Regulation rewrites the terms for interest rate swap buyers

Basel lll raises cost and complexity for banks providing interest rate derivatives, reports Alex Catalano

For UK real estate borrowers, interest rates swaps are a fact of life. Banks lend to you at floating rates, but require you to swap some or all of the lending to a fixed rate. This makes sense – you are controlling your interest cost, while the bank is controlling its risk that you’ll default on the loan because your interest costs have spiralled upwards.

“Hedges are bespoke to the customer, depending on the character of assets and income to service the debt,” says Mark Elliott, Lloyds Banking Group’s head of real estate solutions and group risk advisory.

Hedging is now integral to transactions; no longer can borrowers arrange a swap two days before closing a deal. Not only does the documentation take longer to prepare, but also, because of regulatory changes, pricing and managing risk has become much more complicated for banks.

Loan heads of terms may include swap arrangements. “That’s helpful because you can judge the total cost of the facility,” says Bill Bartram, a director at JC Rathbone Associates. “However, if things change in negotiations and you decide that you want a cap, it’s not flexible.”

Today, interest rate swaps are generally aligned with loan length: the trouble caused by breakage costs associated with long-dated swaps taken out in 2006 and 2007 is well understood (see below). Once burnt, twice shy.

Borrowing costs largely unchanged

Since the financial crisis, Libor and swap rates have dropped dramatically (see chart), although because the margins banks charge on loans have risen, the total cost of borrowing hasn’t changed that much. However, swap rates are not the only story.

There is also the credit spread the bank charges on top. “There are various input costs – funding and liquidity, regulatory capital costs, credit costs,” says Elliott. “The two things that create significant cost and uncertainty are regulatory – Basel III is adding a credit value adjustment, and risk weighting assets.”

One swap arranger says: “Now we do not do a single trade without thinking about regulatory capital, because it is so con-strained. The amount of regulatory capital we have to assign to every transaction is multiples of what it was before.”

Credit value adjustment (CVA) is a new regulatory charge intended to ensure that banks hold enough capital against credit risk – the risk that the borrower defaults.

Before the financial crisis, banks did not use particularly sophisticated ways of analysing and pricing counterparty risk on swaps and other derivatives. They were not required to account for it, but Basel III makes it compulsory.

The change was meant to come into  force in Europe as Capital Requirements Directive IV from the start of next year, but has been delayed. Nevertheless, banks are already pricing it into their swaps.

CVA covers the average exposure the bank will have to the swap over its lifetime: in other words, the risk that the borrower will default owing the bank if the swap’s mark-to-market value is in its favour. “In the past three years CVA has exploded in terms of the resources banks are deploying to assess it,” says Bartram.

It should be noted that CVA also carries  a potential headache for those borrowers who use international financial reporting standards – listed companies and cross-border funds that use this global accounting language to provide standardised reports for their international investors.

A new valuation standard, IFRS 13, comes into force at the start of next year, making them report the ‘fair value’ of their swaps. This specifies how fair value is calculated and CVA now has to be included.

Given the complexity of the factors making it up, the credit spread currently charged on swaps is quite variable, but ranges between 15bps and 25bps for a swap on a three-to-five-year, standard grade investment loan. “Each bank looks at it differently, depending on their funding costs, how they score for CVA, their hurdle return etc,” says Bartram.

Mike Riley, joint CEO of Local Shopping REIT, says: “Sometimes you can agree what the credit spread is going to be. That makes it easy for everyone, because if you’re drawing down lots of properties, every time you put a swap in place at least you know what margin you’re going to get.

Negotiating on banks’ profits

“What people forget is that there’s a bid-offer position and banks will try to get as much profit as they can, and you need to negotiate what their profit is.”

Each bank has its own way of calculating CVA, but a somewhat consistent approach has emerged. “What is less consistent is the funding element and the cost of regulation embedded in the trade,” says Jonathan Lye, director at Chatham Financial.

“What makes this interesting is that if you borrow from a syndicate of banks, the bank offering the best execution isn’t necessarily the bank that can hold that derivative, having the best funding cost or risk. So being able to use that syndicate in a flexible fashion by allowing one party of the syndicate to carry out the execution and another to hold it in the long term is a useful situation to be in.”

Swaps in syndications pose special problems for German pfandbrief-issuing banks. In the UK, swaps are usually secured, with the loan and real estate providing the ultimate collateral, and it will rank in equal terms with the lender(s) in payment priority.

However, this doesn’t work for pfandbrief banks. Their swaps need to be subordinated, because their loans need to be unencumbered to be used in the collateral pools for their covered bonds. So in syndicates and club deals including pfandbrief banks, the swap will usually be split pro-rata among the participants.

The security position of a swap is relevant, given that it is a different part of the lending bank – or even a different bank altogether – that is providing it. “Ideally, if you can get the swap lower down the security chain you’re able to negotiate with the lending bank a bit more,” says Riley.

“It gives you more flexibility with the bank, because they can do things without getting consent from the swap counter-party. If the swap comes first then you have to deal with it first.

“There’s always a negotiation about how it gets paid out in the waterfall – whether the bank takes the interest cost first or the swap cost first. It’s always better to get the hedging partners to rank afterwards.

“When you’ve syndicated a loan, the syndicating banks would want their interest paid before the swap rate got paid out, because typically the agent bank would provide the swap.”

Loans and hedging decisions are very closely intertwined. For a core, standard investment, it is usually not difficult to put a swap in place. However, for a portfolio or more complicated property, the financing can be more complicated and the hedging process more convoluted.

