kaiser interest rate hedging and swaps 2011

Hedges, Swaps, Collars and Caps – A Primer on the Wonderful World of Interest Rate

Protection Devices Required by Lenders

Presented by:

Peter J. Rue

Briggs & Morgan

Kevin W. Kaiser

Lindquist & Vennum

Business Law Institute

May 2011

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Objectives

Overview of financial derivatives

Discussion of how derivatives can be used to manage interest rate risk

Deal terms, documentation and drafting considerations

Regulatory changes

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Financial Derivatives

What is a derivative?

A derivative is a financial arrangement that derives its value based on the changes in value of some other asset (either a single asset, a group of assets, or anything that can be valued).

Examples – Stock options, forward contracts, futures contracts, swaps.

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Why do companies use derivatives?

Insulate against risk (hedge)

Profit from risk (speculate)

Tax and accounting

Arbitrage opportunities

Enhance yield

Reduce funding costs

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Hedging

Derivatives allow taxpayers to manage risks, including the following:

Market fluctuations

Interest rates

Credit

Foreign currency

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Why do companies use derivatives?

Many companies use derivatives to limit exposure to movements in currency exchange rates, interest rates, or pricing of commodities critical to the business.

A excerpt from a recently filed Form 10-K from a public company:

“The company enters into contractual derivative arrangements in the ordinary course of business to manage foreign currency exposure, interest rate risks and commodity price risks. A financial risk management committee, composed of senior management, provides oversight for risk management and derivative activities.”

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Types of Derivatives

There are two broad types of derivatives:

Forward-based, and

Option based

Forward-based derivatives contain both the right and the obligation to perform under a contract.

Option-based derivatives provide the right, but not the obligation, to perform under the contract.

Swap - a forward-based type of derivative

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Types of Derivatives

Option-BasedInterest Rate Cap or Floor

Put Option (on Equity or Debt Security)

Call Option (on Equity or Debt Security)

Interest Rate Option

Currency Option

Forwards

Forward Rate Agmt

(FRA)

Fx

Commodity

Futures

Index

Equity

Currency

Commodity

Swaps

Interest Rate

Equity

Currency

Commodity

Forward-Based

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Options

One-sided protection/risk

“Calls,” “Puts,” and “Collars”

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Call Options

The writer of a call has unlimited downside risk and gain to

the extent of the premium received. The holder of a call

has unlimited upside potential and loss limited to the

premium paid.

Underlying Price

Holder’s pay-off curve

De

riva

tive

Va

lue

Underlying Price

Issuer’s pay-off curve

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Put Options

The writer of a put has unlimited downside risk and gain to the

extent of the premium received. The holder of a put has unlimited

upside potential and loss limited to the premium paid.

Underlying Price

Holder’s pay-off curve

De

riva

tive

Va

lue

Underlying Price

Issuer’s pay-off curve

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Swaps

Definition

Generally, a swap is an agreement between two parties to exchange (or “swap”) payments at specified intervals calculated by reference to an index upon a base dollar amount.

Tax Name – Notional Principal Contract (“NPC”)

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Example of a Interest Rate Swap Contract

For example, a swap contract may provide that Customer is to pay, i.e. counterparty, amounts equal to 7% of $10,000,000 and Bank is to pay Customer amounts equal to the LIBOR + 2% on $10,000,000.

The reason why Customer enters the swap contract is to hedge against interest rate fluctuations. Assume Customer has $10,000,000 of outstanding debt where the interest rate is LIBOR + 2%. By entering the swap contract, Customer is protected against a rise in interest rates since Customer is effectively obligated to pay only 7%, regardless of changes in the prime lending rate.

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Interest Rate Swap with

Periodic Payment

Customer Bank

LIBOR + 2%

x $10 mm

7 % x $10 mm

Lender

LIBOR x

$10 mm

Payments are netted

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ISDA Documentation and Contract Terms

Fixed/Floating Swap

Payments are netted on settlement dates. Net result:

If Floating Rate rises, customer receives payment and can apply it to interest on the hedged loan, bringing effective overall rate to the Fixed Rate

If Floating Rate falls, customer pays less interest on loan, but pays Bank up to the Fixed Rate

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Why Do a Swap?

Fixed Rate not available on loan;

Portability – in theory, swap exists separately from loan and could be continued if the loan is refinanced (but many swaps require early termination if loan is repaid)

"Breakage" – For fixed rate loans, breakage goes one-way (from customer to bank, if fixed rates have declined)

For Swaps, as long as "Second Method" is chosen in schedule, payment may go either way.

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Documentation

CAP. Caps (bank will pay customer if floating rates exceed a specified level) can be transactions that are paid for (by customer) up front, and do not involve credit risk to Bank. May be a simple contract.

Swaps, Collars (upper and lower limits) and other transactions require:

ISDA Master Agreement, and related documents;

Approval resolutions; incumbency

Legal Opinion

Documents for any collateral or cross-collateral required (swap exposure may be required to be covered by same collateral as the loan)

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ISDA Document:

ISDA Document itself. ISDA has always been and obscure, difficult document (even for long-time practitioners)

Basic document published in 1987, 1992 and 2002 (1992 is still most popular) Local Currency, Single Jurisdiction is the one to use for most transactions

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Defined Terms

Great number of defined terms and concepts. A couple to watch:

Specified Entities – these are written into the events of default and termination events, so that a default by a Specified Entity will be a default by the customer

Threshold Amount – the threshold for cross-default; should match cross default amount in the credit agreement;

Early termination – Preference should be to "Market Quotation" and "Second Method"

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Other Provisions to Watch

Other Termination Events or Events of Default.

