Guest post by David Nicholson, Owner of Credit Training Inc.
For commercial bankers, a large part of being a value added advisor is understanding the unique challenges faced by others within your client’s or prospect’s industry and offering solutions to those problems. Vertical IQ can help you learn about the types of risks associated with a particular industry so that you can share those insights with your client in an articulate manner.
But when it comes to the complexities of certain banking products and services, it can be difficult to explain all of the intricacies to a business owner when you don’t fully understand them yourself.
In this guest blog post by credit expert David Nicholson, he explains the ins and outs of a credit swap. Could this be a useful pricing option for a business owner you know?
The Swap Challenge
Yes, a swap is fairly complicated for sure. Most commercial bankers shy away from swap options for clients as too complicated. But like any complicated item or concept, being able to understand the primary moving parts before tripping up on the details makes a big difference for the bank, the borrower, and the lender. In this blog, I have simplified the moving parts so both bank and borrower can understand. From there, an informed conversation can be had and an informed decision can be made.
For over 20 years, the banking world has been using swaps as a pricing option for clients, and there are definitely nice benefits for both banks and borrowers. What I have found is that there are some people who can talk about certain aspects of swaps, but not as many can talk about it in a way that is understandable and clearly lays out the benefits, and equally as important, the potential downside of swaps for both the bank and the borrower.
It is in this understanding that a commercial banker can inform (not sell) a client about swaps. As a result, when a borrower is well-informed, they are able to make the decision on a swap option.
As a side note: Why is it important for the borrower to get the right information and make a decision and not have the bank’s commercial lender “pushing” swaps? This is because of “lender liability.” Lender liability is a blog in itself. However, when referencing swaps, lender liability is possible if a lender persuades a borrower into a swap without the borrower fully knowing the potential downside to the swap.
As will be stated later in this blog post, the bank does get a large swap fee, which typically equates to about 2% of the notional amount (loan amount being swapped). So there is significant bank incentive to close swaps. This fee connection can lead banks and lenders to the perception of “pushing” swaps onto clients, which relates to the previously mentioned lender liability.
The History of Swaps
When swaps started to become a mainstream pricing option in the late ‘90s, rates were much higher than today. As one of the potential downsides to the borrower, when rates decrease after the swap-related loan closes, the borrower would be “out of the money” (OTM), which also will be discussed later in this post.
It is this OTM effect that had many borrowers upset in the 2000s when rates were decreasing through to 2008 at which time rates hit relative historical lows. This OTM position is in part what led to parts of the Dodd Frank Act, specifically as it relates to derivatives.
The Dodd Frank Act restricted “smaller” borrowers from having access to a swap, as it may have been thought that smaller borrowers are less sophisticated and less able to understand the swap. So in an effort to shield smaller borrowers from the potential downside of a swap, they were restricted from access to the benefits of a swap.
Looking Under the Hood of the Swap
I have been to a number of swap training seminars and classes over the years. While they did provide the mechanics of how the rates between involved parties work, there has always been a “scratching of the head” on the big picture of why a bank and borrower would want a swap-based pricing option.
In a way, equating it to a computer can help visualize this point. I know the benefits and downsides of having a computer. I know it can make my work much more efficient and organized. I also know it will cost me a good amount of money; there can be risk of identity theft; etc. With that information, I can make an informed decision that the benefits outweigh the cost. So I buy the computer. Keep in mind, I do not know how the electronics under the keyboard work. That is complicated. As a user, in a sense, it just works. Working with swaps for 20 years, I can say how the swap works between the lender, the borrower, and the counterparty — that it just works. The details of how it works would be for another blog.
Most all conversations between the lender and the bank and the lender and the borrower are within the benefits and potential downside to the bank and borrower, which is why this blog stays within this framework of benefits and potential downside to the bank and borrower.
Before discussing the behind the scenes workings of a swap (the equivalent of my example of how a computer works), it is important to understand why we are even talking about swaps. Why would a bank and a borrower even be interested in a swap? This gets us to the benefits of a swap to the bank and borrower. Equally as important are the potential downsides.
Benefits to the Borrower
Longer rate lock period
One of the primary benefits to the borrower is the fact that they can have a rate lock for fixed rate loans longer than the typical 5 years. The client can have a rate lock for as long as the amortization period is. This is an important point especially in such a low-rate environment as borrowers tend to ask for longer rate locks on traditional priced loans to hedge against the potential for rising interest rate. Borrowers like to go out 7 and 10 years if possible while banks do not. With a swap, the bank is fine with the rate lock periods in excess of 5 years.
Potential for “in the money”
With rates at all-time lows, if any time is a good time for a swap, it is now. If rates go up after the swap loan is closed, then the client is “in the money.” While this “in the money” and “out of the money” figure is a number that can be figured out at any time in the life of the swap, it only impacts the company financially if the swap is terminated within the swap period. So if a swap closed with a 7-year fixed rate to the borrower of 4.75%, and the swap was terminated after 3 years when rates increased to 6.25%, the borrower would get a check. Importantly, a prepayment penalty is different.
My prior comment that a low-rate environment is the most optimal time for a swap is identified here because when rates are at all-time lows (like they are currently), the likelihood that rates might increase rather than decrease seems higher. This is the point where lender liability can come into play. We should state facts as a lender, not state that it is more likely that rates will go up. For example, anyone who thought rates would go up in the last 12 years as our national debt has increased significantly would have been wrong.
With that said, as a lender, I always liked when my borrowers did well. As such, it is my opinion that offering swaps in such a low-rate environment does have more likelihood of an upside for the client than a downside as it relates to rate movement. However, to avoid lender liability, stating the facts and letting the borrower decide if they want to engage in a swap avoids the stated lender liability.
