Indirect swaps: we’ve got control issues

Banks looking to manage the interest rate risk of long-term fixed rate loans have several tools at their disposal. They can match fund, hedge at the portfolio level, or hedge at the loan level. One tool used by community banks are indirect swaps. With indirect swaps, the community bank introduces their borrower to their correspondent bank who then provides a swap directly to the customer. Sometimes the swap is called a rate protection agreement or rate conversion agreement, but in either case it is a swap. Your customer has borrowed on a floating rate basis from the bank and entered into an agreement with the correspondent bank to swap their floating payments for fixed.

Indirect swaps' primary appeal is simplicity. The correspondent banks offering this solution tout the ease of use and minimal impact on the bank. But simplicity comes at a cost, particularly as it relates to control of the borrowing relationship with your customer.

COVID-19 has changed a lot of things and much remains to be seen: when will we go back to the office? Will many businesses be able to return to “normal” operations? Will my CRE borrowers be able to pay loan principal and interest when their tenants are struggling?

One question that has come to us recently: what do I do with a loan that I need to forebear and it involves a indirect swap? The answer may surprise you.

The agreement between your borrower and the correspondent bank is a credit instrument for which the correspondent bank requires security. They achieve security on their swap with your customer by taking a first position lien on the loan collateral. If the loan defaults, the correspondent bank has priority in the workout until they are made whole on the swap; your bank is left with what remains. Most banks choose, however, to “buy out” the correspondent bank’s swap position so that they can jointly workout the loan and swap.

Prior to COVID-19, this was an academic exercise. But banks desiring to give relief to their borrowers by amending loans with associated indirect swaps are in a pickle – they don’t have full control of their relationship because it has been assigned to the correspondent bank. They are at the mercy of the correspondent bank to decide how to manage the loan and, most importantly, their interest may not be aligned with those of your bank.

In contrast, with any of the solutions mentioned at the start (match funding, portfolio swaps, and loan-level swaps), the bank completely owns the relationship. The correspondent bank is no longer at the head of the table – they aren’t even at the table! There is no potential for a misalignment of interest. Even in the case of a loan-level swap, the bank decides how to manage the loan and the swap with their customer relationship.

Community banks are just that: banks that serve their local communities. They operate on trust, relationships, and high-touch customer service. While introducing a correspondent bank into the mix may seem simple at first, it can result in control issues for one of the bank’s greatest assets – its customers.