swap documentation in real estate loan transactions...
TRANSCRIPT
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Presenting a live 90-minute webinar with interactive Q&A
Swap Documentation in Real Estate Loan
Transactions: Coordinating ISDA Master
Agreement and Loan Agreement Terms Documenting Covenants, Security, Required Consents,
Voting and Control, Reporting, and Regulatory Issues
Today’s faculty features:
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
WEDNESDAY, OCTOBER 26, 2016
Eddie Frastai, Partner, Clifford Chance, New York
Jeffrey Koppele, Partner, Dentons, New York
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Swap Documentation in Real Estate
Loan Transactions: Coordinating ISDA Master Agreement and
Loan Agreement Terms
Strafford Webinar October 26, 2016
Introduction
October 26, 2016
Jeffrey H. Koppele
Partner
Capital Markets/Tax
Dentons
D +1 212 768 6916
Eddie Frastai
Partner
Real Estate
Clifford Chance LLP
D +1 212 878 4931
[Eddie to supply picture]
6
Agenda
October 26, 2016
• Introduction: Interest Rate Risk in Real Estate Financings
• Hedging Interest Rate Risk: Rate Caps and Interest Rate Swaps
• Integrating Hedge Agreements Into Loan Documentation
• Regulatory Issues: Dodd-Frank
• Negative Interest Rates
7
Interest Rate Risk in Real Estate Loans
October 26, 2016
• A commercial mortgage loan often bears interest at a floating rate.
• Floating rates can rise quickly at any time.
• Rental income of the property owner/borrower generally changes gradually.
• A spike in interest rates is thus a risk for borrower (and lender).
8
Mitigating Interest Rate Risk
October 26, 2016
• Lender often requires borrower to mitigate the risk of interest rate volatility.
• A hedge is a form of "derivatives contract."
– Derivative: an agreement whose value is derived from the value or amount
of an underlying index, asset or event.
– Here the index is an interest rate, usually 1-, 3- or 6-month LIBOR.
9
Rate Cap
October 26, 2016
• The most common hedge in commercial real estate finance is a rate cap.
• Borrower purchases rate cap from a counterparty, usually a bank ("Rate Cap
Provider").
• Borrower pays to Rate Cap Provider a fixed amount at the inception of contract.
• Rate Cap Provider pays to borrower the excess, if any, of LIBOR over a
specified Strike Rate, periodically over the term of the contract.
Borrower Rate Cap
Provider
LIBOR - Strike
Fixed Upfront
Payment
Rate Cap cashflows:
10
• Lender determines the strike rate for the Rate Cap, based on the property's
expected cashflows/interest coverage.
• Rate Cap sets a cap on the Borrower's effective interest rate under the loan.
• Rate Cap and Loan periodic cashflows:
• Rate Cap Provider pays the excess of LIBOR over the Strike rate.
• Borrower's effective interest rate is capped at Strike + Spread.
Rate Cap
October 26, 2016
Lender Borrower Rate Cap
Provider
LIBOR - Strike LIBOR + Spread
Rate Cap: Loan:
X X
11
• Facts
– Loan interest rate: LIBOR + 1%
– LIBOR at closing: 2%
– Strike Rate on Rate Cap: 3%
– Borrower net cost capped at Strike + Margin 4%
• If rates go up, Rate Cap proceeds fund Borrower's increased LIBOR cost.
– Example: LIBOR increases to 4%
□Borrower pays Loan interest rate: 4% + 1% = 5%
□Borrower receives from Rate Cap Provider: 4% - 3% = 1%
□Borrower net borrowing cost: 5% - 1% = 4%
– Example: LIBOR increases to 6%
□Borrower pays Loan interest rate: 6% + 1% = 7%
□Borrower receives from Rate Cap Provider: 6% - 3% = 3%
□Borrower net borrowing cost: 7% - 3% = 4%
Borrower Cost Capped Whether LIBOR Rises or Falls
October 26, 2016 12
• Facts
– Loan interest rate: LIBOR + 1%
– LIBOR at closing: 2%
– Strike Rate on Rate Cap: 3%
– Borrower net cost capped at Strike + Margin 4%
• If rates go down, property cashflow funds Borrower's Loan interest rate.
