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Interest rate swaps: don't play with matches.

Our moms, from opposite ends of Mississippi and two decades apart, admonished us not to play with matches. It was, and remains, good advice. As one matures, he or she realizes the operative word is "play" We can "use" matches, but we shouldn't "play" with them. The same holds true for interest rate swaps. The goal is to keep from getting burned.

This article describes a standard interest rate swap whereby a commercial borrower desires to "swap" a variable interest rate for a fixed interest rate. Our example will involve a corporate borrower, Risk Adverse, Inc., closing a $25,000,000 term loan, with even principal payments of $100,000 per month, interest accruing at a variable rate of one month LIBOR plus 250 basis points, and a balloon payment of all remaining principal at the end of ten years. At inception, assuming a March 11,2015 closing, the initial variable interest rate would have been 2.6765%. Assuming the variable rate remained the same for the first year, total interest paid over the first 12 months would equal $665,363.

Let's assume the clairvoyant CFO of Risk Adverse, Inc. is convinced that interest rates are about to skyrocket like AAPL since 2009. The diligent, albeit cautious, CFO has stress-tested the company's pro forma financial statements for the next ten years to quantify the impact of increased rates. After all, the one month LIBOR rate (now a paltry 0.1765%) was a whopping 5.824% as recently as 2007. Gosh, if only the company could hedge against rising interest rates. They can? Interest rate swaps to the rescue!

Assume Risk Adverse, Inc. entered into an interest rate swap on March II, 2015 for a fixed rate of 4.69% pursuant to a standard ISDA derivative contract, which shifts the floating risk from the borrower to a third party. As interest payments are due, the borrower will pay the interest on the loan at the fixed rate into an account. Depending on movement of rates, the third party swap provider will either (1) pay the additional amount needed to make up the difference between the fixed and LIBOR-floating rate [if the variable rate loan is higher than the fixed rate] or (2) pocket the extra money [if the fixed rate is greater than the variable rate]. Risk Adverse, Inc. would pay $1,165,909 in accrued interest in the first year (rather than $665,363 for a variable rate assuming rates didn't move) and the third party swap provider would pocket the difference in consideration for having absorbed the risk.

Risk Adverse, Inc. can quit worrying about interest rates and instead focus on producing widgets.

Everyone is happy! What could go wrong?

Buyer's Remorse. To borrow, butcher and hyperbolize a phrase, hell has no remorse like a CFO who entered into a swap right before rates fell. Swaps--like stocks --are priced by the second. We have watched CFOs price swaps daily in an effort to pick the best moment to lock the rate. And for good reason. Add a few basis points to the interest rate on 10-year large commercial loan and the numbers add up quickly. In our example, a swing of a mere 50 basis points on the fixed rate would cost (or save) the borrower a net present value of $891,800 in interest cost over the fife of the loan.

Change in Plans. But interest rates aren't the only things that

change. So do markets and business models. At the time the swap contract was executed, Risk Adverse, Inc. was pleased to have locked the rate for 10 years. But then, some years later, the business changed. Who knew their product (think Blackberry) could possibly lose market share? Or the price of oil would fall? The once perfectly acceptable swap could become a pecuniary albatross.

Higher, Counterintuitive Math. Regardless of the reason, let's assume Risk Adverse, Inc. wants out of the swap. Not surprisingly, the swap contract contains a breakage fee provision (somewhat similar to a make-whole provision in a non-recourse, permanent loan). The sophisticated third party swap provider made a 10 year deal, has invested accordingly on its end, and expects its bargained-for return over the remaining life of the contract.

So, how do you calculate the breakage fee? Good question. Conventional wisdom --such as an option price compared to the strike price--doesn't apply. The breakage fee is less of a function of today's LI BOR rate and more a function of expected future rates over the remaining term after taking into consideration the declining principal balance. It can be counterintuitive. And unlike a make-whole provision, the "breakage" of a swap could result in a payment to the borrower. Our advice? Don't trust your own calculations (or a trust) but instead obtain frequent quotes from a swap desk.

If we have made interest rate swaps sound complicated, it is because they are. And we have barely scratched the surface. We have yet to discuss forward swaps, cross-collateralization, cross-defaults, embedded swaps, mark-to-market valuations, or the twenty-eight page ISDA Master Agreement. Although the goal is to reduce risk, an interest rate swap is not for the faint of heart.

On the positive side, a swap is flexible. You can swap part of the debt or even swap it for less than the full term of the loan. Risk Adverse, Inc. could have swapped $12,500,000 for 5 years (instead of $25,000,000 for 10 years). It is a question of how much you want to hedge, your time horizon, and your level of risk aversion.

For the sophisticated commercial borrower, interest rate swaps offer a viable derivative tool to manage interest rate risk over the long term.

Live long and prosper.

Ben Williams and Molly Jeffcoat Moody are attorneys in a commercial law practice at Watkins & Eager PLLC ( Ben is recognized by Chambers USA and Best Lawyers in America and was selected as Best Lawyer s 2014 Commercial Finance Lawyer of the Year in Jackson. Molly is recognized by Chambers USA in the area of Real Estate Law.
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Title Annotation:COMMERCIAL FINANCE 701
Comment:Interest rate swaps: don't play with matches.(COMMERCIAL FINANCE 701)
Author:Moody, Molly Jeffcoat; Williams, Ben
Publication:Mississippi Business Journal
Date:Mar 20, 2015
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