In a Nov. 6 article for American Banker, John Heltman provided a comprehensive overview of the challenges banks will face when the Federal Open Market Committee finally raises short-term interest rates. Margin pressure, deposit runoff and increased loan defaults from struggling floating-rate borrowers are all valid concerns that we see our bank clients wrestling with as they prepare for the long-awaited policy shift.
But the article's mention of rising rates causing potential loan defaults by commercial borrowers, and the potentially costly unwind of related interest-rate swaps, tells only part of the story. It misses the equally likely scenario of medium-sized lenders and their borrowers that are active in the swaps market actually standing to gain from a rate increase.
Since most business and commercial real estate loans have variable interest rates — with rates affected by the London interbank offered rate and other interest rates set by the Federal Reserve — borrowers face the obvious risk of higher costs when rates rise. But to ease that transition, many large and medium-sized banks with business and CRE loan borrowers offer them a simple, vanilla interest rate swap to effectively grant the borrower a rebate in a rising-rate environment.
The Nov. 6 article suggested that this set of circumstances against the backdrop of an uncertain Fed policy situation poses a double whammy of risks facing regional and medium-sized banks, if more businesses default on their loans because of higher interest rates and then the lender has to unwind the swap.
But it is precisely this concept of a swap being utilized as a hedge that protects both borrower and bank during a rising rate environment. Banks typically enter into a pair of back-to-back swaps to facilitate a long term hedging solution, one with the borrower and one with an upstream dealer, which is typically a larger money-center bank.
The article referenced these secondary deals only briefly. If the borrower is still a going concern and paying back the loan, the first swap corrects its higher interest costs via the rebate. In the event the borrower defaults in a higher interest rate environment, both swaps would typically be unwound. However, because that secondary swap can be terminated at a gain, it would serve to improve the bank's position in working out the troubled commercial loan. The ability of the upstream dealer to handle its obligation has never been questioned.
Jumping to the conclusion that swaps are always costly to unwind is tempting because that has been the experience of the past thirty years. The long-term cycle of falling interest rates has shined a bright light on the profit-reducing aspects of hedging while causing some to forget that the primary purpose of swaps is to provide a tangible payoff when needed most — when interest rates rise. As the December FOMC meeting approaches, speculation will grow about the Fed's intentions. And in a market where the only thing certain is uncertainty, utilizing interest rate swaps as a hedge can help to smooth out potential bumps in the road.
Bob Newman oversees the financial institutions advisory practice at Chatham Financial and counsels institutions on interest rate hedging.