SWAP Negotiation

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Negotiating Equitable Hedge Pricing
Different Approaches for Swaps and Caps

“Negotiation” … is not a word that comes into most borrowers’ minds when thinking about interest rate hedges, particularly interest rate swaps. In fact, most borrowers are quite surprised to learn that there is even anything to negotiate. They just assume that the bank has passed on its cost and added the negotiated loan spread to arrive at a fixed interest rate. Yes, Virginia, there IS a Santa Claus, but he doesn’t reside in the derivatives section of your bank.

Actually, banks should be making a profit (spread) on the swap because they are at risk. If the borrower fails and the market has fallen, the bank stands to lose money. That being said, the swap spread should be relative to the risk and that is where things can get a bit muddy.

The calculation of that CME (contingent market exposure) is not exactly a back of the envelope task. There are many approaches that are based on statistically weighted market data and formulas. A good swap negotiator will be able to logically discuss these risks with the banker and relate those to the credit of the borrower to arrive at a fair spread. However, when a swap negotiator is not utilized, banks will tend to charge what they consider to be a fair mark-up. This mark-up is invariably higher than one that is negotiated and has more to do with what the market will bear than the real risk on the swap. Additionally, there is generally only one place where the borrower can obtain a swap and that is the lender. That is because the lender will accept the collateral for the loan as collateral for the swap. Any other swap provider would require the posting of substantial collateral.

Caps, on the other hand, can open the door to any number of providers and a real competitive environment. While all too many borrowers accept the price their own banks provide, a knowledgeable borrower will turn to a professional. A good negotiator will issue an RFP for a cap and simultaneously have several qualified providers bid against one another to assure the most favorable pricing. While the cash requirement in the purchase of a cap can be limiting, it is a tool that should be carefully considered where there is additional funds available.

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Hidden Swap Charges Reach All Time High
Borrowers Paying as Much as 5% of Loan Amount in Added Fees

Based on a sampling of swap confirmations executed during the last quarter of 2011, Swap Negotiators has reported a continuing trend in the widening of swap spreads from all banks. It is now not unusual to find that banks are imbedding up to 5% in undisclosed hidden fees into interest rate swaps where they are undetected by borrowers. This is particularly fertile ground for the bank to reap profits because the historically low swap rates give the banks the ability to add on basis points and still give the impression of highly attractive rates. Without the representation of a swap negotiator, the borrowers cannot see the true costs and the rates posted in the WSJ don’t apply to their own swaps because they are based upon several different factors. They are, in fact, substantially higher than the swap applied to a monthly payment and based on 30-day Libor.

Here is a typical example of how the banks imbed these profits: A $10MM borrower whose current floating rate is 30-day Libor + 250 decides that he wants to hedge his interest rate risk and the bank offers a 10-year interest rate swap. When the borrower asks what that rate would be, the bank responds by telling him that they can fix at 4.75% (swap of 2.25% plus 2.50% loan spread). The bank tells the borrower that there will be no fees. The borrower agrees to the rate and assumes that his swap rate is whatever the cost of the swap was plus his loan spread of 2.50%. He is wrong and just ended up paying the bank the equivalent of an additional 5.01 % in origination fees!!! More than a half million dollars. [See “Anatomy of a Price-Up”]

Now, many informed borrowers are creating transparency and negotiating their spreads by reaching out to swap negotiators who have the expertise to negotiate swap spreads and ensure the swaps are executed in accordance with the agreed pricing. While banks are due a fee when booking a swap to cover the element of risk, the borrower should be represented so that he may competently negotiate a reasonable price and then have access to live market data assuring that the contract is concluded in accordance with the negotiation.

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Swaps v. Conventional Fixed Rates
Major Differences

Originally, our partner, Andy Johnson, was supposed to write this article. He is by far the brightest of our lot and has much greater expertise in interest rate hedges than I do. However, when I read his draft and got to the second sentence about a synthetic income stream and underlying variables, I knew a much needed translation (rewrite) was in order. So, please accept this simplified version which may become an excerpt from my forthcoming thriller, Conversations with a Quant.

Your Choice
When looking for a fixed rate, a bank may offer the borrower a choice of a conventional fixed rate or a fixed rate through a swap. Admittedly, the conventional fixed rate is easier to understand. The borrower pays a fixed rate and, if there is an early termination, there is typically a penalty. Swaps are more complex and, without the assistance of a swap advisor, can become a minefield of issues and expenses. However, with the assistance of a swap advisor, a swap can be less expensive, more effective and provide greater flexibility. Here is an explanation of some of those advantages.

Rate Continuity with Changing Banks – It’s always good to think that a relationship will last a long time. But marriages and even bank relationships sometimes don’t last forever… or even the 10-year term of a fixed-rate loan. Let’s look at a borrower that had two properties and entered into two 10-year fixed-rate loans with the Forever Bank. After 5 years, the borrower decided it wanted to leave Forever Bank for Younger Bank. The borrower may wish or may have to terminate its loans with Forever Bank in favor of new loans with Younger Bank. In the case of the conventional fixed rate loan, the borrower must start from scratch. If the cost of funds has risen by 2% in that time, the new fixed rate will be 2% higher and the borrower will have lost the advantage of the last five years at the lower rate. However, with the swap, the borrower can have the swap assigned to Younger Bank as long as the banks have credit lines between them. In this manner, the borrower has maintained the original cost of funds and will retain the original rate less some fee for the assumption of credit.

Hedging the Hedge– There is always a struggle in deciding between the attractiveness of the initial cash flow advantage of a floating-rate loan and the surety of a fixed-rate loan. With a conventional fixed rate, it’s all or nothing. With a swap, borrowers can have it both ways. We see most Swap Advisors today recommending that borrowers take the majority of risk off the table by fixing somewhere between 65% and 75% of the loan amount. The remainder can float for the duration of the loan or until the borrower becomes concerned about rising rates and then fix later (at a higher rate). This strategy, generally only available with swaps, enables an enhanced early cash flow and the ability to prepay a portion of the debt without any penalty.

Do Not Attempt This at Home – As demonstrated here, swaps can be a great tool. But, because swaps are a separate contract with many complexities and opportunities for banks to make substantial additional profits that are not easily seen by the untrained eye, make sure that you work with a Swap Advisor such as Pensford Financial of Charlotte and Cardea Partners out of Cleveland. With either by your side, you may find these and other advantages that would not be available in a conventional fixed-rate loan.