MLR

Interest rate swaps may have hidden risks

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By Bob Durak, CPA, CGMA, Director of AICPA Center for Plain English Accounting

Once only seen on Wall Street, interest rate swap derivatives have migrated to Main Street and become a common way for companies to attempt to borrow with a fixed amount of interest.

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These interest rate swap derivative arrangements are typically receive-variable, pay-fixed with underlying pay-variable rate debt. The intention is that the receive-variable leg of the swap cancels out the pay-variable rate debt, leaving the pay-fixed debt. This is perceived to be the “synthetic fixed-rate debt.”

However, the perception that synthetic fixed-rate debt is the economic equivalent of fixed-rate debt is problematic. Some borrowers who have used interest rate swaps to obtain synthetic fixed-rate debt have been unpleasantly surprised by hidden risks associated with interest rate swaps, which, in some cases, has caused significant hardships.

Interest rate swaps used to accomplish synthetic fixed rate debt:

  • May not be economically effective during periods of economic turbulence
  • Do not have publicly available trading information to reference price quotes
  • Must be settled separately from the associated debt
  • Have provisions regarding early termination settlement amounts that are subjective and provide opportunity for abuse
  • Can be subject to lack of liquidity premiums to terminate
  • Expose the borrower to counterparty risk (on the interest rate swap)

Effectiveness of Interest Rate Swaps During Periods of Economic Turbulence

The receive-variable leg of the interest rate swaps is intended to match the borrower’s pay-variable interest rate on the debt obligation. In times of economic turbulence, this assumption has not been valid.

In some cases, clauses have been invoked on the variable interest rate debt obligation, such as, but not limited to, a market disruption clause, to raise variable interest rates that are not applicable to the interest rate swap. This leaves the borrower paying a high variable interest rate without receiving a compensating payment on the interest rate swap since the market disruption clause is typically not found in the corresponding swap agreement.

Pricing of Interest Rate Swaps

A prudent borrower that is entering into an interest rate swap to accomplish a synthetic fixed-rate loan should check the rate on the pay-fixed leg against the rates published by the Federal Reserve Bank. Swap Manager on Bloomberg terminals (SWPM) also can allow a user to see real-time trading in interest rate swaps and permit a user to see trading data customized for the interest rate swap’s maturity date, notional amount and applicable rates.

A borrower contemplating an interest rate swap for a synthetic fixed-rate loan should closely scrutinize any differences noted in the fixed rate for the interest rate swap offered to the borrower and fixed rates noted in trading for the same interest rate swap found on the Federal Reserve Bank’s website or by using SWPM on a Bloomberg terminal. Unfortunately, the lack of scrutiny of the interest rate swaps by borrowers can lead to potential abuse by interest rate swap counterparties.

Counterparty Risk and Right of Offset

Synthetic fixed-rate debt exposes debtors to counterparty risk that fixed-rate debt does not. Since a pay-fixed, receive-variable interest rate swap is needed to create a synthetic fixed-rate position, the debtor is exposed to a risk that the counterparty to the pay-fixed, receive-variable interest rate swap will not perform on its obligations on the interest rate swap. It is important to note that the counterparty to the interest rate swap may not be the same as the creditor for the underlying variable-rate debt in a synthetic fixed-rate position.

In the event of a counterparty default on an interest rate swap, a synthetic fixed-rate borrower may look to offset the amounts it is owed on an interest rate swap with the amounts owed on the underlying variable-rate debt. However, this typically will not be possible if the defaulting counterparty is not the same legal entity as the creditor to the underlying variable-rate debt.

If the defaulting swap counterparty also is the creditor to the underlying variable debt, a borrower may have some right of offset depending on the terms of the agreements between the parties. However, the right of offset should not be assumed. In some agreements, the lender has the right to offset amounts owed to it in the event of a borrower default, but the borrower does not have a corresponding right to offset amounts owed to it in the event of a swap counterparty default.

Interest rate swap participants are required under U.S. generally accepted accounting principles (U.S. GAAP) to measure their positions at fair value under FASB ASC 815. The determination of fair value includes a credit valuation adjustment (CVA) to the interest rate swap position. The CVA adjusts the interest rate swap position for the risk of counterparty default.