A Perfect Storm: Why are Rate-Swaps or Commercial Loan Hedging Arrangements on the Rise?

I regularly work with both lenders and commercial borrowers.  In the last 12 months, I have noticed that interest rate swaps are becoming a part of more and more financing arrangements.  While I am not an economist, there are a handful of reasons why including swaps or derivatives in a financing arrangement should be part of more conversations between banks and commercial borrowers.

In this post, I am considering a “plain vanilla” interest rate swap.  A simple example of this would be a bank offering a 10 year fixed interest rate loan to a borrower.  The bank then swaps this fixed interest payment with someone (maybe another lending institution, swap bank, or even back to the borrower) in exchange for a variable rate payment – usually tied to LIBOR plus some amount of basis points.  At the end of the swap period, the difference in interest payments between the fixed and the variable interest rate is paid out to the appropriate party.

Increasing Competition Among Lenders

Many of my commercial clients complain that banks only want to lend money to people who don’t need it.  This is not entirely the decision of lenders.  Today’s regulatory environment has forced banks to tighten their risk tolerances.  The net result of this is that it seems there are more loan demand than there is loan supply.

I think of it as Venn Diagram.  One circle is borrowers who need financing.  The other circle is businesses with acceptable risk.  Where those two circles intersect, banks and borrowers are doing business.  If your project falls into that middle part of the diagram, congratulations! You will have lots of banks competing over your business.

This competition is a problem for lenders.  I have seen banks offer extreme terms just to “win” some of these “good loans.” Many banks just cannot compete with lenders who are willing to cut deep into their profits just to secure a deal.  This is not good for banks, and when banks struggle or consolidate, it ultimately harms borrowers, too.

Interest Rates are Really Low … For Now

Interest rates are near historical lows right now.  But no one thinks that they will remain at these rates over the term of most commercial loans that originate today.  Plus, an increase of just 1% in interest rates over the next five years represents a relatively large increase – maybe 20 -25% — of the actual interest on a loan.  Going from a very low rate to just a reasonably low rate can be a significant jump.

Obviously, borrowers want to lock in fixed interest rates at these low rates.  This creates a lot of risk with banks when interest rates rise. Plus, the bank’s liabilities – their deposit accounts – are linked to variable interest rates.  This multiplies the risk that banks face. Of course, some borrowers are not in position to bear all of the burden of rising interest rates in the future. So the uncertainty of future interest rates is leading both borrowers and lenders to do something to mitigate those risks.

Better Derivative Balancing and Accounting Standards

In a vanilla rate swap with a borrower, a bank may give the borrower a fixed rate, which is swapped for a floating rate. In this case, the bank is bearing the risk of an interest rate increase. (Of course, the borrower bears the risk of interest rates not rising, but that risk is capped by the fixed rate.) The bank generally tries to hedge this risk by entering into an opposite rate swap with a separate “counterparty.”  The bank can reduce its risk by swapping a variable rate with a similar fixed rate.  This gives the net of the two transactions as a variable interest rate loan, protecting the bank. With more people seeking to mitigate risk, and a larger market, banks have more opportunity to protect themselves in this way.

Also, my understanding is that the Financial Accounting Standards that deal with derivatives like these are more predictable than ever.  FAS 133, as amended by FAS 138 – whether it is right or wrong – has been vetted out over nearly a decade.  This should mean that smaller community banks can feel more comfortable accounting for and therefore offering these arrangements.

The Advantage in Financing Transactions

I do not want to go through the details of rate swapping transactions here.  It would take up much more space than a blog post allows.  But I want to show that rate swaps can benefit both parties in a transaction.  The bank can offer a borrower an attractive and predictable fixed rate.  The bank may be able to stretch its borrowing limits a little, by eliminating the risk of long term interest rate increases.  In addition to this long term benefit, the bank can improve its spread through origination fees for the swap arrangement.  This fee income gives a short term yield “boost” to the loan.  It may allow banks to fight the competition from other lenders offering bargain-basement terms.  When you look at it from a distance, from the borrower’s perspective, this is kind of comparable to paying points in a residential mortgage to get a lower long term rate.  Paying a swap origination fee at the time of the loan may be a kind of closing cost.

Interest rate swaps or commercial loan hedging is not going to be right for every transaction.  But in some transactions, it might be a very useful tool to bring together a bank and a borrower.

Aaron Marines is an attorney at Russell, Krafft & Gruber, LLP, in Lancaster, Pennsylvania. He received his law degree from Widener University and practices in a variety of areas including Business, Commercial Real Estate, Land Use, Land Planning and Zoning matters.