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Managing Borrowing Costs Across Time
By John Finley, CPA, CMA

John Finley serves as SVP, Director of Finance at Graystone Tower Bank and is responsible for interest rate risk management, investment portfolio, treasury, strategic forecasting, and budgeting operations. He has over 29 years of professional experience spanning public finance, executive leadership, teaching, operations consulting, and public accounting. John has a B.S. degree in Accounting from Messiah College and an MBA from Shippensburg University of Pennsylvania. He can be reached at jfinley@graystonebank.com or 717-724-4603.

As direct participants in the financial system, we (both lenders and borrowers) are living through some of the most turbulent times of our careers. In recent years, we have witnessed high-profile financial institution failures, mergers and acquisitions resulting from inadequate credit assessments and underwriting standards, and extraordinary government intervention. These forces have been on display globally (most recently in Europe), nationally with the failure of mortgage giants Fannie Mae and Freddie Mac, and locally as businesses adapt to a weakened economy. For many nations, companies, and individuals, the consequences of excessive leverage have become the current reality. 

While interest rate cycles naturally occur over time, recent rate movements have been particularly dramatic. The charts below depict the magnitude of the volatility in interest rates over long periods of time (US Prime Rate) and over the past three years (US Treasury Yield Curve). Based on current events, it is reasonable to assume that interest rate volatility will continue indefinitely.

The key to successful capital management is to manage borrowing and equity costs over time through balancing cost, flexibility, and interest rate risk. For many companies, there is a tendency to focus primarily on the first objective – minimizing borrowing costs. However, such an approach sacrifices a certain degree of flexibility that is often necessary to exploit new opportunities or manage unforeseen future events.

One popular tool to minimize borrowing costs is the interest rate swap. In its simplest form, a swap is a derivative contract that establishes the exchange of payments between a borrower and a broker-dealer or bank (known as counter-parties). The cash flows being exchanged are typically the interest payments of a debt obligation. In the current environment, the typical swap structure involves locking in a fixed rate for a defined period of time through an interest rate swap that is executed in connection with an underlying loan that pays interest indexed to the London Interbank Offered Rate (LIBOR). Since there is no exchange of principal, the swap agreement is denominated at a notional amount that corresponds to the outstanding principal amount of the borrower’s debt, either in whole or in part. It is important to note that the obligations under both the swap agreement and the loan agreement are absolute regardless of what happens with the other agreement. The diagram below differentiates the obligations between the debt obligation and the swap agreement.

The use of an interest rate swap adds a layer of complexity that extends beyond the core business relationship between the lending team of the bank and its borrowing customer. In many instances, a bank enters into a corresponding swap with a separate third party to mitigate the risk of the swap with its borrower. Often a separate profit center within a bank, tasked with managing its own profitability and risk, structures the two swaps. If the borrower wishes to terminate the swap, the bank will likely elect to terminate or negate the second swap with its counter-party in order to cancel its swap risk.

Interest rate swaps carry both benefits and risks. The primary benefit of interest rate swaps, in the current market, is the ability to obtain longer term fixed rates than are typically offered by commercial banks that use consumer deposits as their principal funding source. This benefit should be considered within the context of the risks associated with interest rate swaps including, but not limited to:

1. A swap is a derivative contract. As such, it has a value that is derived from the relationship of interest rates at a  
    given point in time. If the swap is terminated prior to its maturity, this value is settled between the counter-parties of
    the swap. This settlement, known as termination value, is based on the difference in the present values of the
    exchanged cash flows discounted at the then-current market rate and may result in a payment to the borrower or
    an additional obligation to be paid by the borrower. The termination value tends to be higher if the remaining term
    of the swap is longer. For example, the termination value of an interest rate swap with ten years of remaining term
    is generally higher than a swap with a remaining term of five years.

2. Since the value of most interest rate swaps are a function of the LIBOR interest rate swap curve, the borrower is
    exposed to risk when the slope or shape of the LIBOR curve moves in a way that disadvantages the borrower.
    Recent events have demonstrated that LIBOR is more volatile than the prime rate and is influenced by many
    international factors and events.

3. The value of the swap changes on a daily basis. As such, all or a portion of the change in value of the swap may
    be reflected in the income statement of the borrower when financial statements are prepared under generally
    accepted accounting principles, thereby creating earnings volatility for the borrower. While this volatility may be
    taken into account with respect to debt covenants, a borrower may have other constituencies that do not have the
    ability to ignore such earnings fluctuations.

4. Since the interest rate swap is a distinct agreement from the loan agreement (or in some instances, embedded in
    the loan agreement), restructuring debt requires addressing the obligations under the loan agreement and the
    swap agreement.
Depending on interestrate movements, this additional layer of complexity may limit theflexibility
    to restructure debt.

5. The apparent risks of interest rate swaps when they are initiated may not be the actual risks, which only become
    evident in the future.
For example, in the mid 2000’s, many Pennsylvania school districts,counties, and other
    public entities entered into interest rate swapsthat eventually resulted in substantial losses because market factors
   
and interest rate relationships were not consistent with historical experience.

Practical Considerations Regarding the Use of Interest Rate Swaps

1. What is the business purpose of the swap and how does a derivative solution help accomplish that objective?

2. Can other financial tools be used to accomplish that purpose without conceding debt restructuring flexibility and
    incurring the interest rate risks associated with swaps? For example, a single loan could be structured to include a
    combination of a fixed rate, a variable rate indexed to LIBOR, and a variable rate indexed to the prime rate. The
    fixed rate component exploits the historically low interest rate environment and the variable rate components
    provide flexibility should debt restructuring be needed. By indexing variable rate debt to both LIBOR and prime, the
    borrower minimizes its exposure to a single interest rate index.

3. Have you considered the option of applying the swap to a portion of the outstanding loan balance to partially
     mitigate the risks?

4. Do you understand the transaction well enough to explain it to others?

5. Do you have a thorough knowledge of the accounting implications of interest rate swaps and the potential impact
    on the income statement?

6. Is there an unusual level of enthusiasm for the use of an interest rate swap to structure the loan? It is important to
    note that banks and counter-parties receive fees when structuring the swap. While these fees compensate the
    parties for their work and the increased risk of the swap (banks do incur additional risks that the borrowing
    customer does not bear), there is the potential to generate fees that may be disproportionate to the related risk.
    Some financial institutions may link such fees to lender incentive plans which may not be disclosed to the borrower.

The interest rate swap is just one of several tools to manage borrowing costs over time. This is particularly true if the interest rate swap is applied only to a portion of the loan balance. Before selecting this option, lenders and borrowers should explore the relative risks and rewards of derivatives in relation to other tools in order to achieve the appropriate mix of capital management objectives that include managing cost, flexibility, and interest rate risk.

 
 
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