What is an Interest Rate Swap?
During my 15 years in banking, I found that one of the most confusing products for my clients was an interest rate swap. It’s not surprising as this is a challenging topic not only for commercial lending clients but for bankers as well.
What exactly is a swap? A swap is a derivative contract and/or an agreement between two counterparties to exchange a series of cash flows or financial instruments over a period of time.
There are Several Different Swap Products
There are several different swap products including Currency Swaps, Commodity Swaps, Interest Rate Swaps, Total Return Swaps, Credit Default Swaps, etc.
Total Return Swaps have been in the news lately as this was a product used by the Family Office, Archegos Capital Management, run by Bill Hwang. The collapse of Archegos Capital was brought on by investments in concentrated positions using derivative products such as Total Return Swaps. Total Return Swaps are common derivative instruments which allow a customer to bet on underlying securities without actual ownership of those securities.
Investors in these derivative instruments receive the total return of a security from a dealer. These returns are typically amplified in either direction with the use of leverage.
The family office, Archegos Capital, was highly leveraged and substantial losses resulted from margin calls and bets turning against the firm. There was lack of transparency and disclosure between the investment banks and brokers offering the same products; investment banks lost billions.
You may have also heard of a Credit Default Swap (CDS). A CDS is like an insurance policy that protects against the default of bonds. Investors also use them to protect against collateralized debt obligations and mortgage-backed securities. This financial instrument played a big role in the 2008 financial crisis. According to the International Swaps and Derivatives Association (ISDA), there were $62.2 trillion outstanding Credit Default Swaps by the end of 2007. Due to the lack of transparency and reporting, it wasn’t realized that the financial institutions selling the credit default swaps were actually undercapitalized. When debtors defaulted, the system failed and large insurers like AIG were left needing a bailout. AIG insured collateralized debt obligations (CDOs) against default using credit default swaps. Although the insurance product generated a lot of revenue for years, big losses took the insurance giant down to its knees when bonds and mortgages defaulted.
Interest Rate Swaps
Back to our topic at hand, Interest Rate Swaps. An interest rate swap (IRS) is actually one of the simplest swaps. There are typically two parties that are exchanging interest rates. The interest rate in an IRS has been based on Libor in the past although banks are required to end the use of Libor at the end of 2021. The Secured Overnight Financing Rate (SOFR) will likely take its place.
“Plain Vanilla” swaps exchange fixed-rate payments for floating rate payments; this is the most common type of interest rate swap. One party pays a fixed interest rate while the other party pays a floating interest rate. Every year the fixed rate payer pays a cash flow that equals a percentage of the principal. The difference of the cash flow payments is exchanged meaning the principal itself is not exchanged, just the notional principal/cash flows. The streams of cash flows are called legs of a swap.
After the swap is executed, the bank usually offsets the swap through an inter-dealer broker. The inter-dealer broker may sell it to counterparties. Each counterparty may benefit from the exchange. For example, an interest rate swap product may benefit the lending client by providing a potential reward depending on which direction interest rates are likely to go. The lending client also benefits by receiving a steady fixed rate which helps to manage cash flow. Institutional investors use interest rate swaps to manage risk, hedge and speculate on the direction of interest rates.
Interest rate risk is the main risk within a swap. Ultimately, it’s a zero-sum game. The gain of one party will be the loss of the other party. If your company decides to enter into an IRS contract, it will be bound to the agreement for the length of the contract.
Advantages of swaps for commercial borrowers:
Borrowers typically want long-term fixed rates. Since many banks do not want to offer a long-term fixed rate, they may suggest an interest rate swap. Three main benefits include: possible prepayment benefits; swaps typically provide the lowest rate available; and swaps provides the borrower with a steady fixed rate and flexibility.
How does the bank benefit from Interest Rate Swaps?
Interest rate swaps definitely benefit the bank by reducing interest rate risk. Banks tend to have a mismatch between their assets and liabilities. Liabilities are deposits while assets are the loans given to different companies. Long term loans are funded by short-term deposits.
If rates were to rise, the bank would be obligated to pay depositors a higher interest rate but are often locked into loans with lower rates. Banks have a risk management group called Asset Liability Management; this group focuses on the balance sheet by matching the risks of the assets to the risks of the liabilities. A swap allows the bank to convert some of its long-term fixed rate loans into variable rates. The bank is safer when they have assets and liabilities at a floating rate.
There is economic benefit to the bank as well. The bank receives a fee for executing the original swap. Non-interest income (fee income) is recognized in the period that the swap is executed.
What are the Risks of an Interest Rate Swap Product?
There are two main risks: counterparty risk and interest rate risk. Counterparty risk otherwise known as credit risk relates to the chance that one party will default. Given that many swap contracts are cleared through Center Counter Parties (CCP), default risk is minimized but not eliminated.
If your bank is suggesting an Interest Rate Swap there are a few things to consider:
- The borrower must meet swap product eligibility requirements under the Commodity Exchange Act which generally means that a borrower has greater than $10 million in total assets and net worth in excess of $1 million. The borrower must qualify as an Eligible Contract Participant (ECP) and each guarantor must also qualify as an ECP. Many banks may limit swap transactions for borrowers to those with principal loan amounts of at least $1 million and a minimum of three-year loan term length.
- Are you comfortable with a variable rate loan or would you prefer a fixed rate loan? Companies with tight cash flow may want a fixed rate loan to minimize vulnerability related to interest rate volatility. If you are a borrower that is sensitive to changes in interest rates, a fixed rate loan via an IRS may be right for you.
- It’s important to consider the future direction of interest rates. In a rising rate environment, the interest rate swap protects the borrower against higher borrowing costs associated with higher interest rates. If interest rates drop, the borrower will be locked into the swap contract therefore the borrower will forgo the benefit of lower interest rates.
- Do you have an interest in paying the loan down early or making extra principal payments? When you enter into an interest rate swap agreement, you are bound to the length of the contract. Both parties are exchanging a series of cash flows over a specific period of time. The payment schedule must be followed.
- If the borrower pays off the loan prior to the date of termination, the borrower will either receive a termination payment from the lender or possibly owe a termination payment to the lender.
- With a fixed rate loan, a prepayment penalty is due if you pay off the loan early. Variable rate loans do not have prepayment penalties. With a swap, the borrower must settle the swap contract at market value. Depending on the direction of interest rates, you may be in a liability or you may have an asset.
- A swap will allow you to secure an interest rate on future financing but it should be noted that banks typically require a company to establish an interest rate swap product at the time of loan initiation or before loan initiation (not after the loan is in place).
- A swap can be completed on just a portion of your loan.
To learn more about LonaRock, LLC and our business debt finance consulting services, please visit our website at www.lonarock.com or contact us directly at 234-217-9033. We look forward to helping you become an ideal business client and helping you obtain the best possible financing for your company.