Go ahead, buy it. That little black dress is calling your name. You know you don’t have anything to wear to the upcoming gala event. You can totally justify this purchase! You already have the perfect matching shoes and handbag. All you need is that one last item, that stunning dress, which has singled you out amongst the shopping masses, and wants nothing more than to be owned by you! Besides, you just need it for this one night. Maybe you can buy it, wear it, and return it for a full refund, all within the same credit card billing cycle. If you do, you’ll probably make that sensational appearance that you imagined – but you’ll also certainly be committing a form of retail theft called “wardrobing.”
Believe it or not, wardrobing and other forms of return fraud cost retailers more than $10 billion each year. We’re not just talking dresses either, as it happens just as often with tools, technology equipment, and TVs (think Super Bowl time). Retailers have a hard time with this because these items do not come back in the same condition, or with unblemished packaging and materials, as one would expect. The result is that retailers too often cannot resell these items as new, cutting into their bottom line on a surprisingly massive scale. Now, one retailer plans to put a stop to it.
At the risk of alienating clients, Bloomingdale’s last week began a policy of tagging every dress priced at $150 or more with a large, prominent “B-tag,” attached to the garment at the time of purchase. The tag is placed in a highly visible area so the item can’t be easily worn with the tag in place (without everyone knowing, that is) and Bloomingdale’s will no longer accept returns on items where the tag has been removed. While this is sure to make it more difficult to commit return fraud, the store’s policy is being closely watched by other retailers to see if it has a negative impact on Bloomingdale’s sales. If this new return policy catches on, generous returns may fall out of favor in the retail space for good.
It’s too bad Bloomingdale’s isn’t selling interest rate swaps. Unlike retail items, swap returns are still accepted, regardless of your use or time of possession, and can even be returned to different parties than those to the original transaction. There is no “all sales final” policy, nor “receipt required,” nor “B-tag” in order to unwind a swap. You can even buy it knowing that you will return it, without losing a bit of sleep over the morality of your decision. As we examine the various ways returns are made with over the counter derivatives, be mindful that not all returns are alike. Some returns are more hassle than others, and cost is always a factor in your decision on how and where to go.
Unwind it. The classic unwind. You entered a transaction with your swap counterparty, and now you need to return it. Whether you have had it one month or ten years, your counterparty should determine the present value of all remaining cash flows, and put a price on it for you. The value has everything to do with the replacement rate, i.e., where a new transaction of the same remaining terms would be priced in the market today, as compared to your original swap rate. The actual unwind price, however, has more to do with your swap counterparty’s own costs, their other business dealings with you, and ultimately their appetite for such a return transaction. Such costs above mid (“transaction fees”) could range from near zero to tens of basis points. Knowing the magnitude of these transaction fees will help you understand if you are getting a great deal getting out, or if you need to seek a better solution to your termination transaction.
Transfer it. You’ve been shown the unwind price by your swap counterparty, and it’s not pretty. You expected better, and quickly determined after discussing with your counterparty that there is no room for improvement, in their dealings with you. What to do? In the case of an extremely unreasonable unwind (high transaction fees relative to actual market value), you might consider a transfer. The way this works is that you need to involve another swap counterparty, who quotes you a more favorable unwind price on the same transaction, but only if your original transaction can be first transferred to this new dealer. As “transfer” requires consent from all three parties (transferor, transferee, remaining party), the deal needs to make sense all around. You increase your odds of a successful transfer if there are ISDA agreements already in place between and among the parties, along with active trading relationships. Assuming this scenario is accepted, you agree to transfer your position to the new swap counterparty, who has pre-agreed to let you “return the swap” at a more reasonable price. Note: if your original swap counterparty withholds consent, this approach falls apart. Best to discuss this scenario early in the unwind process, and be prepared to consider still other approaches for the best result.
Lock in the gain or loss. Still another approach, where both “Plan A” and “Plan B” are untenable, is to consider going the opposite direction, with someone else. Assuming you have credit and trading lines elsewhere (not a small assumption), you can elect to receive fixed (if you previously paid fixed) and vice versa, at current market rates, on the remaining terms of your existing agreement. In doing so, you are locking in the remaining cash flows as the difference between swaps, and thus locking your asset or liability position. You will want to check with your accountants on how this needs to be treated, as a quantifiable asset or liability may need to be recognized in the current period or over the remaining life of the original hedge transaction, depending on the associated hedge accounting treatment (or lack thereof). While this may be your best remaining unwind option, you are fundamentally agreeing to perform on two swaps with different counterparties for life of trade in order to accomplish such a plan. Nonetheless, it could still make sense in the right situations.
Cancel it. Still another popular return approach is to contemplate your exit up front with an embedded cancel feature. For a fee (generally, in the swap rate), you can purchase the right, but not the obligation, to cancel the transaction at a point or points in the future, for no additional cost. In a cancellable swap, you and your counterparty will agree to tear up the swap agreement, if you exercise your option, and on the condition that you exchange the final fixed and floating leg cash flows for the current period. You avoid the hassle of a negotiated settlement, or involving other parties to your transaction, but in exchange your swap rate will be higher than the standard swap rate. The price of the cancel feature and thus the additional cost in basis points is largely dependent on the type of option (European – one exercise date, Bermudan – multiple exercise dates, or American – anytime), as well as the length of the “lockout” period (ranging from months to several years, typically) and on current levels of swaption volatility. Of course, if the position is an asset to you at the time of your contemplated exit, you can elect to unwind your deal rather than exercise your option, and thus benefit from the current rate environment.
Even with the new return policy at Bloomingdales, if you find the perfect dress there, you know you’re going to buy it! While we can’t help you with impulse buys and retail returns, Chatham can help you think through your unwind alternatives, and help secure the best deal for your circumstances. There’s no better time to get us involved than right now, before your swap purchase even takes place. Give us a call 610.925.3120 or email us!