Third-party swaps: we’ve got control issues

June 8, 2020 Ben Lewis

Banks looking to manage the interest rate risk of long-term fixed rate loans have several tools at their disposal. They can match fund, hedge at the portfolio level, or hedge at the loan level. One tool used by community banks are Third-Party Swaps. With Third-Party Swaps, the community bank introduces their borrower to their correspondent bank who then provides a swap directly to the customer1. Sometimes the swap is called a rate protection agreement or rate conversion agreement, but in either case it is a swap. Your customer has borrowed on a floating rate basis from the bank and entered into an agreement with the correspondent bank to swap their floating payments for fixed.

Third-Party Swaps’ primary appeal is simplicity. The correspondent banks offering this solution tout the ease of use and minimal impact on the bank. But simplicity comes at a cost, particularly as it relates to control of the borrowing relationship with your customer.

COVID-19 has changed a lot of things and much remains to be seen: when will we go back to the office? Will many businesses be able to return to “normal” operations? Will my CRE borrowers be able to pay loan principal and interest when their tenants are struggling?

One question that has come to us recently: what do I do with a loan that I need to forebear and it involves a Third-Party Swap? The answer may surprise you.

The agreement between your borrower and the correspondent bank is a credit instrument for which the correspondent bank requires security. They achieve security on their swap with your customer by taking a first position lien on the loan collateral. If the loan defaults, the correspondent bank has priority in the workout until they are made whole on the swap; your bank is left with what remains. Most banks choose, however, to “buy out” the correspondent bank’s swap position so that they can jointly workout the loan and swap.

Prior to COVID-19, this was an academic exercise. But banks desiring to give relief to their borrowers by amending loans with associated Third-Party Swaps are in a pickle – they don’t have full control of their relationship because it has been assigned to the correspondent bank. They are at the mercy of the correspondent bank to decide how to manage the loan and, most importantly, their interest may not be aligned with those of your bank.

In contrast, with any of the solutions mentioned at the start (match funding, portfolio swaps, and loan-level swaps), the bank completely owns the relationship. The correspondent bank is no longer at the head of the table – they aren’t even at the table! There is no potential for a misalignment of interest. Even in the case of a loan-level swap, the bank decides how to manage the loan and the swap with their customer relationship.

Community banks are just that: banks that serve their local communities. They operate on trust, relationships, and high-touch customer service. While introducing a correspondent bank into the mix may seem simple at first, it can result in control issues for one of the bank’s greatest assets – its customers.


1. Some correspondent banks assist their clients by offering a derivative solution, but do not transact with the bank’s customer like described here.


Disclosures

Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal/notices/.

Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved. 20-0176

About the Author

Ben Lewis

Ben Lewis works in Chatham’s Hedge Advisory group advising financial institutions in the western United States. He manages relationships with community and regional financial institutions to help hedge their balance sheet interest rate risk through the use of derivatives as well as enable them to offer derivative products to their qualified commercial borrowers. Previous to serving financial institutions, Mr. Lewis worked with private equity funds in hedging leveraged buy outs, commercial real estate investors hedging their debt, and general corporate clients to identify and manage foreign currency, commodity, and interest rate risk through the use of derivatives.

Follow on Linkedin More Content by Ben Lewis
Previous Article
Effective balance sheet hedging in the current climate
Effective balance sheet hedging in the current climate

See how current market conditions present financial institutions, equipped with the proper tools and strate...

Next Video
Helping your customers understand interest rate swaps
Helping your customers understand interest rate swaps

Learn how to help your commercial customers understand why an interest rate swap makes sense.

×

Subscribe to Chatham's Weekly Market Insights

First Name
Last Name
Company Name
!
Thank you!
Error - something went wrong!