When I was about 16 years old, I became obsessed with basketball trading cards. This was during the time of the gold-medal winning Dream Team 2 during the 1996 summer Olympic Games (1,000,000 points to the 1st person to comment with the silver-medal team during the games). That summer was the first time that I had ever been to a swap meet. I never imagined that there were places that you could go and swap your stuff for other people’s stuff, and both would walk away thinking they got a good deal.
Fast forward 25 years and I helped a client execute an interest rate swap. These financial vehicles have been helping entrepreneurs and banks achieve strategic objectives and manage interest rate risk since the 1980’s. However, many entrepreneurs have no idea that this option even exists. Today, we are going to explore what an interest rate swap is, review the qualifications for a swap transaction, and identify some potential issues that that entrepreneurs need to be aware of. Next month, we will dive in to how the money flows in an interest rate swap, discuss what could happen if you pay the swap off early, and explore some really cool features that can maximize the effect this tool has on your business.
So, what exactly is an interest rate swap? An interest rate swap is a financial agreement between the entrepreneur, the bank, and a 3rd party (the counterparty) that allows the entrepreneur and bank to off-set interest rate risk; while at the same time, swapping a variable rate for a fixed rate. I don’t want to get too technical, but the entrepreneur enters into the agreement with the bank; and the bank enters into a separate agreement with the counterparty. The counterparty is willing to do this because they make a spread when they arbitrage the “demand” from the entrepreneurs and the “supply” from investors. To make it even more complex – some banks don’t use a counterparty, instead they manage their own interest rate book of business. In these instances, they typically have a program to hedge their interest rate risk. Wow, that is a lot of bank-nerd talk, even for me. The important thing to remember is that you have an interest rate swap contract with the bank – what they do with the interest rate risk after that is on them.
Let’s imagine that you are purchasing $3 million of new equipment and you want to get a 7-year loan for $2.4 million. When it comes to interest rates, you have 3 options:
- A variable rate loan, where you are charged a certain amount above (or below) a specific financial index. For example, the London Inter-Bank Offered Rate (LIBOR) + 2.25%. In this scenario, the entrepreneur bears all the interest rate risk and the bank has no interest rate risk.
- A bank held fixed rate loan, where you are charged a fixed amount over a specific time frame. For example, a fixed 5.35% for 7 years. In this scenario, the entrepreneur bears interest rate risk only if rates go down (but they may be able to refinance at a lower rate), if interest rates increase, then the entrepreneur is protected. However, the bank is exposed to interest rate risk. Imagine rates increase 4 years from now and the bank is paying 5.50% on their savings accounts (this is money flowing out of the bank), but your interest rate is fixed at 5.35% (that is money that is flowing into the bank). This is obviously the risk the bank runs when it fixes the rates, as they can’t come to you 4 years from now and raise your loan interest rate (unless you agree).
- An interest rate swap, where the entrepreneur signs sign a variable rate loan agreement with the bank (protecting the bank from interest rate risk), at the same time, the bank signs an interest rate swap agreement with a counterparty, effective setting up a fixed rate . This transaction protects the entrepreneur from interest rate risk, with the price being set immediately after the loan is closed. Many times, this rate is lower than the bank is willing to offer, because it is being set by the open market, in this instance the agreed to swap rate may be 5.10%.
If this is such a good idea for entrepreneurs and banks, then why is not every commercial loan swapped? The fact is that interest rate swaps do bear some risk, and as such, only an Eligible Contract Participant (or ECP) can qualify. An ECP (which is bank-nerd speak for borrower, guarantor, or a related entity) must have a tangible net value greater than $1 million OR $10 million in Total Assets. Tangible net worth is defined as net assets minus net liabilities. A related entity is defined as a legal entity that has similar ownership or controlling authority as the borrower (an example of this would be a family trust).
Another reason that every loan is not swapped is a more practical one. It takes a certain amount of effort, record keeping, and expense for a counterparty to enter into a swap agreement. Remember, the counterparty makes money through the arbitrage of the entrepreneur and the investor. Therefore, it does not become economically feasible to swap a $20,000 loan. While there is no hard and fast rule limiting the size of a swapped transaction, when you overlay the ECP requirement, it typically leads to loans that are at $1 million or greater.
While those may be high qualifications to hit, there is a significant amount of companies that do qualify for an interest rate swap transaction. We have already established that swaps fix the rate for entrepreneurs; so why does not everyone that qualifies, swap on every loan? The answer is financial flexibility and risk. Entrepreneurs should strive to maximize their financial flexibility in every relationship they have. One of the reasons that entrepreneurs don’t swap every loan is that when you enter into a swap contract, you agree to a very specific repayment schedule. This repayment schedule tells the investor what type of payments they are going to receive over a specific period of time. If you go off of that repayment schedule (either through additional principal reduction, paying off the loan early, or slower principal reduction) then you may be opening up yourself to interest rate risk (in bank nerd terms – creating a partial un-hedge) can be very complex and is better explained one-on-one. If you are interested to learn more, contact me directly and we can discuss further. In addition to the loss of financial flexibility, if you pay the loan off early (either through early principal payments or a refinance) you may actually be charged a make-whole fee, which is one of the biggest risks associated with interest rate swap agreements. We will explore the make-whole fee in greater detail in the next article.
Interest rate swaps can be part of a win-win solution for entrepreneurs and bankers; but they are not for everyone and you have to be comfortable with the risk and loss of some financial flexibility. Be sure to check out next week’s article where we will dive in to how the swap actually works, how the swap is shown on your balance sheet, and some really cool features of interest rate swaps that can maximize the effect this tool has on your business.
One final note, swaps are a regulated financial transaction. Therefore, I want to be perfectly clear that I am not licensed to “sell” interest rate swap products. Before entering into any swap agreement, everyone should contact the licensed professional they are dealing with, along with their legal, tax, and accounting advisers. They can provide you with the proper legal, tax, and accounting perspectives to ensure that you understand and agree with the risks associated with interest rate swaps. The purpose of this article it to provide a general understanding of interest rate swaps and to stimulate conversation as how entrepreneurs can use this to help achieve their strategic goals.
Being an entrepreneur is one of the most difficult and demanding things you can do. The good news is that entrepreneurship today is a team sport. Hit the connect button on LinkedIn or Facebook NOW and together we will work towards hitting your 10-year target. Along the way we will increase your profit, strengthen your leadership skills and define your strategic vision. This will lead to confidence in your path, freedom to dream up bigger targets and a strategic banking relationship. When we connect, tell me if you have ever heard of an interest rate swap before reading this article.
Greg Martin is an entrepreneur’s insider to the banking industry and passionately believes that every person was uniquely designed for a higher purpose and calling. Greg guides entrepreneurs in defining and achieving their purpose and calling. His deepest passion is living life with his wife of 17 years and their wonderful son.
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