With the growth of non-bank lenders, hedging the floating interest rate on loans is becoming much more complicated. To start with, there is the issue of where the swap sits in the priority of creditors if something goes wrong with the loan. Unless it is super-senior – first in line to be repaid – it is difficult to get a swap.
“If it is junior or pari passu, it’s extremely difficult to put a swap in place with a third-party bank, so borrowers have to buy a cap,” says John Edwards, managing director of JCRA with responsibility for interest rate hedging. “That is an up-front premium which can be pretty significant for a five-year loan.”
But regulation is adding another twist, which has to do with the counterparty risk involved in swaps and caps. Some, but not all, lenders require the counterparty providing the hedge to stay above a specific credit rating – that is, its creditworthiness as judged by rating agencies such as Moody’s or Standard & Poor’s.
This is to protect the lender against the risk that the bank providing the swap or cap might default. “Often it will be a long-term rating of A3 (Moody’s), though sometimes it can be a short-term one of P-1,” says Edwards.
Today, many banks will have lower credit ratings than they did before the financial crisis, so there are fewer high-scoring potential swap providers. Stronger banks such as HSBC and Royal Bank of Canada have an Aa3 rating, while Lloyds and Barclays are rated A2. But in March, Moody’s slashed RBS’s long-term rating to Baa1, and warned it could be cut further.
Providers need strong credit rating
“In their documentation, some non-bank lenders are insisting on language saying that the hedging counterparty is ‘adequate’ or ‘suitable’, so you have to go to a bank that is strong and has a high credit rating,” says Edwards. “But that pool is limited.”
Moreover, the downgrade provisions in loan documentation will typically say that if the hedge counterparty’s rating slips below a minimum threshold, it must post more collateral to compensate for the lower rating, putting it into a segregated account. Or, alternatively, the counterparty must arrange to novate the transaction to a suitable alternative counterparty.
“This downgrade language can be quite costly,” says Edwards. “For regulatory reasons, when a bank comes within two notches of the downgrade credit rating, the bank has to progressively allocate capital in case it breaches the threshold.” In one case, it doubled the cost of a cap.
Collateralising swaps and caps isn’t new, but since the demise of Lehman Brothers and AIG highlighted the risk of counterparties defaulting, more lenders have been requiring the hedging bank to collateralise the transaction or agree to novate the hedge.
These downgrade provisions are not meant to cover the risk that a borrower’s collateral – the property – isn’t of good enough quality to underpin the loan, but rather to protect the lender’s counterparty risk: that the creditworthiness of the bank providing the hedge will take a dive.
However, the downgrade language and collateral requirements can vary. In some cases it is quite severe and precise – this is typical of the language used in the swaps embedded for special-purpose vehicles that are used in structured finance deals, such as CMBS.
In this case, there are rating “triggers”– for example, if the bank’s credit rating hits the trigger, it will have to start posting additional collateral, regardless of whether the swap is out of the money.
Extra collateral increases expense
Crucially, putting up extra collateral also increases the amount of regulatory capital the bank has to allocate to the swap on its balance sheet, making it more expensive for the lender. This means that the bank will charge more for providing a hedge on a loan that has quite severe downgrade provisions.
“The cost is negotiated; it depends on the language and the triggers,” says Edwards. These stricter downgrade conditions for hedging are creeping into real estate loans; some of the new non-bank lenders include them in their loan documentations.
However, the practice varies widely across the financing market. Some lenders leave counterparty downgrades out altogether, while others will use general language and have less severe requirements.
“We want hedge counterparties to have a certain rating,” says Neil Odom-Haslett, head of Standard Life’s debt fund, which works with around 25 banks. “We have a minimum threshold and the counterparties are all well above it. The wording is that the counter-party has to have a minimum credit rating and it shouldn’t slip by a certain amount.”