Credit considerations when evaluating interest rate swap strategies
- March 8, 2021
Head of Sales
Financial Institutions | Denver, CO
In this brief video, Ben Lewis discusses the importance of considering credit when evaluating traditional and indirect interest rate swaps.
In a previous video, we discussed the two ways that community banks offer interest rate swaps to their borrowers: traditional interest rate swaps (offering swaps directly to a borrower) and indirect swaps (where a community bank introduces a correspondent bank to their borrower who then offers an interest rate swap).
Considering credit when evaluating swap strategies
There are three focus areas which a community bank should consider as it relates to the credit implications of indirect swaps.
The correspondent bank requires a senior position in the loan collateral
An interest rate swap is a credit instrument, and can be an asset or a liability to the customer. As such, the correspondent bank requires a senior position in the loan collateral. That means that the community bank, in a workout situation, is actually subordinate to the correspondent bank in the loan collateral.
The community bank has an unrecognized contingent liability
The community bank has the option to make the correspondent bank whole for any borrower swapped liability, and that is typically what a community bank would do. It also means that for each indirect swap that a community bank has, it also has an unrecognized contingent liability (the borrower potentially failing and the borrower's swap being a liability). It's unrecognized because a community bank does not actually show that on their balance sheet.
The correspondent bank must agree to the amount of loan-to-value proceeds
Because of the credit nature of swaps, the correspondent bank must agree to the amount of loan proceeds, i.e. loan-to-value (LTV) at which the bank lends. This has real-world implications for banks as they compete for loans.
For example, a $2.6 billion dollar Midwest bank wanted to offer a 10-year fixed-rate deal at an 80% LTV. They were going to have the correspondent bank offer an indirect swap to the customer to lock the rate on the deal, but the correspondent bank actually denied their request for an indirect swap and wanted the community bank to lower their LTV.
It is important that community bankers understand the credit implications of indirect swaps. In contrast, traditional swaps provides a community bank with complete control of the credit decision without having to bring a third party into the relationship.
We'd like to hear from you
Contact us if you have questions about how to measure the contingent liability of an indirect swap or are interested in offering swaps directly to your borrowers.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.21-0057
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