Cost of breaking long-dated swaps blocks debt resolution

High swap breakage costs are preventing work-out of some legacy loans, writes Alex Catalano

The high cost of breaking interest rate swaps is keeping banks from working out troubled commercial real estate loans, CBRE says. “Loan portfolios have proved impossible to sell and/or work out because of the impact of swaps,” says Michael Haddock, CBRE’s director of EMEA research and co-author of its Swaps: The unintended consequences report.

CBRE calculated that breaking a sterling swap contract to sell or refinance a property can cost up to 23% of its value (see chart) enough to wipe out any recovery in values since 2010 and putting the borrower into negative equity. In the case of longer-dated swaps, the lending bank is also likely to be hit with a loss if it forecloses on a loan.

“It’s a big problem,” says Jim O’Leary, director at Capita Asset Services. “The loan- to-value quoted is typically the loan amount divided by the valuation. It usually doesn’t describe factors like swaps, which could be seen as another level of indebtedness on a property. As a result, much healthier ratios are reported than what the real situation is.”

The biggest problems are with loans taken out in late 2006/early 2007, when in a reversal of the normal market, long-term interest rates were lower than short-term ones. Taking out a 20- or 30 year swap alongside their typical five-year property loans allowed borrowers to shave some basis points off interest costs and also to borrow at higher LTVs, as there was less amortisation over the loan term.

“At a 90% LTV, every little basis point has a huge impact on the cash-on-cash yield and return on the equity investment,” says Haddock. “There was a tendency to swap out  to improve the cash-on-cash yield.”

In the 2006/07 UK boom, a couple of UK lenders are said to have been particularly keen on long-dated swaps. “At that point, LTVs were rising and the higher the loan’s LTV, the more likely the bank was to want a swap as security, because the interest rate cover would be lower, with less headroom to cope with interest rate rises,” Haddock says.

Swaps can have an impact even on loans with conservative terms. CBRE’s example  of a 70% LTV loan taken out late in 2006 assumes the property value has risen in line with the market average. Without a swap, the LTV would now be 100%; the lender can be repaid. With a swap of 10-plus years, breaking it puts the loan under water (see lower chart). The position is similar for eurozone loans.

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Problems for performing loans

Swap breakage costs can also cause head-aches with performing loans, as they usually rank super senior, ahead of repaying any others in the structure. “If the cost is significant it can cause the servicer not to enforce, as to do so is to crystallise that liability, whereas the property may be generating more than sufficient cash to service the loan and swap,” says O’Leary.

Another problem, particularly for CMBS loans, is that the rights of a swap’s counter- party are not standardised and their consent may be needed to extend a loan. “Everybody else may agree to an extension, but in today’s market the swaps counterparty will usually refuse on the basis that if they do that they can crystallise their super senior position and be paid out,” notes O’Leary.

The divergent interests of lender and swap counterparty can even cause difficulties when the same bank provided the hedge and the loan. While it is in the bank’s best overall interests to take action, internal politics and allocation of losses between the bank’s two sections can keep it from doing this.

Lessons for the future will feed into the hedging best practice guidelines being produced by the Commercial Real Estate Finance Council Europe. “It is ironic that a tool that was designed to reduce risk is now itself a source of substantial loss in some cases,” says CBRE.