Terminating Your Interest Rate Swap
Terminating Your Interest Rate Swap
Contemplating Terminating your Interest Rate Swap? Here’s Why it Will Likely Cost You
In decades of advising borrowers of all shapes and sizes, one topic that comes up repeatedly is the best practice for a borrower to terminate an interest rate swap when the underlying loan is paid off early. Has your bank ever told you not to worry, that you can “make money” from your interest rate swap? The following will explain that most of time, it just isn’t so.
Why Terminate an Interest Rate Swap?
When closing a floating rate bank loan and entering into an interest rate swap, borrowers generally don’t expect to terminate the swap prior to its maturity. Why would a borrower terminate early?
- A change in the credit provider: In most cases the swap is cross-collateralized with the loan. If the bank loses the collateral, they have the right to terminate the swap. If the new loan is indexed similarly to the now paid off loan (e.g. LIBOR), the borrower can transfer the swap to the new bank. Such action is called a “novation”. The old bank is simply replaced by the new one. While the explanation of novation is simple, the actual process of novating a swap isn’t, especially when the swap has a negative mark-to-market (MTM) value. In most negative MTM cases, the new bank usually charges a fee to take the swap on its books. The charge can vary significantly between banks and depends on the remaining tenor and how far underwater the swap is. When deciding to novate, it’s very important that the borrower understands how the novation charge is calculated in order to determine if the cost of novating is justified by the risk the new bank is taking by accepting the swap onto its books. Novation charges are negotiable, but determining how much should be charged involves many variables.
- Sale of real estate or other asset: In this case, while there isn’t a change in credit provider, the bank has lost its collateral, therefore the swap must be terminated unless the borrower can provide replacement collateral. Replacement collateral can be provided under what bank’s call a negotiated “credit support annex” (CSA) to cover the MTM exposure it retains by maintaining the swap on its books without underlying collateral. Most importantly, swap termination costs should be incorporated into the decision to sell the asset in the first place.
- A sale of the business: Sale of a business that supports cash flow exchanges on the swap, or a change of management control, may also drive a decision to terminate. In some instances, the new owner may be able to assume the swap liability along with the rest of the businesses debts and assets.
The second and third termination events described above generally involve either paying or receiving the MTM value when the swap is terminated. The calculation determining a swap’s termination value is similar to when the borrower is initially entering into a swap; the value is based upon discounting the expected future cash flows to arrive at the swaps present value.
Anatomy of a Mark to Market
A swap’s true value at any point in time is determined through the same valuation models used to generate the swap rate at the loan closing. While every bank’s valuation model is different, a back of the envelope calculation is similar to a yield maintenance calculation:
Value of a Swap = Present Value of (Fixed Rate – Replacement Rate) X Average Remaining Notional X Years Remaining
Example: A borrower has a $10 million, floating rate, interest only loan at 3.75% for 5 years. At loan close, the borrower enters into a 5-year, $10 million interest rate swap, synthetically fixing the floating rate for 5 years. However, the borrower chooses to prepay and exit the loan after year 3.
Step One: What is the 2-year swap rate today (since three years have gone by)? Let’s assume it’s 3%.
Step Two: What is the Average Remaining Notional? We’ll assume the loan terms were interest-only; therefore, $10 million.
Step Three: Time remaining on the swap? The swap had a 5-year tenor originally, and it is now three years in, thus, 2 years remain.
Here’s the calculation:
(3.75% – 3.00%) X $10 Million X 2 years
= (0.75%) X $10 Million X 2 years
= Present Value of $150,000
In this example, banks typically inflate this number by $50,000 or so, and quote a “breakage” cost of ~$200,000. The bank is obligated, per Dodd-Frank, to provide underlying detail that determines their breakage calculation, specifically the “mid” or true market level used. Despite this requirement, the bank will mark up the “mid” by any amount they choose, legitimizing the mark up via a claim to “funding costs” or some other term irrelevant to the borrower. It’s this mark up or “spread over mid” with which the borrower should be concerned.