Threshold Amounts (for cross default).

Netting Provisions.

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Collateral Security

It's common for Banks to require same collateral that supports the loan to support any swap obligations. Issues are:

Personal Property. Covered by Security Agreement (either specifically or under dragnet clause) and perfected by UCC-1. Probably few issues.

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Real Property. ISDAs often have a provision in the definition of 'Credit Support Document" that states that any agreement that supports the loan supports the swap obligations. This raises the issues:

If ISDA obligation is not described as a secured obligation in the Mortgage, is it secured?

ISDA may be an obligation separate from the loan and interest on the loan for Minnesota mortgage registration tax (and equivalent purposes in other jurisdictions). If MRT is not paid, is ISDA effectively secured? How much extra MRT should be paid?

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Representation:

Tax Representations

Many ISDAs will require the Customer to represent that it is an "eligible contract participant" under the Commodities Futures Trading Commission Modernization Act of 2000

Schedule may include additional representations concerning capacity to enter swaps, and awareness of customer that Bank is not advising customer or acting as its representative.

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Governing Law

Rare to have any law but NY govern – this and the real property issues create issues for customer's counsel requested to give legal opinion.

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Set Off Provisions

Most 1992 ISDA Schedules have fairly elaborate setoff provisions applicable on termination of swaps. There are a variety, and are generally intended to give the non-defaulting party the right to include obligations to and from its affiliates in an overall netting of obligations.

2002 ISDA attempts to incorporate these provisions, so they will not be in the Schedule.

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Foreign Exchange Provisions

If foreign exchange or currency option transactions are anticipated, the form ISDA will include additional provisions, including

reference to published ISDA definitions (1998 FX and Currency Option Definitions)

Often, even more elaborate "netting" provisions. The intent of these is to net premiums and payments, and also "novation netting" (which means that if a transaction is entered, then afterwards a transaction with matching qualities is entered in a greater or lesser amount, the initial transaction and later transaction will be deemed terminate, except to the extent of the increase or decrease in amount).

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Proposed Regulatory Changes and Dodd-Frank

Dodd-Frank Act, particularly Title VII. Signed into law July 21, 2010

Regulations: All are in the proposal phase

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Basic Principles Applied to Swaps

SEC will regulate "security swaps" and CFTC will regulate all others.

"Swaps Pushout" (called the "Lincoln" rule)

No federal assistance for any swap entity;

Banks will put derivatives activities (except for certain customer swaps) in a separate, non-insured, entity;

No federal bailout, no "too big to fail“

Mandatory Clearing through a Market or Swap Execution Facility

Registration of Swap Dealers and Major Swap Participants.

Prognosis

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Regulation: The primary regulators of Swaps will be the SEC and CFTC;

SEC:

Security Swaps – narrower definition, as swaps based on a single security, debt instrument or narrow index of securities

CFTC:

All "Swaps" (which excludes Security Swaps), including

interest rate swapsforeign exchange forwards and swapscredit default index, equity and debt index swapstotal return swapscommodity swapsoptions on all swaps

may exclude certain swaps where physical delivery of a commodity is intended

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“Swaps Pushout”

Called the "Lincoln" rule after proponent in congress.

There will be no "Federal assistance" for any swap entity (swap dealers, non-bank Major Swap Participant). This will not apply to insured depositary institutions that limit swap activity to (i) hedging related to their own activities, and (ii) swaps that are permissible for investment by national banks, which should include customer swaps to hedge interest rates on loans.

Otherwise, Banks will have to put derivative activities in a separate, non-insured entity.

Premise is no federal bailout; no too big to fail

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Mandatory Clearing

All Swaps outside of specified categories must be cleared on an exchange - a Designated Contract Market ("DCM") or Swap Execution Facility. DCMs were created in 2000, but regulatory underpinning will be changed.

Exception is for end-users, that (i) are not financial entities, (ii) use swaps to hedge commercial risk, and (ii) notify regulators how they generally meat financial obligations of non-cleared swaps

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Registration of Swap Dealers and Major Swap Participants

Specialized – will pass over for this session. Includes capital and margin requirements.

This will effect markets in which Banks operate;

In effect, all swaps will be "collateralized" and marked to market by a credit support annex

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Statute set up regulatory framework–execution is to be by regulations

Where regulations stand. Massive sets of proposals published by agencies including SEC and CFTC (30 regulations, many running to several hundred pages) were published late in 2010 and early 2011. Mid-April, the comment deadline on the basic regulations published late 2010 were again extended.

House Republicans, have been urging that rules be pushed back to 2012. Will not be enacted in any law Dodd Frank ran to 848 pages, published proposed rules to many thousand.

Prognosis – review and comments will continue. Regulations may start to be finalized late in 2011.

Effect on Lender-required swaps

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Not a complete change – transactions will continue to be done on ISDA agreements, as one-to-one transactions (not any sort of exchange)

Markets in which Banks operate will be changed. Economic effect on the basic interest rate swap market may be subtle.

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Derivatives and swaps

Q&A

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Contact Information

Kevin W. Kaiser

Lindquist & Vennum PLLP

Phone: (612) 371-2467

E-mail: [email protected]

Peter J. Rue

Briggs and Morgan LLP

Phone: (612) 977-8638

E-mail: [email protected]

The information contained herein is of a general nature and is not intended toaddress the circumstances of any particular individual or entity. Although weendeavor to provide accurate and timely information, there can be no guaranteethat such information is accurate as of the date it is received or that it willcontinue to be accurate in the future. No one should act on such informationwithout appropriate professional advice after a thorough examination of theparticular situation.

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