(and Other Embedded Derivatives or Hidden Provisions)

Hamburger or Horsemeat?

Move over pink slime, there’s a new yuck factor in the food supply. That delicious fast food hamburger you crave now looks just a little more suspicious. It doesn’t smell or taste any different, but how do you know it’s still 100% real beef? Most folks would not have given it a second thought, but more than a few consumers in a dozen European countries were aghast to find that some of their favorite meals were made with meat more likely to have been hit with a riding crop than poked with a cattle prod. “Horsemeat” has contaminated an alarming array of delicious dishes in Europe, including burgers, meatballs, pasta, and lasagna. The global downturn is partly to blame, as horse ownership has proved to be a costly and expendable endeavor when economic crisis hits home. The result is cheaper meat entering the food supply. Even school lunches may contain such horsemeat, a disturbing possibility leaving parents incensed; neigh, outraged!

There are a number of reasons why consumers are so upset about this Clydesdale-size scandal. While some cultures do eat horsemeat, cultures that don’t are simply repulsed by the thought of it. Unlike with beef cattle, horses are generally not even raised for such purpose, and consequently some horsemeat contains trace equine medicines that are wholly unsuitable for human consumption. And without truthful ingredient and nutrition labels, consumers are unable to make appropriate choices for themselves and their families. But the biggest reason this scandal has legs and is moving faster than a thoroughbred at Churchill Downs is because nobody knew about it. Consumers were unsuspecting, and were duped. And that’s just not right.

Nobody really knows how widespread the practice has been, so food inspectors have resorted to using DNA test kits to confirm the makeup of several popular meals. Also, getting out in front of the problem could take some time, as even the food suppliers themselves may not know their beef ingredient has been switched to cheaper horsemeat. Still, the prepared foods industry is only the latest to wrestle with the introduction of unwanted or unknown ingredients. If you think they have it bad, you should see the horsemeat that ends up in some commercial loan agreements and derivative contracts!

Horsemeat in my loan agreement (derivative pre-conditions). Your loan has closed and you are ready to purchase interest rate protection. You plan to buy an interest rate cap, and tell your advisor to prepare for a competitive auction to pay the lowest out-of-pocket cap premium. But a quick scan of your loan agreement alters those plans. You are obligated to purchase this cap directly from your lender, or someone agreeable to your lender! This language is more common than you think, and while this does not necessarily translate into a higher priced cap, it very well could by eliminating competition or excluding certain providers that typically price well on competitive deals. Cap pricing is not at all based on your creditworthiness, but rather the market price and a bank’s appetite for your business. Outliers to a typical cap auction can be thousands or even hundreds of thousands of dollars away from the best level. You absolutely want the freedom to select your cap provider, but this type of language limits choice and can increase cost. Now that’s some horsemeat!

Horsemeat in my loan (embedded derivatives). “I don’t do derivatives,” you say. Who could blame such a sentiment in this day and age, with so much negative press about these complex transactions? “That’s why I only take out conventional loans, like floating rate loans (subject to a minimum rate) or fixed-rate loans (with prepayment make whole provisions).” Wait, what? Maybe you didn’t think you do derivatives, but you have just embedded a sold floor or swap breakage into your loan! Lenders in many cases have minimum yield requirements, whereby a borrower pays a minimum LIBOR rate so long as LIBOR remains below a predetermined level (the floor strike). As a borrower, not only are you not getting value for this instrument (and there is real value in a sold floor), but as a high quality borrower you may actually be subsidizing the low quality borrowers of this lender. If you instead go the fixed-rate loan route, and have breakage language based on swap rates, an early loan prepayment would likely be less costly than traditional yield maintenance. But if you have this type of one way breakage language, and prepay in a rising rate environment, additionally you would actually forego the possible “positive breakage” afforded a borrower who did an actual interest rate swap. So, the embedded swap breakage in your note gives you the same downside breakage potential, but none of the upside potential. If there are embedded derivatives in your loan that your lender did not explain and that you were not aware of, now that’s some horsemeat!

Horsemeat in my swap (pricing ambiguity). You’ve been working with your lender to close a loan and execute an interest rate swap at the same time. Your lender explains how they price swaps for borrowers and says the bank will add a fair, market-based spread or credit charge over the observable swap rate to come up with your rate. Then your lender shows you the 10yr “semi-bond” swap and says your rate would be that plus this spread as an indication. Interesting. A quick call to your advisor confirms your concerns. Your loan is based on 1 month LIBOR, so why is your lender quoting based on a 3 month LIBOR instrument? Furthermore, your loan is 10 years, amortizing, so why is your lender quoting against the “bullet” interest only swap rate? These two issues alone could easily increase your swap rate 25 to 50 basis points over where it would otherwise be. What else is in that agreement? Maybe the lender does not have access to a customized pricing tool, to give you pricing based on your matching structured swap. Or maybe he does, and he is counting on you not to know the difference. If your lender is not quoting you a swap rate based on your specific structure, now that’s some horsemeat!

If you think you might have some unknown ingredient in your loan agreement or derivative contract, give us a call or send us an email! No one should have to get up from the table, after the fact, wondering what was really in that meal – or deal!