When an issuer engages in several swaps with the same counterparty, a master agreement can be used to limit credit risk and speed up the negotiation of terms.
The International Swaps and Derivatives Association has drafted a widely used sample master agreement. Introduced in 1985 and updated in 1992, the ISDA master agreement allows two parties to enter numerous swaps and related transactions under the umbrella of one legal contract.
Swap transactions are generally customized to suit the parties involved. A swap may have an unusual maturity, interest rate calculation, or other unique provisions. Each swap that an issuer enters might differ in these ways.
But other terms may be acceptable to an issuer on every swap. Some issuers may require that collateral be posted in the same manner on every transaction, for example.
So an issuer and a counterparty can negotiate these terms one time and set them down in a master agreement. The next time the issuer wants to enter a swap with the same counterparty, the basic terms are already laid down and do not have to be renegotiated, saving time and perhaps reducing legal costs.
The master agreement also helps mitigate credit risk by solidifying the legal status of netting. Netting is an accounting view that considers offsetting transactions on a bank's balance sheet together and reduces the bank's assessment of its credit risk.
For example, a bank may enter two swaps with an issuer. On one transaction, the bank may agree to pay the issuer a fixed rate and receive a floating rate on a principal amount of $100 million. On a second deal, the bank may agree to pay a floating rate and receive a fixed rate on a principal amount of $150 million.
The swaps create opposite effects for each party. If the bank is paying more than it receives on the first swap, it is likely to be receiving more than it pays on the second swap.
In assessing its potential credit risk on the transactions, the bank looks at the whole picture. The $100 million first swap counter-acts two-thirds of the $150 million second swap.
So the bank nets the exposure of the transactions with the issuer, leaving a $50 million principal portion of one swap. The bank's potential loss if the issuer defaults is not equal to the $50 million principal, but rather is the loss of interest to be paid on the $50 million over the life of the swap.
A danger to the bank arises if the issuer can choose to default on one swap but not the other. If the issuer defaults on the swap that is profitable for the bank, but stays current on the swap that is unprofitable, the netting arrangement breaks down.
If that happens, the bank has underestimated its credit exposure, which then could be as high as the interest expected on the $150 million second swap.
But by using a master agreement to govern both swaps, it's much harder for an issuer to selectively default, which is sometimes called cherry-picking. The issuer cannot pull out of one swap without canceling the other, too.