Debunking the myth of interest rate swaps

By Dan Mikes

The product is not the esoteric mystical instrument that some paint it to be.

Over the last couple of years a few articles have been written on the subject of interest rate swaps. Some have been authored by individuals purporting expertise on the topic, yet never referencing any direct role in or experience with the execution of an interest rate swap.

Often their commentary includes references to churches who were upset with their lenders after being surprised to learn that the potential benefit of refinancing in the current low interest rate environment was reduced by virtue of a prepayment penalty owing on their current interest rate swap.

Understandably, no one likes surprises in a business relationship, certainly not of such a nature. While borrowers should always understand the contracts they sign, many lenders may have understated the risk of a prepayment penalty when selling swaps.

I have made more than $3 billion in church loans and have been a direct party to the execution of hundreds of millions of dollars in interest rate swaps for church loans. When the upfront disclosure is comprehensive, informed decisions can be made to use swaps in conjunction with other loan products to achieve a certain level of insulation against future interest rate volatility while also retaining the flexibility to prepay some of the debt without penalty.

Anyone encountering a swap for the first time will admittedly need some educating. However, the product is not the esoteric mystical instrument that some paint it to be. In fact, on June 7, 2012, during his testimony before Congress, Federal Reserve Board Chairman Ben Bernanke was asked about interest rate swaps. He stated: “ … interest rates swaps are typically among the most straightforward and simple to understand of derivatives.”

What is a swap?
Swaps essentially convert a variable rate loan to a fixed rate loan. While clients want to lock in historically low interest rates for as long as possible, lenders prefer variable rate loans. If a bank were to commit to a low fixed income stream for the next five years or 10 years, and if the economy later gathers steam, then three or four years from now the bank may be paying more to their depositors on CDs than they are receiving from the church loan. Church loans are specialty credits. Consequently, the bank cannot readily securitize and sell off the church loan – or get out from under the fixed income stream as they commonly do with more standardized credits such as single family residence mortgages.

In essence, the swap can be thought of as a three-party agreement. While the bank may not be willing to commit to a fixed income stream in a historically low interest rate environment, another institution (the counterparty) may be willing to do so. The other institution then commits to pay the lender bank the variable income stream that they prefer. The two financial institutions effectively exchange the interest income streams – thus the term swap.

The church gets what they want – a fixed rate loan, and the bank gets what they want – a variable income stream. The counterparty also gets what they want: as long as future variable rates do not rise above the fixed rate, the counterparty receives the benefit of the difference between the variable and fixed interest rates without putting any capital at risk (they don’t fund the loan, the lender bank does).

Per the lender bank’s credit rating, the counterparty also benefits from limited credit risk because should the borrower default and disappear at a time when a penalty is due on the swap, the counterparty will look to the lending bank to make them whole. The two financial institutions reach a comfort level with each other based on their credit ratings (Standard & Poor’s, Moody’s, etc.).

Why consider a swap now?
A good lender will provide a comprehensive disclosure upfront so that the borrower can select the appropriate product, or mix of products, based on their repayment plans. For debt with a fixed interest rate via an interest rate swap, the risk of incurring a prepayment penalty can and should be understood. While it is hard to illustrate the math in an article such as this, suffice to say when prepaying against a swap (or attempting to refinance) at a time when interest rates are lower, a prepayment penalty will be incurred.

However, this is a two-way street. If rates increase sufficiently in the months or years following the execution of your swap, prepayments will generate a cash gain back to the borrower. Given that interest rates are currently at or near historic lows, one might argue that now is not a bad time to consider interest rate swaps.

A church seeking to borrow in the current environment should attempt to forecast their best- and worst-case repayment capacity. Now is an ideal time to insulate the church from the near certainty of substantially higher interest rates several years from now. Therefore, place a substantial portion of the debt on a long-term fixed interest rate.

Some lenders offer a 10-year fixed interest rates via a swap. In order to retain some flexibility to prepay without a penalty, place the balance of the debt under a 1- to 5-year adjustable rate as such may be available without a swap or risk of a prepayment penalty.

For example, perhaps the church has some limited near-term prepayment capability via some outstanding pledges from an existing capital pledge campaign. A portion of the debt can be placed on a low variable interest rate. The note will likely be paid off before interest rates increase very much. The benefit of the lower variable rate outweighs the risk of the interest rate increasing on this small portion of the debt.

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. The portion of the debt, which the church does not anticipate prepaying, may be placed on a 10-year fixed rate.

The interest rate swap can be a very beneficial instrument in the current interest rate environment, particularly when the lender is willing and able to offer other supplemental products. Structure your debt to achieve a measure of insulation against longer-term rate volatility while also retaining the flexibility to prepay a portion of your debt without risk of incurring a penalty.

Don’t let a fear of the unknown cause you to shy away from an instrument that can provide a 10-year fixed rate at a time when rates are at or near historic lows. If you pass by this opportunity now you may find yourself renewing your debt at much higher interest rates five years from now. Look for a good financial partner that can work with you to achieve a level of understanding that will enable you to make the best possible decision for your church.

Dan Mikes is executive vice president and national manager of the religious institution division of Bank of the West, San Ramon, CA.


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