Hedging Your Bet—Interest Rate Risk In Financing Transactions

The expression that "a rising tide lifts all boats" may be easy to disregard in today's "low tide" of interest rates, but investors and companies that fail to have an appropriate hedge program in place risk being flooded by unanticipated financing costs as the tide inevitably starts to rise. The Federal Reserve appears poised to continue raising its federal funds rate target in 2016. Although many factors influence long-term rates, increases in short-term rates make material increases in long-term rates more likely. Higher long-term rates in turn could expose borrowers in various market segments to considerable hardship.

Liberal underwriting standards and a proliferation of lenders have allowed equity investors, for example, to finance huge amounts and to refinance at their convenience. Corporate debt has also increased dramatically in the seven years since the financial crisis. Effectively managing interest rate risk will be of vital importance to many market participants in the months ahead.

One of the primary ways in which borrowers can mitigate interest rate risk in financing transactions is through the use of interest rate hedge agreements, which provide both borrowers and lenders with protection against escalating rates. This article raises and addresses several key issues, from both lender and borrower perspectives, including the basic types of hedging agreements, the Dodd-Frank restrictions on eligible contract participants, security and collateral considerations, including Dodd- Frank clearing and margin requirements, and bankruptcy and offset issues.

Basic types of hedge agreements

The three most common types of interest rate hedge products are rate caps, interest rate swaps and collars. The following paragraphs explain how a borrower may use these products to hedge interest rate exposure on a floating rate loan.

In a rate cap transaction, a borrower and hedge provider agree to a maximum interest rate, known as the "cap rate" or "strike rate." If the floating interest rate index governing the underlying loan (the loan index rate), typically LIBOR, climbs above this strike rate, the hedge provider pays the borrower the excess. In exchange, the borrower pays the hedge provider a one-time fee when the agreement is signed. The result is that the borrower receives protection against any subsequent increase in LIBOR above the cap rate without surrendering the benefits of any subsequent declines in rates.

A collar transaction effectively sets both a maximum and minimum interest rate. If the loan index rate remains between the maximum and minimum rates specified in the collar (referred to as the cap strike and floor strike, respectively), the borrower neither makes nor receives payments under the collar. If the loan index rate rises above the cap strike rate, the hedge provider pays the difference to the borrower. Conversely, if the floating interest rate dips below the floor strike rate, the borrower pays the difference to the hedge provider. The borrower is thereby exposed only to the confined range of interest rate fluctuations between the cap strike and floor strike rates, and is protected in the event rates rise above the cap strike rate. In addition, although the borrower retains some of the potential benefit associated with declining interest rates, the borrower surrenders the savings that would accrue if rates were to dip below the floor strike rate. In exchange for protection in the high rate scenarios, the borrower may be required to pay the hedge provider an upfront fee, which would typically be lower than the fee required under a rate cap. In some cases the fee may be waived altogether, if the value of potential payments to the hedge provider in the low rate scenario adequately compensates the hedge provider for its potential costs in the high rate scenario.

Eligible contract participants

The Commodity Exchange Act, as amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank)1, requires that any party to a swap be an "eligible contract participant" (ECP), unless the swap is entered into through an exchange (referred to as a derivatives contract market) registered with the Commodity Futures Trading Commission (CFTC). No such exchange has been registered to date, and thus it is currently unlawful for any non-ECP to be a party to a swap or even to act as a guarantor or credit support provider of swap payments.

The Commodity Exchange Act defines the term "swap" quite broadly—the term includes all three types of hedges described above. Generally, an entity is an ECP if it has total assets of at least $10,000,000, or net worth of at least $1 million if the entity is hedging commercial risk (among other possible qualifications).

This restriction on non-ECP entities is broadly interpreted to preclude enforcement of a swap if a non-ECP...