I’ve been seeing a relatively new lending design with increasing frequency.
Many banks are making variable-rate loans with embedding interest rate floors. In light of the low level of interest rates, this practice is neither ill-logical nor unwarranted; but at the same time, these bankers may also be creating an accounting land mine that could later explode for the borrower. The problem arises if the borrowing company chooses to hedge the loan’s variable interest rate exposure. For most such companies, qualifying for hedge accounting is of critical concern, in that this accounting treatment allows effective unrealized gains or losses on the derivative to be recorded in AOCI, rather than earnings. Unfortunately, if the hedge isn’t structured correctly, much of these unrealized results could end up being considered to be ineffective, and therefore the intended deferred income recognition won’t happen.
Pitfall to Avoid
The first pitfall to avoid is using a standard pay-fixed/receive-floating interest rate swap in conjunction with this loan. This plain-vanilla swap design fails on its face because the exposure is one-sided, while the swap’s result is symmetric. That is, the swap’s value (and/or settlements) will be sensitive to movements in interest rates at all interest rate levels, but the exposure exists only for rate movements above the floor rate. Hedge accounting is simply disallowed if the asymmetric interest rate sensitivity of the loan isn’t matched by a similar asymmetry in the interest rate sensitivity of the derivative.
The requirement to come up with the purchase price of
the cap at the start of the hedge is often a deal breaker.
When the loan has an embedded interest rate floor, the perfect derivative design is an interest rate cap, subject to the caveat that the cap rate cannot be lower than the floor rate. Note, however, that if the cap rate and the floor rate happen to be equal, the effect of adding the cap position to the loan with an embedded floor is that the borrower has created a hedge that effectively synthesizes fixed rate funding—at least economically. In fact, this result is generally the objective of hedging.
Suppose, for example, the variable rate loan requires paying LIBOR with no spread, subject to a 2 percent floor; and assume the borrowing company buys a 2 percent cap. If LIBOR remains at or below 2 percent, the interest expense paid to the banker is 2 percent, and the cap has a zero payoff. Ignoring the cost of the cap for a moment, the cost of borrowing is 2 percent (=2 percent + 0 percent). Now suppose LIBOR rises to 3 percent. The floor isn’t constraining, and hence the interest paid to the bank is 3 percent.
In this environment, however, the cap returns the difference between the market rate (3 percent) and the cap rate (2 percent), generating a 1 percent cash flow to the benefit of the borrowing company. Again, the cost of funds (and again, ignoring the cost of the cap) is 2 percent (=3 percent – 1 percent). (Note that if the banker charges a non-zero spread over LIBOR, the all-in cost would rise, commensurately.)
Although we’ve economically synthesized fixed rate funding, this result won’t be transparent in terms of the way the accounting works. The disconnect arises as a function of the accounting treatment for the cost of the cap. If we were able to prorate this cap premium and divide this cost equally for each period, we’d preserve the economics by reporting a fixed cost of funds; but the accounting rules specifically proscribe this treatment. Instead, we’re required to reverse engineer this cap and view it as a consolidation of a portfolio of caplets—one for each reset exposure. The cost of the cap is just the sum of the costs of these caplets. These costs, however, will generally be higher for longer dated caplets; and as a consequence, this treatment tends to back-load these expenses, resulting in a rising reported cost of funds throughout the term of the hedge.
A Deal Breaker
These accounting concerns notwithstanding, the requirement to come up with the purchase price of the cap at the start of the hedge is often a deal breaker; and the aversion to paying this up-front premium is widespread—whether deservedly so, or not. In consideration of this preference, many derivatives dealers have structured an alternative design, reflected in the accompanying chart, below.
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