Hedging Commercial Loans with Interest Rate Swaps

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Looking in detail at some examples of interest rate swap transactions, Martin McConnell, banking consultant at Provident Risk Management, identifies the advantages a swap structure can generate and best practices to overcome the challenges involved in introducing interest rate swaps into a bank's commercial lending business.

If your bank is considering a derivatives strategy, or is currently hedging against risk, but is looking for more direction and better results, then this webcast is a must-see presentation.

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Hedging Commercial Loans with Interest Rate Swaps

  1. 1. Hedging commercial loans with interest rate swaps<br />PRESENTER:<br />Martin McConnell, Banking Consultant<br />Provident Risk Management<br />
  2. 2. Interest Rate Swaps and Commercial Loans<br />US and European regional banks have used interest swaps as <br />a core of their commercial lending business for more than<br />twenty years.<br />Commercial clients are presented a fixed rate financing composed<br />of two complimentary transactions.<br />2<br />
  3. 3. Interest Rate Swaps and Commercial Loans<br />The Credit Transaction: <br />A floating rate note indexed to LIBOR or Prime<br />Credit Spread is priced based on asset quality<br />Credit spreads are not eroded by changing interest rates<br />The Rate Transaction:<br />An interest rate swap<br />Bank pays the floating rate on the note<br />Borrower pays a fixed rate<br />Borrowers cost of funds on the financing is fixed for the life of the hedge<br />Bank hedges away any exposure to rising rates<br />3<br />
  4. 4. Back to Back Swaps<br />The Fixed Rate financing structure combines a swap and a variable rate note<br />The Borrower’s cost of funds is fixed for the life of the hedge<br />The bank earns a credit spread over LIBOR<br />The bank’s interest rate exposure is hedged<br />4<br />Loan<br />LIBOR + Spread<br />Variable Rate <br />Funds<br />Fixed<br />Bank<br />Borrower<br />LIBOR + Spread<br />LIBOR + Spread<br />Fixed<br />Hedge Provider<br />
  5. 5. Why Use Back to Back Interest Rate Swaps<br />5<br />Credit Risk and Market Risk<br />Generate Fee Income<br />The Back to Back Swap Structure eliminates a banks exposure to changing interest rates<br />Use of swaps allows a bank to impose a higher level of discipline in pricing loans based on credit quality<br />
  6. 6. Why Use Back to Back Interest Rate Swaps<br />6<br />Competition<br /><ul><li>Community banks, regional and super regional banks offer swaps;
  7. 7. Many banks are currently shut out of the long term fixed rate loan market due to rate fears;
  8. 8. Swaps are flexible and can be customized for borrowers
  9. 9. Back to back swaps create non interest fee income: 25 to 40 bps per transaction</li></li></ul><li>Why Use Back to Back Interest Rate Swaps<br />7<br />Accounting<br />The recent FASB Exposure Draft on Accounting for Financial Instruments and Derivatives proposes loans are carried at Fair Value (market to market)<br />Accounting for Back to Back swaps is based on mark to market valuation<br />Positions offset and eliminate earnings volatility<br />Reporting is transparent and simple<br />
  10. 10. Barriers to Entry<br />8<br />What resources are needed to create a back to back swap program:<br />Swaps Policy and Procedures<br />Swap Valuation Model<br />Valuation Reports: Income; Counterparty market to market<br />Credit Policy and Credit Exposure Model<br />Credit Adjusted Fair Value Model (CVA)<br />Swap Documentation<br />Banker Training and Support<br />Banks do not need to make an investment in new hires or in house<br />technology to build a back to back swap book.<br />
  11. 11. Removing Barriers to Entry<br />9<br />PROVIDENT<br />FINCAD<br />Credit Exposure<br />Calculations<br />Banker Support<br />Independent <br />Valuations<br />ISDA Documentation<br />Policies and <br />Procedures<br />CVA Model<br />
  12. 12. Commercial Loan Swap Case Study<br />10<br />Community Bank has $400 million in assets.<br />Community Bank is making a $3.5 million dollar loan to a<br /> German Logistics Company.<br />Purpose of the loan is to fund the acquisition of real estate<br /> Loan Pricing: LIBOR plus 3.00%<br /> Loan Term: 5 years<br /> Principal Amortization: 20 years<br />
  13. 13. Pricing and Independent Valuation<br />11<br />Banks needs to have access to independent market valuations to:<br />Keys to independent pricing:<br />Market standard pricing models<br />Open access: Systems should provide management and auditors open access to models, and market data<br />Independent Market Data-Data source should be highly visible and verifiable<br />
  14. 14. Commercial Loan Swap Case Study<br />12<br />Borrower Pays Fixed<br />Community Bank Pays Floating<br />
  15. 15. Documentation and Credit Risk Management<br />13<br />An effective Back to Back swap program will provide for effective credit<br />Risk management and documentation.<br />Credit:<br />Evaluating Credit Exposure<br />Securing Credit Exposure<br />Documentation of credit approval<br />Documentation:<br />Prepare ISDA Documentation<br />Negotiate ISDA Documentation<br />Documentation should be executed and in hand prior to executing a hedge<br />
  16. 16. Credit Approval<br />14<br />
  17. 17. Potential Credit Exposure<br />15<br />
  18. 18. ISDA Documentation<br />16<br />
  19. 19. Loan Documentation<br />17<br />
  20. 20. Hedging<br />The Swap is set up to match the terms of the loan and priced<br />Borrower Credit exposure on the swap is approved and cross collateralized<br />ISDA documentation has been executed<br />When locking in the Borrower’s rate, the bank will simultaneously enter an offsetting swap to hedge away all market risk and lock in fee income<br />18<br />Loan<br />LIBOR + 3.50%<br />Variable Rate <br />Funds<br />5.37%<br />Bank<br />Borrower<br />LIBOR + 3.50%<br />LIBOR + 3.50%<br />5.02%<br />Hedge Provider<br />
  21. 21. Swap Valuation<br />19<br />
  22. 22. Fee Income<br />20<br />
  23. 23. Credit Adjusted Valuation<br />21<br />
  24. 24. Accounting and Earnings Volatility<br />22<br />
  25. 25. Keys to implementing a Commercial Loan Hedging Program<br />23<br />Bankers who want to use interest rate swaps to improve competitiveness and grow loan production are the key to a successful commercial loan hedging program.<br />Credit officers need to understand how swaps create exposure, have policies and procedures for calculating approving and recording approval.<br />Swap and loan documentation must be coordinated to ensure exposure is cross collateralized.<br />
  26. 26. Keys to implementing a Commercial Loan Hedging Program<br />24<br />Banks must be able to independently value swaps and have access to a full range of valuation reports.<br />Fair Value Insight provides a complete suite of valuation reports at transaction, counterparty and portfolio level, including credit adjusted valuations.<br />
  27. 27. Contacts<br />25<br />FINCAD:<br />Phone: 1-604-957-1200<br />Email:info@fincad.com<br />Website: www.fincad.com<br />PROVIDENT:<br />Phone:1-704-552-3881<br />Email:info@providentrisk.com<br />Website: www.providentrisk.com<br />

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