Interest Rate Hedges: Get the Benefit of Your Bargain
- Oct 20, 2010
At first glance, interest rate hedging products can appear confusing and dangerous. However, and particularly since the heyday of CMBS, these kinds of products regularly find their way into real estate finance transactions and often are a requirement for closing loans.
At first glance, interest rate hedging products can appear confusing and dangerous. However, and particularly since the heyday of CMBS, these kinds of products regularly find their way into real estate finance transactions and often are a requirement for closing loans. In order to shed some light on these often obtuse contracts, this article will examine some commonly overlooked provisions in a typical hedge transaction.
Generally, the terms of hedging contracts are governed by the documents promulgated by the International Swaps and Derivatives Association which include such standard forms as an ISDA master agreement, a schedule to such master agreement where the deal specific terms are negotiated, and a confirmation which sets out the basic financial terms of the deal. Sometimes the confirmation and the schedule are combined into one long-form confirmation. By and large, once the basic financial terms are established in the confirmation, most of the negotiating regarding the substantive legal terms of the contract takes place in the schedule, and it’s here that most borrowers find unwanted surprises.
Most interest rate hedge agreements come with a number of built-in issues and concerns: Is this a one-off hedge or part of a series of on-going transactions? Will the interest in the hedge be pledged as collateral for an underlying loan? Under what circumstances should the rights and obligations under the hedge agreement survive the maturity of other unrelated obligations between the parties? Are the rights of the parties under the contract assignable? Each of these issues requires careful thought and, undoubtedly, a modification to the standard documents initially proposed by most interest rate hedge providers.
However, a number of unusual and often overlooked areas of concern arise in transactions where interest rate swaps are sold by the trading desk of a borrower’s real property lender. Simply put, from the borrower’s perspective, interest rate swap transactions essentially convert a floating interest rate obligation into a fixed interest rate obligation, provided that the borrower also takes on additional payment obligations if interest rates fall below a predetermined floor. In this context, when the borrower purchasing the swap is a special purpose entity whose only asset is the real property, third party swap providers will often require separate collateral or credit support to stand behind such borrower’s potential payment obligations for the floor component.
However, when borrowers purchase swaps from their existing real estate lender, they not only are able to get better pricing than they would if they purchased an interest rate cap, they can also often avoid such additional credit support obligations (which would otherwise likely come from a guarantor) by expanding the obligations secured by the real property collateral under the security instrument securing the real property debt obligations.
But there are some unique issues that come into play when a borrower’s real property lender is also its swap provider. For example, consider the following additional termination events, any of which will permit the lender/swap provider to close out the contract:
• Lender transfers its interest. Many ISDA Schedules provide for an Additional Termination Event when the swap provider/lender assigns its position in the underlying real estate loan, a standard ability for which most borrowers have no control or consent rights. Should the borrower lose the premium or face having to purchase a replacement hedge in order to satisfy loan requirements if the lender, at its election, decides to sell its interest in the real property loan?
• The loan is repaid. If a borrower that purchases a 5-year swap when a loan closes repays such loan before the swap term matures, such borrower may be surprised to learn that the repaid lender/swap provider has the ability to close out the swap. A borrower hoping to pledge the remaining term of an ‘in the money’ swap to a new lender (e.g., as part of a refinance) may be left having to start from scratch when the existing swap provider closes out the swap.
• The lien on the property is not released. On the other hand, a borrower seeking to sell or refinance its property and pay off the existing loan may have a serious title issue if the lender/swap provider does not close out the swap and the borrower obligations thereunder remain secured by a lien on the real property. These types of provisions are typically drafted so that the borrower is the sole affected party, so if a swap is in the money to the benefit of the lender/swap provider, the borrower could find itself over a barrel.
At the end of the day, borrowers should be mindful of these kinds of issues when entering into standard form/non-negotiable interest rate hedge contracts. There is a lot of value to be had in these contracts and, as is often the case, a commensurate amount of liability if one is not careful.