Magazine article The Journal of Lending & Credit Risk Management

Interest Rate Swaps: Does Your Borrower Understand the True Nature of the Arrangement?

Magazine article The Journal of Lending & Credit Risk Management

Interest Rate Swaps: Does Your Borrower Understand the True Nature of the Arrangement?

Article excerpt

Interest rate swaps provide a useful tool for bridging the gap between a borrower's desire for certainty in credit costs and loan payments and the lender's desire to avoid interest rate risk. Traditionally, swaps and similar hedging products have been reserved for larger transactions and customers. Due in part to increased competition for loans, these products are now being offered on smaller and smaller loans to less financially sophisticated borrowers. Unlike sophisticated corporate borrowers, this newer group of swap customers often does not have specialized in-house financial personnel or access to counselors who are familiar with these transactions. This can lead to a misunderstanding on the part of the borrower about the true nature of the arrangement, which, in turn, may lead to serious issues for the lender,

In cases in which the lender is also the swap counterparty, the lender must be able to demonstrate that a proper explanation of the arrangement was given. If not, the borrower may claim to be unaware of provisions it considers disadvantageous or may view (or choose to view) a swap as creating a fixed interest rate obligation. Borrowers who do not properly understand the arrangement may view payments under the swap as interest payments on the loan. The swap transaction may be viewed as concurrent with the loan and the borrower may expect that repayment of the loan ends and satisfies the swap. Based on these perceptions, the borrower may refuse to pay breakage fees if it prepays the loan or if the swap is terminated early due to loan acceleration after default. The borrower may demand the release of collateral when the loan is satisfied even though it has not met the remaining obligations under the swap or otherwise resist compliance with the swap transaction. In a worst-case scenario, a borrower may even atte mpt to avoid liability under the loan itself or assert affirmative counterclaims if the lender enforces the swap. While these types of claims generally would not overcome the terms of a written contract between commercial parties, they can serve to delay the collection process and significantly increase expenses. In general, courts do not yet have a great deal of experience dealing with the enforcement of interest rate swaps. Under these circumstances, a court may be sympathetic to a borrower's claim that it never fully understood the arrangement.

To help avoid these problems, lenders must explain to their borrowers the true nature of the transaction.

The True Nature of the Transaction

The loan and the swap are two separate transactions constituting independent obligations. An interest rate swap is a derivative, not a loan or other credit facility. It is an exchange of cash flows for a fixed period of time.

Although the same collateral documentation may secure both, the loan and the swap have separate and distinct agreements. Instead of a note and a loan agreement, the swap utilizes an ISDA Master Agreement (a standardized document containing the general parameters and a uniform set of definitions), a Schedule (which fills in some of the specifics, selects alternatives, and sometimes modifies the ISDA Master Agreement), and one or more Confirmations (which execute the swap and provide the economic terms). It is these agreements, and not the loan documents, that govern the swap arrangement.

The swap hedges the loan's floating interest rate. It does not fix the loan's rate of interest or convert the loan into a fixed rate obligation. This concept may be the one most commonly misunderstood by borrowers. It reinforces the separateness of the swap and the loan. It is also useful when explaining and characterizing the various payments to be made under the swap.

The length of the swap may not mirror the length of the loan. In addition to the obvious case in which, for example, a borrower uses a swap to hedge the rate for the first four years of a seven-year loan, there are other circumstances where the lengths of the two arrangements may differ. …

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