Understanding Interest Rate Swaps
By: Dan Mikes
In the last couple of years, a number of articles have appeared in religious industry periodicals on the subject of interest rate swaps. Some have been written by professionals from various industries suggesting expertise on the topic. I have not seen these authors reference any direct role in, or experience with, the execution of an interest rate swap for a religious institution loan.
These commentaries typically allude to religious institutions that became upset with their lenders after being surprised to learn that refinancing in the current low interest rate environment was less beneficial by virtue of an early termination cost or loss (commonly referred to as a prepayment penalty) owing on their interest rate swap. Admittedly, no one appreciates surprises in a business relationship, certainly not of this kind. Some lenders may not have done an adequate job of communicating this risk upfront.
Through my career, I have made over $3 billion in loans to religious institutions. Those loans included hundreds of millions of dollars in interest rate swaps. I know from experience that when a religious institution's finance committee is provided with a comprehensive presentation, they can make a decision without fear of future surprises. An interest rate swap can be used in conjunction with other loan products to provide the borrower with a level of insulation against future interest rate volatility, while also retaining the flexibility to prepay a portion of the debt without penalty.
Those encountering a swap for the first time will admittedly need some educating. However, in my view, the product is not the esoteric instrument that some paint it to be. On June 7, 2012, when asked about interest rate swaps during his testimony before congress, Federal Reserve Chairman Ben Bernanke stated, "Interest rate swaps are very straightforward and do not pose the same risk as credit default swaps" (as quoted in Joint Economic Committee Examines the Federal Reserve's Economic Outlook).
In the current interest rate environment, religious institutions want to lock in a fixed rate while rates are at historically low levels. However, if the banks were to agree to accept a low fixed income stream for the next five or ten years, and if interest rates rise in the future, several years from now the Bank may be in the undesirable position of paying higher interest to its customers on their CDs than they are receiving from their borrowers. Consequently, Banks want to make variable rate loans, thus, the interest rate swap enables both parties to have what they want.
At this point, a basic definition of an interest rate swap is warranted. An interest rate swap is an agreement between two counterparties to exchange payments that are based upon different interest rate characteristics. At its simplest, the swap may be considered as a LIBOR hedge that essentially fixes the variable rate nature of the underlying LIBOR rate of the loan. The religious institution borrows from the Bank based on a variable rate tied to LIBOR. The swap exchanges that variable rate for a fixed interest rate. Consequently, the religious institutions gets what they want – a fixed rate loan, and the bank gets what they want – a variable income stream. It is important to understand that a swap is a contract separate from the loan.
Versus any point in the past 33 years, now appears to be a good time to insulate your religious institution from the possibility of rising interest rates. Lenders commonly offer religious institutions 20 to 25 year amortization durations. Religious institutions typically make prepayments along the way, resulting in the elimination of debt over a shorter period. A religious institution planning to borrow should begin by forecasting a best and a worst case prepayment scenario. The debt can then be divided across several notes.
For example, a religious institution may need to borrow $5 million. Between regularly required monthly payments and prepayments, the Religious Institution expects to reduce the debt to $3 million within 10 years. Consequently, the religious institution may decide to place $3 million of the debt on a note with a 10-year fixed interest rate via an interest rate swap. The remaining $2 million may be placed on adjustable rate note, which has no risk of prepayment penalty. This approach provides the borrower with a measure of insulation against future rate volatility, while also affording the borrower the flexibility to make some prepayments without worrying about incurring a penalty.
Said another way, perhaps the religious institution has some limited near term prepayment capability via outstanding pledges from a capital pledge campaign, or the anticipated proceeds from the pending sale of a piece of property. A portion of the debt can be placed on a low variable interest rate note. The religious institution expects to pay off this note in the near term, so the benefit of the lower variable interest rate may outweigh the risk of higher interest rates down the road.
Further, if a subsequent capital pledge campaign is contemplated, it may make sense to put a portion of the debt on a 5-year fixed rate note. The variable and 5-year fixed rate notes will likely not have any prepayment penalty. The portion of the debt that the religious institution does not anticipate prepaying may be placed on a 10-year fixed rate via an interest rate swap. A conscientious lender will provide comprehensive consultation upfront so that the borrower can select the appropriate mix of products based on their unique repayment plans.
Swaps have been in play in the religious institution market segment for approximately 10 years. Over the past 10 years, interest rates have generally trended downward. As a result, religious institutions that did not understand the product when signing up for it were surprised later when they learned a prepayment (or a termination payment) would be due upon early termination of the swap together with early prepayment of the note. Given interest rates are currently at or near historic lows, one might argue that the risk of owing a prepayment penalty in the future is less likely.
The interest rate swap can be a beneficial instrument in the current rate environment. Some lenders are able to offer other supplemental products that do not include the risk of a prepayment penalty. Structure your debt based on your unique objectives and determine for yourself the right measure of insulation against longer term rate volatility and the amount of flexibility you need to prepay debt.
Don't let the fear of the unknown cause you to shy away from a product that can provide a 10 year fixed rate at a time when interest rates are at or near historic lows. If you pass up this opportunity now, you may find yourself renewing your loan at a much higher interest rate 5 years from now. Look for a good Bank that can work with you to achieve a level of understanding that will enable you to make the best possible decision for your Religious Institution.
Dan Mikes is executive vice president and national manager in the Religious Institution Division at San Francisco-based Bank of the West. He has more than 20 years of experience in banking and finance and can be reached at firstname.lastname@example.org.