Factors that Inflate a Swap Breakage
The Bank’s Swap Profit. Simply put, a bank makes a profit on a swap by “marking up” the prevailing market swap rate and passing on the higher rate to the borrower. This spread between the true market rate and the borrower’s swap rate artificially inflates any calculation of breakage costs down the road.
Rolling Down the Yield Curve. All else being equal, pay-fixed interest rate swaps are likely to move against the borrower. Here’s why:
- Assuming a 10-year floating rate loan swapped to a fixed rate, also for 10 years, and assume the difference between a 5-year and 10-year swap is 1%.
- If the borrower pays off the loan after 5 years and swap rates are unchanged, the swap will have moved against the borrower by 1%.
- On a $10 million swap, this would translate into a breakage of approximately $425,000 even though swap rates haven’t moved since the swap was executed 5 years prior.
Forward Premium. If a borrower locks in a swap that begins on a future date versus today, this forward premium also inflates the future breakage valuation.
Profit at Termination. When a swap is terminated early, banks usually attempt to generate additional fees. If the borrower owes the bank due to a negative MTM, the bank will inflate the breakage amount owed. If the bank owes the borrower, a positive valuation, the bank will typically reduce the amount it is willing to pay.
While coming up with a swap’s termination value can seem straight forward due to the fixed income market being large and liquid, MTM values for swaps in particular are much more difficult to calculate, due to each swaps unique attributes, e.g. tenor, amount, amortization and day count just to name a few. A borrower should consider the following when staring down the barrel of a swap termination:
- Is the bank valuing the termination at the True Market? Dodd-Frank regulation did its best to provide transparency to the financial markets by requiring that a bank providing a swap provide its customer a gauge on where the true market or “mid” is trading. “Mid-market” hasn’t provided the transparency that was intended. In decades of experience in the capital markets, we have rarely seen a bank terminate a swap at the true market value. Entering into a swap has credit risk to the bank selling it, as well as to the borrower (in the event the swap has a positive MTM and the bank defaults). One would assume that the bank would value the swap at the true market level because by unwinding it eliminates credit risk for the bank’s books, yes? Not so. In an effort to generate additional fees from the transaction, banks routinely quote termination values that require the borrower to pay more for the termination or receive less than they are due if the MTM is in their favor.
- Each Bank has their own Unique Pricing Model: While this may be true, the inputs to a bank’s swap valuation model are very similar to every other bank’s inputs. There are minor differences in the way a pricing model interpolates data; however, DL’s experience is that the output among various models is quite similar. To ensure the input data isn’t corrupted or delayed, banks and hedge advisors (like us) use multiple data sources as a cross-check. This is why it is important to obtain valuations from an independent advisor to make sure the swap is terminated at or near the true market value.
- What if there is a Dispute? While banks generally price termination values at a price that includes a fee, the borrower is often beholden to the bank it purchased the swap from to close out the position. If the reason for the termination is a change in credit providers, the bank has no incentive to terminate the swap at the true market value. Why should the bank unwind the swap at the market value without any fee if they don’t expect future revenue from the borrower?
There are methods to reduce termination fees. As mentioned previously, the borrower can transfer or novate the swap to the new credit provider. While novating allows the borrower to keep the swap without terminating, the new bank may have costs of its own, which they’ll likely also build into the value of the freshly novated swap. If circumstances don’t allow for a novation, in the case of a sale of the business or real estate asset, then the swap could be assigned to another bank to terminate for a more favorable valuation. It’s a complicated process with numerous steps involved, thus borrowers should have an independent guide on their side through the process.
Bottom Line: Borrowing at fixed or floating interest rates each have their pitfalls. When paying a fixed rate loan off early, borrowers are usually faced with the expense of Yield Maintenance. When paying off a floating rate loan hedged with the swap early, a negative swap value often confronts the borrower. Neither is usually a pleasant experience.
The most effective method for determining if you’re getting a fair shake from your bank on a swap termination is to have an independent swap valuation from a hedge advisor, who works on behalf of the borrower and assists to negotiate a fair exit. Negotiating the ISDA, the document that governs the borrowers and the bank’s rights and obligations in the swap prior to entering into the swap in the first place will dramatically improve a borrower’s outcome when terminating. Going it alone when terminating a swap? Do so at your peril.
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