Swaps are Back - Derivative Logic

We have noticed an increase in bank balance sheet financing of late. Typically, bank loans are indexed to a variable rate (e.g. LIBOR) plus a credit spread. In offering the financing, the banks may require that the borrower enter into a pay-fixed interest rate swap.

There are a lot of misconceptions and negativity associated with interest rate swaps, and much of it is justified. The confusion often results from the bank’s swap “advice”, and their main objective in selling swaps to borrowers – maximizing profits. This often means the borrower locks into a fixed rate via a swap for the full loan balance for the entire loan term. Why? Interest rate swaps are one of the most lucrative financial products a bank can offer. We are talking high double digit, or even triple digit returns, which rival check cashing stores. The secret: Banks get to post the swap profit on their books immediately, and even though swap pricing is more transparent due to Dodd-Frank legislation, determining if the bank’s swap profit is “fair” is usually impossible without structuring expertise and costly pricing systems. Who pays for the bank’s swap profits? YOU DO, in the form of interest expense.

We Love (Well-Structured and Reasonably Priced) Swaps

Hedging interest rate risk by synthetically fixing the rate with a swap is by far one of the best methods to manage rate risk. One needs to distinguish between bank and non-bank fixed rate financing. Life, CMBS, and Agency loans are fixed by circling the 10-year swap or Treasury rate and adding a credit spread. It’s all or nothing, you fix for the entire term for the whole amount. Paying off, or defeasing the loan comes at a substantial cost. The pre-payment penalty is always going to be more than the cost of terminating a swap early.

An interest rate swap is highly customizable. The borrower usually doesn’t have to hedge the entire amount of the loan or fix to the maturity date. A swap can be utilized for 50% of the loan and mature at the hedger’s discretion. For example, an investor intends to sell the asset in 5 years, but the loan is for 10 years. Why fix for 10 years if the intent is to sell in 5 years? Fixing the loan for 10 years when the game plan is to sell in 5 years is adding risk, not mitigating rate risk. If the bank is requiring that the swap be for the total loan amount and the full term, an independent advisor (like us) can negotiate a swap structure that’s more in-line with your plans for the asset, and thereby reduce your exposure to a potentially costly swap termination down the road.

Generally, in higher interest rate environments, it makes sense to consider hedging less than 100% of the loan. A 50% fixed, 50% floating position is commonly considered “neutral”. In other words, if short-term rates rise by 25 basis points the hedger is only exposed to 12.5 basis points of additional interest rate expense. Conversely, a drop of 25 basis points equals a savings of 12.5 basis points.

Very Conservative Borrower = Unwitting Risk Taker

In our experience, when a borrower insists on borrowing at a fixed rate or fixing the rate on a floating rate loan for the entire term with an interest rate swap, their decision is based upon:

Living through “stagflation”
Unwarranted fear of inflation
A belief that interest rates can only go higher

Each is irrelevant to the hedge decision-making process. Strategic decision making based upon history, fear, or expectations is a recipe for disaster. Unfortunately, without the help of an independent third party, fear and greed are all too often a borrower’s main decision-making drivers. Specifically, fear that rates are going higher and greed in believing that by locking in historically low term rates via a swap, that they can eventually sell the swap down the road for a profit. In our decades of experience, emotional choices = disastrous results. The bank’s swap salespeople understand that capitalizing on emotion generates more fees for the bank.

Never Ever…

…enter into an interest rate swap or other type of interest rate hedge without independent advice. With over 150 years of capital markets experience we have the confidence to make such a claim. Ask yourself why the bank is telling you it does not make sense to hire an independent derivative consultant. What if the bank said you should not hire legal counsel to negotiate the loan agreement because the terms are not negotiable – when it is common knowledge that 90% of a loan agreement is stock and 10% subject to revision? The same logic applies to interest rate hedging decisions.

Why Do Borrowers Need Swap Advisors?

