In the 1990s, many of the larger lending institutions began using the London Interbank Offering Rate ("LIBOR") as the index of choice when making commercial (and residential) loans due, in large part because of the desire for a global standard for adjustable rate obligations. Along with the rise of the use of LIBOR, interest rate swaps have become increasingly popular.
An interest rate swap is a financial derivative (meaning it has no inherent value but its value is tied to an independent measure such as an interest rate) between two parties which allows, for example, a borrower to exchange payment of its variable LIBOR rate with its swap counterparty (typically a bank or other financial institution) for an agreed-upon fixed rate of interest. It is a contract that is separate and distinct from the financing transaction with which it is coupled. Interest rate swaps are attractive to borrowers because they can, in effect, allow a borrower to achieve a predictable fixed rate on its financing obligation. These contracts are often required in connection with commercial loans and tax-exempt bond financings. There are, however, risks associated with interest rate swaps that borrowers must carefully consider.
One risk is that the terms of an interest rate are negotiated between the parties to the interest rate swap transaction (rather than acquired through a recognized financial market), so a borrower cannot determine whether it is achieving the best terms available. In order to offset this risk, borrowers may want to negotiate with several potential counterparties or, particularly in larger transactions, retain a swap advisor.
Borrowers must also be aware that there is a risk that the counterparty may fail to perform its obligations under the swap contract. This risk was highlighted when Lehman Brothers, which served as a counterparty on many interest rate swaps, filed for bankruptcy in September 2008. A bankruptcy filing is a default under the standardized swap contract, but the bankruptcy does not automatically terminate the swap. After Lehman filed for bankruptcy, many borrowers were left with their obligation to pay the variable rate required under their financings to their lenders and the fixed swap rate to Lehman while deciding whether to terminate their swap. Additionally, when a swap is terminated early, the borrower will likely owe an early termination amount to the counterparty if the fixed interest rate that the borrower was paying under the swap contract is higher than current fixed market rates at the time of the termination.
Sometimes the term of an interest rate swap is shorter than the term of the financing. In such cases, there is a risk that a comparable replacement swap cannot be negotiated when the term of the initial swap ends. In addition, the counterparty may require collateral to secure the swap, in which case the borrower will have reduced liquidity and may be prevented from entering into further financing arrangements.
Another risk, which was highlighted during the recent economic downturn (and more typically arises in connection with tax exempt bond financings), is the risk that the floating rate payments received from the swap counterparty are insufficient to pay the floating rate due under the financing. Many tax exempt financings have been based on the Securities Industry and Financial Markets Association ("SIFMA") rate (an index for tax exempt investments) while interest rate swaps are typically based on the commercial LIBOR rate. Borrowers were often able to get a lower fixed rate under the interest rate swap contract when they agreed that the swap floating rate would be tied to a LIBOR rate, and, up until the fall of 2008, the SIFMA index had historically correlated with a percentage of LIBOR, so many considered the risk associated with coupling the two indices minimal. However, during the economic downturn, there was, at times, an unprecedented narrowing of the spread between LIBOR and SIFMA. As a result, many Borrowers had to supplement payments received from the swap counterparty in order to meet their payment obligations under the financing while still paying its fixed rate to the counterparty under the swap. This risk must also be considered when changing interest rate modes for an existing bond financing.
In addition, when interest rate swap contracts are formed in connection with a tax exempt bond financing, the Internal Revenue Code requires that certain certificates be delivered by the parties within a specified time period in order for the swap to be considered a "qualified hedge" for tax purposes. If these certificates are not delivered in a timely manner, the borrower cannot take interest under the swap contract into account for arbitrage purposes.
To conclude, interest rate swaps can be a beneficial option for borrowers incurring variable rate debt. However, there are several risks associated with swap contracts that borrowers must carefully weigh before deciding whether to enter into these types of transactions.
|
