Interest rate swap transactions are derivative financing products which are confusing to many but are becoming more and more popular for banks and borrowers these days. Most banks in this tough financial market require that their loans be based upon LIBOR, the London Interbank Offering Rate, which is the rate by which banks borrow from, and lend money to, each other. LIBOR based loans allow banks to vary the interest rate based upon market conditions.
To protect against the possibility of soaring interest rates, borrowers frequently enter into interest rate swap transactions allow to effectively convert variable interest rate loans into fixed rate loans. These transactions are thereby devices to hedge against variable interest rates such as LIBOR. In such transactions borrowers with term loans of multiple years and variable interest rates enter into agreements with their bank or a third party to exchange or “swap” interest payments for a set period in order to eliminate the volatility of the variable rate.
For example, a borrower has a $10,000,000 term loan with a 10 year term and a rate of LIBOR plus 250 basis points. (Currently LIBOR is trading at approximately .22%, so the effective rate is about 2.72%). The borrower contracts with a third party (called the swap counter party) to pay monthly, for a term of ten years, an interest payment equal to 3.00% times the outstanding principal amount of the loan (called the notational amount). The swap counter party in turn agrees to pay to the borrower, monthly, for a term of ten years, an amount equal to LIBOR plus 200 basis points times the notational amount. This transaction is in addition to the payments of principal and interest required to be made to the bank pursuant to the underlying loan documents.
|Borrower interest payment to Bank||(LIBOR plus 2.50%)|
|Borrower interest payment to Swap Counterparty||(3.00%)|
|Sub Total||(LIBOR plus 5.50%)|
|Swap Counterparty interest payment by Borrower||LIBOR plus 2.00%|
|Total (Effective Interest Payments by Borrower)||(3.50%)|
In our example the borrower ends up paying an additional .78% (3.5% minus 2.72%) in order to lock in a fixed interest rate. Should LIBOR rise over 1.00% during the term of the contract, the borrower will have made an excellent decision. Should LIBOR fall, the result will not be as good. Regardless of the rise or fall of LIBOR, the swap contract provides stability and permits the borrower to plan for future capital needs.
Using swap transactions to hedge against variable interest rates is a tool still available to borrowers in this economic climate. When properly negotiated, a swap transaction can provide capital stability when interest rates rise. For more information regarding interest rate swaps contact the Business Organizations and Tax Department at Wickens, Herzer, Panza, Cook & Batista Co.