The fixed swap rate for the borrower is typically a lower rate than the traditional equivalent
The liquidity of these derivative instruments through the trading on the secondary market via legal contracts allows for a borrower fixed swap rate that is often around 0.5% less than the traditional equivalent.
Option for the borrower to roll in closing costs
Through the pricing process with the bank’s swap desk, rolling closing costs into the rate is a nice option. For example, when pricing a loan, if Bank A has $15,000 of closing costs that the borrower pays, this $15,000 can be rolled into the interest rate. Although it will vary depending on certain factors, one of which is the amount of the closing costs, I have typically found it falling into the range of 6-8 basis points increase in the rate to cover the closing costs.
The takeaway of this benefit to the borrower is that an all-in swap rate inclusive of rolling in closing costs is typically around 42 basis points less than the traditional equivalent.
Of note: The borrower pays the closing costs at the time of closing and then gets reimbursed approximately three business days after.
Downside to the Borrower
Potential for “out of the money”
As great as it can be for your client to be “in the money” if interest rates go up, it is equally as important to discuss with the borrower the impact of being “out of the money” if rates go down.
It is important to remember that scenarios for “in the money” and “out of the money” are easy for your swap desk to calculate at any point and prior to the swap closing based on projected interest rate scenarios at different projected points in time throughout the life of the swap. It is a good exercise to go through with the client or prospect so they get a feel for the upside and downside potentials.
The client should be fully aware that the swap derivative product is a contract with definitive terms and conditions. There is no negotiating with the bank after the swap is executed. Unlike a prepayment penalty, which many times can be renegotiated or waived, the terms and conditions of the swap cannot be.
Benefit to the Bank
Large swap fee income
This benefit can be substantial, and the fee is able to be recorded on the bank’s income statement the day the swap is executed. Typically, the swap fee is approximately 2% of the notional amount of the loan. Not too many bank-related loan facilities generate that kind of fee income. It can be a significant incentive to have swap fee income as a part of the commercial lender or business development officer’s goals.
I have heard a number of times that the swap fee is a one-time fee and not recurring. That is true, however, if each lender closes on two to three swaps per year, then the swap fee income has a recurring nature to it and can be significant.
It is important to note that this type of goal can create issues related to lender liability where a lender may be “pushing” or “leading” a borrower down the path of a swap. How this happens can be through emphasizing the benefits of a swap while not mentioning or misleading the borrower as to the potential downside to a swap. This is why informing the borrower of the benefits and the downside of a swap is very important. Letting the borrower decide what option is right for them is a good way to reduce lender liability risk.
A typical question that is asked is who pays the fee. Initially, the borrower pays at closing and then is reimbursed a few business days later. Ultimately, the fee is paid through the ticking up of the rate to the borrower.
It is common for the net loan fixed interest rate to the borrower to include 25 basis points. This basis point number is a variable in determining the actual swap fee income for the bank. The higher that number of basis points, the higher the swap fee. Bottom line: The swap fee is paid through the interest rate.
Keep in mind that although the bank does get this robust swap fee income, they also get a lower floating rate than they typically would with traditional pricing (mentioned later in this blog post). This takes us to the next benefit, which also has a negative tied to it.
Bank hedge against interest rate risk with a floating rate
If you have ever been to an ALCO meeting at a bank, you understand very quickly that banks look to hedge a portion of their loan portfolios against interest rate risk. One way to do that is to have floating rate loans. The swap provides a floating rate loan for the bank while, as we discussed, the borrower gets a fixed rate loan. Yes, both sides get what they are looking for
As previously stated, the floating rate is typically priced lower than the bank typically likes their floating rates to be. Remember, this floating rate is tied to 30-day LIBOR, which is currently 12 basis points. This brings us to the next topic, which relates to the downside to the bank.
Downside to the Bank
The floating rate for the bank is typically lower than the traditional equivalent
It is important to note that the swap rate is derived using the 30-day LIBOR rate. As of 3/1/21, the 30-day LIBOR rate is 12 basis points, or 0.12%. From there, the bank adds a spread, a swap fee embedded into the rate and possibly a tick up in the rate to cover closing costs.
As you can see, while the bank does enjoy a hedge against interest rate risk, the rate is more compressed than a bank typically likes. Remember, this is partially offset by the one-time swap fee, which typically is about 2% of the notional amount of the loan facility being swapped.
Credit risk exposure: Collateralize this risk…
The default thinking for a commercial banker is that all loans need to be collateralized, or at least almost always. As with the loan, the credit risk exposure related to the swap needs to be collateralized.
The “out of the money” is not only a risk to the borrower, but very importantly, it is a risk to the bank. The reason is because if the borrower does not or is not able to pay this swap breakage fee, if incurred, then the bank is responsible for the obligation to the counterparty. This is why, during the approval process, banks should run the potential risk calculation and then collateralize this amount along with the traditional loan facility or facilities collateral coverage.
An excellent way to help manage the credit risk exposure related to a swap is to use a legal firm that is savvy in this type of commercial banking legal work. Most all commercial deals use legal firms for closing documents, so using a legal firm capable in this aspect of commercial banking is highly recommended.
Conclusion
There are upsides and downsides to a swap for the bank and the borrower. If your bank is offering swaps to your clients, the key is to understand the upside and downside potential to both the bank and the borrower. This allows for informed banks and informed borrowers. That is the goal for banks: to have lenders who are informed and able to provide real value to clients so they can make informed decisions as to what is best for their company. As a result, a better bank/borrower relationship means everyone wins. What’s better than that?
Image credit: August de Richelieu, Pexels