Vedder Thinking | Articles Collateralization of Swap Obligations in Leveraged Financings
Loan documents for leveraging operating leases often include interest rate swaps that convert a borrower/lessor’s floating rate loan obligations into fixed rate obligations to match rental receivables. This article discusses our recent experience of lenders requiring counterparties to collateralize those swap obligations.
“Collateralization” of a swap transaction refers to a situation where either or both parties to a swap are required to offer security or credit support for the risk that their counterparty is taking on the transaction at any given point in time. This risk arises if the then mark-to-market (or other) value of the swap transaction would cause one party to have an exposure to the other if the swap transaction were terminated.
The concept of requiring swap transactions to be collateralized is not new. Since 1994, ISDA has published its “Credit Support Annex”, which provides multiple options for collateralizing swap transactions, including interest rate swap transactions. Swap desks at most financial institutions have been using Credit Support Annexes and have been managing the posting of collateral under such arrangements for many years.
Recently, the market has been reminded of the very real nature of counterparty risk by the collapse of Lehman Brothers and Bear Stearns, and the frenzy of activity caused by AIG’s near demise. We also have seen ratings downgrades suffered by many financial institutions, which have in turn trigged obligations for the downgraded financial institutions to post collateral under their structured finance transactions. Across the financial services industry, including in equipment finance, these developments have focused attention on swap counterparty risk.
As a result, our recent experience has been an increased incidence of lenders requiring that swap transactions be collateralized in leveraged operating lease transactions. In particular, there has been a marked increase in collateralization requirements in “non-recourse” operating lease transactions (i.e., transactions with recourse strictly to the assets the subject of the transaction) and in syndicated transactions with external, third-party swap providers.
Conventionally, lenders in “non-recourse” or “limited-recourse” transactions have formed a view that they are protected from swap breakage exposure by the excess value of their collateral over and above the balance of their underlying loan and possibly also by parent guarantees of breakage costs.
Collateralization of such transactions offers the additional protection of cash collateral (or any other agreed collateral) to cover the exposure of the lenders. Collateralization is effected in the context of conventional fixed rate financings by building in the equivalent of an ISDA mark-to-market mechanism into the loan agreement to calculate the amount of collateral required and then incorporating applicable rules. These are typically rules that determine (i) the frequency of testing whether the counterparty should post collateral, (ii) the thresholds at which collateral is required to be posted, (iii) the minimum transfer amounts if collateral is required to be posted, (iv) requirements for delivering and returning collateral, and (v) the type of collateral that can be posted, which is typically cash.
In a different context, lenders in syndicated transactions with external, third-party swap providers (which may be one of the lenders) recently have been requiring the swap bank, as the borrower’s counterparty, to post cash collateral. This is not a requirement because of any risk that the borrower’s collateral may not be sufficient, but is rather required to manage the borrower’s—and through the borrower’s, the lender’s—counterparty risk on the swap bank. These collateralization arrangements reflect typical credit support arrangements that would be entered into by bank trading desks (and in this type of arrangement are likely to be negotiated, at least on the part of the swap bank, by its swap desk). Arrangements are likely to be documented by an ISDA Credit Support Annex, and posting is likely to be contingent upon a downgrade of the swap bank below an agreed threshold credit rating.
Including a requirement for the swap bank to collateralize its position raises some interesting questions. If a swap bank is required to post collateral, should the borrower also be required to post collateral in some situations? What level of access should the swap bank have as a secured party to the lenders’ collateral if it also has access to collateral posted by the borrower under the swap? Also, if the swap bank posts collateral to the borrower, then what should happen to that posted collateral in the event of a borrower default under the swap agreement and/or the borrower’s loan documents?
While exploring these points is beyond the scope of this note, suffice it to say that these types of questions, while raising the complexity of a transaction, may have to be answered if swap exposure is a concern.
The summary for lenders and borrowers is that swap transactions remain an important part of many equipment finance transactions. While market practice very much remains for fixed rate loans to be documented without additional credit support for swap positions, we have noticed some market participants paying further attention to the additional risk that swaps create. As a result, some participants have tried to manage that risk, specifically by requiring that their swaps be collateralized.
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