Unsecured swaps for larger players

Big corporations – the likes of British Land and Land Securities – can arrange unsecured swaps on their borrowings. But for these, the banks arranging the swaps will be looking at the company’s treasury policy, the profile of its debt and carrying out asset/liabilities studies. For most borrowers, swaps on portfolio lending will be secured, with some flexibility for moving properties in and out.

“We may allow substitution of assets in portfolios, but based on key features of assets,” says Lloyds’ Elliott. “There are complex considerations that make the deal more involved from a modelling and risk analysis perspective. More uncertainty means more expense.”

These days, because existing swaps can pose a problem for refinancings, banks have been novating them – allowing the swap to be transferred to a new (or renegotiated) loan. Duncan Hubbard, a partner at Norton Rose, says: “The dramatic cost of unwinding swaps is a hindrance to many refinancings and the restructuring of swaps is often critical to successfully achieving refinancings.”

Elliott adds: “But there’s room for discussion. If we are in a refinancing, we will continue the swap at the pricing agreed at the time. We’re also happy to novate the swap to a new borrower, provided they are an acceptable credit risk. In all other instances we would terminate it.”

Novation generally requires the borrow-er’s consent. “It isn’t straightforward,” says Hubbard. “You can take security on the borrower’s swap rights, so if they default, you can step into their shoes. People are  now much more thorough and mindful that you have to control these instruments.”

However, banks worry about refinancing risk, especially on bullet loans that don’t amortise. Thus, on some new loans the swap term can now extend beyond the term of the loan: for example, a 10-year swap on a five-year loan. Thus, if the loan has to be extended, the swap carries on. These arrangements usually include a mandatory break at five years.

“Clients are sometimes worried. But if you have a 10-year swap with a mandatory break at five years, the bank is only charged five years’ worth of regulatory capital,” Elliott says. “So internally the credit spread will be cheaper and the savings can be passed on.”

For mutually agreed breaks, the regulatory position is more complicated. Borrowers do have another option for controlling interest rates: buying a cap that sets an upper limit on the rate they pay. This has obvious advantages, because the borrower can decide on the level of interest rate protection wanted and still benefits from an upside if interest rates fall; there aren’t any breakage costs.

Caps also provide more flexibility in financing trading assets that aren’t going  to be held for very long. However, the disadvantage is that the borrower has to pay a one-off, up-front premium for the cap. “The minute you require more cash out of a deal, it effectively ups the equity ante and tends to be unpopular. This is even though in practice caps are very flexible,” says one lender.

Lye adds: “Some borrowers will explicitly not do anything other than swaps, because they won’t pay; at the other extreme, given the uncertainty about regulation and current low rates and previous experience with swaps, others will only cap,” says Lye. “They’re much happier to pay a premium than run the risk of a swap mark-to-market that will impede their exit.”

He is trying to get banks and clients comfortable with spreading the cap premium over the life of the trade by having the borrower pay a fixed amount quarterly “so it doesn’t necessarily have a huge impact on your internal rate of return”.

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Swaption buyers pay a premium for more choice

Swaptions are another way of controlling interest rate risk. In the case of a payer swaption, the borrower pays a premium that buys the right – but not the obligation to enter into a swap contract to pay fixed interest at a pre-agreed rate, called the strike rate, on a specific date.

Thus, if the strike rate is lower than the current swap rate on that date (ie the swap is in the money), the borrower can exercise the option and either fix the rate, or alternatively, be paid the cash value of the swap at that time.

EMIR has yet to answer the key real estate questions

The EU is bringing in new regulations on derivatives, including interest rate swaps.  European Markets Infrastructure Regulation (EMIR) aims to improve the transparency of the derivatives market and reduce its associated risks.

EMIR is causing much heartache in the real estate industry because it will:

  • require all parties in outstanding or new swap contracts to report them;
  • require all parties that enter into bilateral over the counter swap contracts to comply with operational risk management requirements;
  • make it mandatory for certain types of bilateral swaps to be cleared through a central clearing house.

EMIR came into force in August, but a number of technical standards to clarify and codify these requirements have not yet been outlined. They are being reviewed by the European Securities Market Authority, in a process that will take three months. It is expected that they will be formally issued as regulations in the first quarter of next year.

The critical issue for real estate borrowers is whether their swaps will have to go through central clearing. This would mean having to post a margin – cash collateral – from the outset, based on the notional principal, which would have to be adjusted on an ongoing basis when the swap was out of the money. This would make swaps much more expensive.

EMIR draws a line between non-financial and financial counterparties. The latter includes banks, insurance companies, investment firms, spread betting firms, pension schemes and alternative investment fund managers  and their funds. Under EMIR, swaps between financial counterparties have to go through central clearing, while those involving a non-financial counterparty do not.

The key question for real estate is how do special-purpose vehicles (SPVs) and REITs fit into the financial and non- financial categories? Real estate funds, and indeed REITs, often finance assets via SPVs. Would those SPVs be considered financial counterparties, like their ‘parents’, or non-financial and hence not needing their swaps to be cleared?

Similarly, will REITs, property companies and joint ventures be considered ‘holding companies’ and classified as non-financial? These are the vital questions that have yet to be answered, but EMIR-watchers believe SPVs, REITs, property companies and joint ventures will escape central clearing.

They also think central clearing will not come into effect until at least the end of next year and more realistically, maybe in mid-2014. However, reporting requirements, which affect all swaps, will come into effect  next summer. In the case of real estate borrowers, reporting the swap is likely to be delegated to the bank providing it; this is how the system works in the US.