– Example: LIBOR decreases to 1%
□Borrower pays Loan interest rate: 1% + 1% = 2%
□Borrower receives from Rate Cap Provider: 0% (LIBOR less than Strike Rate)
□Borrower net borrowing cost: 2%
Borrower Cost Capped Whether LIBOR Rises or Falls
October 26, 2016 13
Disparate Objectives of the Parties to Rate Caps
October 26, 2016
• Lender – robust cap
• Borrower – minimize cost
• Rate Cap Provider – high-volume, low-profit transaction
• Parties' disparate objectives can and frequently do result in risks for the
Lender and Borrower.
• Many of these risks are avoidable.
14
Rate Cap Provider Downgrade
October 26, 2016
• Rate Cap Risks
– Cap Provider bankruptcy or insolvency
• Rate Cap typically includes a "downgrade" provision:
– Cap Provider credit rating must exceed a specified threshold at closing.
– If Cap Provider rating drops below a specified trigger, Cap Provider must
either post collateral or replace itself.
– If Cap Provider rating drops below a second trigger, Cap Provider must
replace itself (and must post collateral until replacement is accomplished).
15
Advantages
• No ongoing borrower payment
obligations (after payment of
upfront premium)
• Borrower benefits from decline in
floating rate
• Typically assignable by borrower
• Borrower may receive, but will
never be obligated to make, a
termination payment.
Advantages and Disadvantages of Rate Caps
October 26, 2016 16
Disadvantages
• Rate cap requires upfront
premium
• Cost increases with duration
• Rate caps typically limited to three
years
• An interest rate swap converts Borrower's floating rate obligation to a fixed rate.
– Borrower makes periodic payments to swap provider at a fixed rate.
– Swap provider makes periodic payments to Borrower at LIBOR.
– Payments are netted; party with the greater obligation pays the difference.
Interest Rate Swaps
October 26, 2016 17
Lender/Swap
Provider Borrower
LIBOR + Spread
-------- Swap --------
-------- Loan --------
X
LIBOR X
Fixed Rate
• If LIBOR goes up/down:
– If LIBOR exceeds the Fixed Rate, Borrower receives money under the Swap,
but its Loan interest payments are higher.
– If LIBOR remains below the Fixed Rate, Borrower pays money under the
Swap, but its Loan interest payments are lower.
• Regardless of LIBOR, Borrower's effective Loan interest rate is equal to the
Swap Fixed Rate plus Loan Spread.
• Unlike a rate cap, a swap usually has no upfront fixed payment.
• Lender may act as swap provider.
• Borrower typically pledges its rights under the Swap to Lender as additional
collateral for the Loan.
Interest Rate Swaps
October 26, 2016 18
Advantages
• No upfront payment required
• Longer durations available
• Fixed/swapped rate will not
change over time
Advantages and Disadvantages of Interest Rate Swaps
October 26, 2016 19
Disadvantages
• Borrower does not benefit from
decline in floating interest rate
• Borrower has ongoing payment
obligations. Therefore:
– Swap provider typically requires
collateral or other credit-
worthiness
– Two way termination payments
possible
• Typically not assignable by
borrower
Acquiring/Pricing a Rate Cap or Swap
October 26, 2016 20
• Rate caps:
– To obtain best pricing, borrower (or its advisor) typically holds an auction for
the rate cap.
– Often, between 2-4 financial institutions bid on rate cap, based on terms
provided in a "bid package".
• Swaps:
– Greater challenge regarding pricing.
– Because borrower has ongoing borrower payment obligations, swap providers
typically require collateral. However, a lender typically will not permit
borrower's obligations to an unaffiliated hedge provider to be secured by the
property.
– Borrowers thus are generally compelled to execute swaps with the lender.
