Banks’ loan proposals that have a variable or adjustable rates based on LIBOR will often also have a “requirement” for the borrower to obtain an interest rate swap. This swap requirement will typically be predicated on the bank wanting to “protect” the interest rate risk of the loan.
While we agree that a swap will limit a borrower’s rate risk of the loan, a swap requirement has more to do with the bank making additional profit than reducing risk.
Because there are many different ways in which a borrower can reduce rate risk other than swapping the all of the loan to its maturity, it makes sense to negotiate the swap requirement clause in the loan commitment letter. DAG can assist in negotiating this requirement to a borrower’s advantage at the initial stages of the loan.
Structuring Flexibility into the Swap/Loan
Before putting a swap agreement for a loan into place, one should consider possible “what-ifs” from the loan being modified in any way. At inception a swap has no value. However, over time, the market value of a swap will change which will benefit one of the two parties. An awareness of potential pitfalls allows the borrower to make sure the swap fits within a given risk profile. The following four examples illustrate how terms can be negotiated and risks moderated.
Matching of Terms – The payments and structure of the swap need to exactly match those of the loan. The amount and the timing of the loan payments as well as any optional pay-downs need to be considered. Any mismatch between the swap and the loan will negatively impact the borrower.
Pre-Payment Penalties – The moment after a swap is executed it has a negative value for the borrower. If rates decline, this negative value grows. If a borrower ever wants pre-pay part or all of the loan, that portion of the swap will also have to be canceled, and a Termination payment will be due to the bank (a Termination payment would also be due in event of a default). Termination payments are typically quite expensive.
Borrowers need to take into account the possibility of loan prepayments to avoid the chances of owing a prepayment penalty. The ability to cancel a portion of the swap without penalty can also be structured into the swap agreement. Any involuntary Termination events should be limited in the swap documentation.
Bank Credit Risk – With any swap there exists the risk the bank could default, and the borrower would loses the swap just when it’s needed the most. This risk can be mitigated by making sure to take into account the credit rating of the bank, and including “downgrade” provisions into the swap documentation.