Negotiate the Terms… and then the price.
Each new swap agreement will contain terms and conditions as set forth by an “ISDA” documentation which should be negotiated to suit the individual client. The swap agreement can be as flexible as the two counterparties agree upon, however, with every change comes the possibility of complications.
Before putting a swap agreement into place, it is important to consider what may happen if terms are modified. At inception, a swap has no value. However, over time, the market value of a swap will change to the benefit of one of the two parties. Below are four issues that can be addressed by prior negotiation of the swap documentation.
Termination Risk – If interest rates decline after an interest rate swap is signed, you will be paying a higher rate than if you had waited. In this case if you want to cancel the swap, a Termination Value needs to be paid. The Termination Value would also have to be paid in event of a default. This could be expensive.
Mitigation: The borrower needs to be comfortable with the fixed rate he chooses, knowing that it is impossible to “pick the bottom” of the rate market. Involuntary termination events should be limited in the swap documentation, or cancellation should be provided for (see below).
Bank Credit Risk – There exists a risk the bank may default on its obligations under the swap and the borrower loses the swap that may have considerable value.
Mitigation: Make sure to select a highly rated counterparty, and include downgrade provisions in the swap.
Mismatching of Terms – The variable rate cash flow the borrower receives from the swap should match the amount and the timing of the loan payments. The length of the swap should also match the length of the underlying loan. Mismatching could negatively impact the borrower’s financial statements.
Mitigation: Cash flows from the swap and underlying loan should be as closely matched as possible in both amount and timing.
Cancellation Clause – Over time, the value of the swap changes and it is a zero-sum gain, with a winner and a loser. The “loser” will have to pay a charge/penalty cost to the other party if the swap is terminated.
Mitigation: In anticipation of a possible future swap cancellation, there can provided within the swap agreement a means to terminate the swap for either no payment or a predefined payment to the other party.