• Documents Affecting Hedge Agreement
– Loan Application
– Loan Agreement/Promissory Note
– Collateral Assignment of Hedge
– Bid Package
– Hedge Documentation
– Dodd-Frank Protocols
Loan and Hedge Documentation
October 26, 2016 21
ISDA Master Agreement
Schedule
Confirmation(s)
ISDA Definitions
-- or --
"Long-form Confirmation"
Counterparty Risk
October 26, 2016 22
• Default by Hedge Provider will trigger replacement obligation on Borrower under
Loan Documents
• Ways to Mitigate Counterparty Risk:
– Require Hedge Provider to post margin equal to value of Hedge
– Require Hedge Provider to replace itself
– Require Hedge Provider to provide a guaranty from a creditworthy affiliate
Security for Borrower's Swap Obligations
October 26, 2016 23
• Borrower is typically required to be an SPE
• Swap Provider requires collateral for Borrower's future swap payment obligations
(N/A for rate cap).
• Lender will not agree to make its collateral (i.e., the property) available to Swap
Provider as collateral, unless Lender itself is also providing the Swap.
• Swap Provider may accept guaranty from creditworthy affiliate of Borrower
instead of taking security interest in the property.
Definite Obligation
October 26, 2016 24
• Various states require mortgage to state the principal amount or definite
obligation to be enforceable.
• Borrower obligations under a Swap do not involve the repayment of principal and
are indefinite.
• If mortgage intended to secure Borrower's obligations under Swap, and:
– Lender and Swap Provider are identical characterize swap payments as
interest payments (potential savings on mortgage recording taxes too).
– Lender and Swap Provider are affiliates characterize swap payments as
obligatory advances, which may "relate back" in various states.
– Lender and Swap Provider are not affiliated mortgage most likely not
available to Swap Provider.
Documentation Tips: Entering into Hedge Agreement
October 26, 2016 25
• Tighten Bid Package
– Defined terms in Hedge should match defined terms in Loan Documents (e.g.,
floating rate, rounding, business day, payment date, strike rate, maturity date).
– Consider requiring more stringent downgrade trigger of Hedge Provider than
trigger in Loan Documents.
– Require payments be made directly to account controlled by Lender.
• Confirm that confirmation conforms to Bid Package.
• Include downgrade triggers in Collateral Assignment.
Selected Loan Agreement Provisions re: Hedge
October 26, 2016 26
• Conditions Precedent re: Hedge Agreement
– Broad outline of hedge terms, e.g., rate, term, notional amount
– Swap provider consent to collateral assignment
– Hedge reasonably satisfactory to Lender (or Agent)
• Borrower Covenants
– Maintain hedge agreement over specified term
– Replace hedge upon swap provider downgrade
– Hedge covering loan extension period
• Lender consent to modifications or termination of hedge agreement
• Borrower obligation to pay interest unaffected by hedge agreement
Selected Loan Agreement Provisions re: Hedge
October 26, 2016 27
• Failure to maintain hedge constitutes a borrower event of default
• An event of default under the hedge is typically a borrower event of default
• Application of hedge proceeds
– In general
– Upon hedge event of default or termination event
• Waterfall
– Borrower swap payments to lender/hedge provider
– Borrower swap payments to unaffiliated hedge provider
Loan Provisions Relating to Hedge Calculations
October 26, 2016 28
• Floating Rate in Loan Agreement and Hedge Should Match
• Notional Amount
– Fixed
– Stepdown
– Overhedging: Optional or Mandatory Partial Breakage
• Breakage
Regulatory Issues: Dodd–Frank
October 26, 2016
• Dodd-Frank Title VII—Regulation of Over-the-Counter Swaps Markets
• Dodd-Frank can have a significant effect on hedges, particularly where a swap,
rather than a rate cap, is used.
• Key issues:
– Eligible Contract Participant (ECP)
□Borrower and every co-obligor and guarantor of swap cashflows must
qualify as an ECP
□Generally, to qualify as an ECP an entity must have:
Total assets of at least $10 million, or
Net worth of at least $1 million, if swap if is in connection with its
business or hedging its assets or liabilities
– "End User" Clearing Exemption
– Swap Reporting - obligation of the Swap Dealer
29
Negative Interest Rates
October 26, 2016
• Central Bank policy initiative to encourage banks to lend rather than hoard cash
• Lenders likely to increase interest rates to recover higher cost of maintaining
funds on deposit with Central Bank
• Floating Rate Loans
– Loans that include a LIBOR floor
□Floor could result in mismatch with rate payable under hedge.
– Loans without a LIBOR floor
□Would a Lender be required to make interest payments to the Borrower?
□Erosion of margin?
30