Swap pricing is not transparent, and fair value is hard to gauge. The bank holds all the cards, and its critical to have experienced, independent help on your side to level the playing field.
Your hedging choices are never fully presented by the bank. They typically show you what makes them the most money, not what is the most appropriate hedge structure for your unique situation. Don’t let that happen.
The ISDA, the contract that governs all interest rate hedging transactions, clearly states that the bank, when discussing the swap with you, is not advising you and does not put your interests before theirs. Without an independent advisor, you’re on your own. And further…
Despite what you have been told, the ISDA is negotiable. It’s a document that’s often overtly favorable to the bank out of the gate, and begs to be negotiated more toward the borrower’s favor. If you think it’s no big deal to negotiate the ISDA, give us a call to understand why it’s important.
Is the bank’s profit on the swap appropriate? What is market standard? Only an independent advisor can set the rules with the bank in this regard.
How much should be hedged and for how long? Will the bank provide objective advice when their goal is to get the borrower to hedge all of the loan for the entire term? Maximum term and notional = maximum profit for the bank.
A hedging strategy which meets the goals and objectives of the borrower can realistically only be determined from independent advice. The bank is not incented to offer solutions which reduce their profit. Only an independent hedging advisor can do that.

The bank is trying to sell you something. It’s your job to understand it. Do you?

Common Myths and Misconceptions Explained

“The bank is making a bet against me.” We hear this one all the time. The fact is the bank is mainly interested in earning fees. Think of it in this way. Is your stock broker making a bet against you if they sell you a stock or bond? Of course not. It’s the same with swaps.
“The negative termination value of a swap isn’t really a loss to the bank, it’s just another way for the bank to make money.” Part of this is true. Banks may and do charge more than the true value of the swap and the same is true if a swap is terminated. However, if the swap value is negative and terminated at fair market, it is a real loss to the bank and they will expect the hedger to make them whole.
“The bank is making extra on my loan because I have to cut a swap check every month.” What if the bank was paying you because your fixed rate is lower than LIBOR, does that mean the bank is losing money? Keep in mind that if you are paying the bank on the swap, the bank is paying someone on the other side of the transaction (it’s a bit more complicated than that, but it’s basically how the cash flows work).
“Derivatives are risky.” To use a swap to fix a floating rate loan is really no more risky 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. Swaps do allow the hedger to diversify their floating rate debt by fixing the rate on less than the total loan amount or for a shorter term than the loan term. In fact, we would venture to say that a traditional fixed rate loan can be more risky than a floating rate loan fixed with a swap.
“Swaps are the best method to hedge risk.” Sometimes – but banks tend to favor selling interest rate swaps because their profit on swaps can be substantially higher than other hedging alternatives (i.e. rate caps, corridors, etc.).
“The bank told me they are giving us a very competitive rate.” You cannot verify that statement unless you can calculate risk exposure, credit value adjustment, and credit costs – or have us do it for you.
“I’m afraid that if we hire an independent derivative advisor, the bank may get upset and we could 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?
“Why pay an independent derivative advisor when the bank can offer the same service.” Problem with this statement is that you aren’t receiving independent advice from the bank. Read the fine print in that slick swap PowerPoint presentation the bank sent you, or, better yet, read the non-reliance clause in the schedule to the ISDA; they suggest getting independent advice right there in black and white. Also, are you truly receiving the best hedging strategies available and appropriate pricing based upon your credit profile? What about your risk to the bank? What happens to your interest rate swap or cap if the bank goes under and these hedges have positive market value?

Other Considerations of Importance for Borrowers

The looming LIBOR – SOFR transition. How will it impact your swap? Your LIBOR-based loan?
Negotiating loan index floors. Does your swap have this costly feature?
Matching the loan terms to the hedge. Correcting inconsistencies between the loan and swap can be costly down the road.

Are you considering entering into an interest rate swap? Be careful. Put our decades of experience in guiding borrowers in their management of interest rate risk to work for you.

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