There are a number of reasons why lenders exposed to the real estate sector have not been as active in recovering their investments as they could have been. One reason not often discussed is the termination cost associated with interest rate swaps entered into by borrowers around the time the loan was made.
What are interest rate swaps?
Swaps provide borrowers with protection against changes in interest rate by locking in net cash outflow to a fixed interest rate. They work as follows:
- the borrower makes periodic payments to the swap provider – commonly the bank which provided the loan – based on a fixed rate, which is set by the swap provider at the outset;
- the swap provider makes periodic payments to the borrower based on a floating rate, which should be calculated on the same basis as the interest under the loan;
- these periodic payments are calculated based on a hypothetical amount called the 'notional amount', which should reflect the principal amount outstanding under the loan;
- the amounts payable by the borrower and the swap provider are offset so that only a single payment needs to be made by whoever owes the greater amount at the time of calculation.
If the floating rate payable under the swap falls below the fixed rate the borrower will have to make a payment to the swap provider, reflecting the rate difference, and the swap provider will make a profit. However, the loan interest payment owed to the lender will have reduced. If the floating rate payable under the swap is greater than the fixed rate the swap provider will have to make a payment to the borrower, reflecting the rate difference, and the swap provider makes a loss. However, the loan interest payments the borrower makes to the lender will have increased. The overall effect of this is that, irrespective of whatever happens with floating interest rates, the net cash outflow of the borrower is fixed.
Swaps on default
Over the last few years the collapse in the value of commercial property has meant that many borrowers have defaulted on their loans. There are many reasons why lenders have been unwilling to call a default but one of the most obvious, and least discussed, is that this may lead to the swap being terminated. Like most contracts, a swap will contain termination events.
Terminating a swap early will result in a termination payment becoming payable from one party to the other which is intended to reflect the market value of the swap at the time of termination. The payer will be the party which was expected to be making the payment under the swap in the future, had it not been terminated. If floating rates have dropped relative to the fixed swap rate – which is likely to be the case if the agreement was signed in a better economic climate - the payer will probably be the borrower.
This termination payment will be added to the principal and interest due under the loan. This will create a greater loss for the bank to carry in the difficult UK commercial property market.