st, 2010 as a result of lax oversight and overly extreme risky lending practices which were just some of the big issues that led to the worst economic recession since the Great Depression of 1929.

Before Dodd-Frank, there were no regulations that required a bank (swap dealers) to disclose the fair market value of an interest rate swap to the counterparty (borrower). To increase transparency, banks (swap dealers) are required to disclose the mid-market value before the trade is executed. While the spirit of the legislation was well intended, the reality is that disclosing the fair market value does not fully address the issue of transparency.

The swap spread banks charge over mid-market is not regulated. The bank can mark up the rate by as much as they want. How the bank comes up with their spread is kept a mystery. The spread is based on too many variables for the majority of borrowers to figure out if the swap fee is fair based upon the risk to the bank of a default.

Engage an independent advisor to provide the necessary transparency to better understand the swap fee and ways to reduce costs.
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7: “A pay-fixed Swap is the best method to hedge floating rate debt”

Banks tend to favor interest rate swaps because the fee income can be substantially higher than other hedging alternatives (i.e. rate caps, corridors, swaptions etc.). For some borrowers, a swap may not be the best solution to mitigate interest rate risk.

8: “My bank is offering a competitive fixed rate”

How do you know? There is no way to verify that statement unless you can calculate risk exposure, credit value adjustment, and credit costs. Simply comparing the rate you’re being offered to other lender’s offers isn’t enough. Knowing the lender’s cost of funds and true risk in making the loan is the real way to negotiate.

9: “I’m concerned if I hire an Independent Derivative Advisor, I may lose some negotiating power”

Would you feel the same way about hiring an attorney or accountant? The bank may say “You don’t need to hire an independent advisor because that is what we do for our clients”. Would the bank say the same thing about hiring an attorney?

10: “Why hire an Independent Derivative Advisor when the bank can offer the same service”

The problem with this statement is that you are not receiving independent advice from the bank. Simply put, the bank is trying to sell you something and it is your job to understand it. Read the non-reliance clause in the last few pages of that snappy swap PowerPoint presentation the bank sent you, or in the ISDA Schedule.

What do they say? They spell out in black and white that the bank does not have your interests at heart, that they are acting in their own interests, and suggest you seek independent advice. Also, are you truly receiving the best hedging strategies available and at pricing appropriate based on your credit profile or the bank’s risk in the event of a default?

Keep in mind the swap is a separate contract from the loan. In credit-challenged times, what about your risk to the bank? What happens to your interest rate swap or rate cap if the bank goes under, and the hedge has a positive market value? How will you realize that gain if the bank no longer exists? There are ways to mitigate the risk in the event a bank defaults on its obligations.