Margrave Celmins, P.C. Newsletter

INTEREST RATE SWAP MAY BE A GOOD DERIVATIVE

There has been a lot of criticism of late about financial derivatives and how they played a role in inflicting substantial damage on the economy. There has even been legislation recently enacted back in Washington for regulating derivatives to a degree. What is a derivative? A derivative is a financial product that is said to derive from an underlying market dealing with currency, interest rates, equities and the like. Contrary to popular belief, maybe not all derivatives are bad, and some may be quite useful.

We had an opportunity recently to assist a client who was concerned about rising interest rates in the future in connection with a sizable real estate loan with a variable interest rate. The client wanted some protection against a drastic rise in future rates that would negatively impact the transaction and cash flow. So the client went to its bank and in connection with obtaining the real estate loan at the going commercial rate, it also entered into an interest rate swap agreement with its lender in an effort to protect itself against future rate increases over a period of time. While the notional amount under the interest rate swap agreement often equals the principal amount under the loan agreement, there is no mandate that it must do so. And the bank's client can enter into a swap agreement for a portion of the loan balance, thereby making it partially fixed with the balance floating.

Overview of How It Works

How does such a transaction work? Here is a very short and simple overview of what is involved and what some of the inherent risks are. The borrower goes to its bank and is offered a floating rate loan for, say, a twenty year term on a real estate project. The bank's customer is concerned that with government spending as it is and the likelihood of inflation as the economy recovers, it has financial exposure to a substantially higher floating interest rate down the road that would negate all of its cash flow projections and the economics of its deal. So in order to "hedge" its risk, the borrower asks its bank if they can offer an interest rate swap transaction on a notional principal amount that would mirror the actual principal amount borrowed under the loan documents. The bank says it can accommodate its customer's needs.

This swap transaction is really an exchange of cash flows whereby the borrower agrees to pay the bank a fixed-rate interest amount pursuant to that swap agreement while the bank commits to pay its borrowing customer a floating rate on the notional principal amount. So in principle, the borrower has effectively swapped its variable or floating rate for a fixed rate. The negotiated fixed rate is going to reflect what the market expects the floating rate, on average, to be in the future. While in the beginning the net interest payable under the two transactions will favor the bank under the scenario outlined above, over time that trend would likely reverse under the rising interest rate scenario so that downstream the payments would favor the borrowing customer. The anticipated result is that over time, the borrower will be able to average out its interest costs and enable it to have more predictable financial results.

In a simple example which assumes a lower variable rate of interest at the present time, the bank's customer pays its bank the lower variable rate of interest under its real estate loan agreement. Under the swap agreement, the customer will pay its bank additional moneys representing the difference between the higher fixed and lower variable rates of interest as long as the fixed rate exceeds the variable rate. Five years down the road and assuming that the variable rate of interest has by then substantially increased, the bank would be paying its customer under the swap agreement the difference between the then-higher variable rate and the then-lower fixed rate. So this swap transaction is really geared to enable the bank's customer to manage its interest rates.