Remedies and Ramifications When A Swap Counterparty Defaults
October 1, 2008
How do you deal with interest-rate swaps when the other side of the swap — Lehman Brothers — is in default and the overall credit market has imploded? Bankers and financial advisers are fielding questions from clients who are trying to determine what action to take — indeed, what remedies are available.
In a nutshell…The implosion of the credit market began 15 months or so ago with the downgrading of the bond insurers — Radian Asset Assurance being the first. Then came the meltdown of the subprime mortgage market and the failure of some structured investment vehicles (SIVs). And in February of this year, the auction-rate market collapsed. While not specifically related to the senior living sector, these combined events dried up market liquidity and, as a result, financial institutions lost confidence in each other. As that loss of confidence expanded to investors and the public, lines of credit were pulled or became unavailable and stalwarts of the industry were swallowed up or went out of business.
Yet everyone turned hopeful when federal regulators stepped in to assist in the buyouts of Bear, Stearns and Washington Mutual by JPMorgan Chase and of Merrill Lynch by Bank of America and in the bailouts of Fannie Mae, Freddie Mac, and AIG. Then, when Lehman Brothers Holdings, Inc. was on the brink, nobody — including the Feds — would provide Lehman with capital, which forced it to file for bankruptcy. The very next day, the entire financial system went into a tailspin. Money-market funds experienced massive withdrawals, forcing many funds to “put” significant amounts of holdings — many of which were tax-exempt VRDBs — to prepare for the redemptions.
As a result of this market collapse, the Securities Industry & Financial Marketing Association (SIFMA) composite variable interest-rate index jumped from 1.8% to as high as 8%, as remarketing agents drew on the credit facilities of banks backing the bonds. But with banks not even lending to each other, the question of whether they could fund all that incoming paper escalated into utter fear.
Once the Feds invoked a 1930s-era program (similar to FDIC) to support the money market funds, withdrawals stopped, that market stabilized, and variable-tax-exempt interest rates have begun working their way down. “It’s going to be a long road, but we’re probably past the worst point,” said Timothy Sheehan, Managing Director of Cain Brothers in Indianapolis. Let’s hope he’s right.
The interest-rate swap market
Most senior living providers with tax-exempt variable-rate bonds entered into fixed-rate swap agreements. An interest-rate swap is an agreement between two counterparties to exchange future cash flows according to a prearranged formula. The most common swap structure is one in which counterparty A (in this case, the senior care provider) pays a fixed rate to counterparty B and receives a floating, or variable, rate usually pegged to a reference index rate such as SIFMA or LIBOR and reset periodically (e.g., every day, week, month, quarter). The swap is a totally separate third-party agreement with a financial institution, and net payments are typically exchanged monthly or quarterly. The SIFMA index usually mirrors the rate Party A is paying on the underlying funds; the 67% of LIBOR method includes a discount of 50 basis points on the fixed rate Party A pays on the swap.
“Many borrowers believed that 67% of LIBOR, with the 50 basis point savings, was worth it,” Sheehan mentioned, “because the SIFMA index, historically, has equaled 67% of LIBOR. But that’s not guaranteed. And in this current market, 67% of LIBOR is about 3% and the variable rates on the underlying funding have been as high as 8%. That should normalize, though, as money returns to the money-market funds.”
To terminate or not to terminate
Historically, parties entering into swaps were interested primarily in rates. “Now, that’s changed,” according to Jodi Wasserstein, Executive Vice President at Herbert J. Sims & Co. “People realize that they must also focus on defaults and remedies when making contracts.”
The ISDA Master Agreement, which governs swap transactions, is relatively clear as to what happens in a default by a counterparty, but the current market turmoil is making some of those options difficult or impossible to implement. Wasserstein noted three ways swaps may be terminated: (1) Based on the mark-to-market valuation of the swap, a termination payment exchange is made and may favor Lehman (you owe money to Lehman) or you (Lehman owes you money). (2) You seek another entity to assume the swap and make the termination payment. (3) The Lehman book is taken over by another entity, similar to the scenario in which JPMorgan Chase assumed all the Bear, Stearns swaps.
Normally, the non-affected party would attempt to replace the defaulting swap by assigning it to another creditworthy counterparty. “That type of assignment requires obtaining market quotes on the value of the swap and assumes a counterparty is willing to honor the terms of the existing agreement,” said John Kautz, Managing Director and Head of Risk Management & Advisory in Ziegler’s New York office. “If you can’t get those quotes or if no counterparties are willing to step into the swap, then valuation becomes a little murky.
For clients who owe money to Lehman on a termination, a replacement swap with a new counterparty would be a wash. “There’s a market for those swaps,” said Sheehan, “although we don’t know how deep it is or how long it will be around.” To do that kind of assignment, though, any payment owed Lehman must be paid.
Some clients may not have the capacity to make a payment or are fearful that they won’t find a replacement provider. “Most of our senior living clients are in very good financial positions,” added Sheehan, “but the decision whether to terminate their swaps depends on their stage of development. A stand-alone entrance-fee startup that’s not yet open probably won’t have excess cash until the units fill up, so a wait-and-see decision is likely. Established organizations can often afford to take more risks and may even be in a position to reduce the fixed-interest rate of their swaps based on today’s market. In those cases, termination might be worthwhile.”
“Rates are also a major focus right now,” Kautz added, “and a lot of organizations that have pay fixed-interest rates in place have a negative mark-to-market on their swaps in today’s low-rate environment. If they terminate the swap prior to maturity, they would be forced to pay Lehman as if it were a purely voluntary termination, an option most people wouldn’t choose to pursue. Instead, they typically keep it in place until it matures with a zero value and never realize that mark-to-market.”
With so many unknowns and so many different opinions swirling around about the swap market, financial advisers can’t say definitively what will happen. When the swap counterparty is in default, you most likely have the right to terminate, but every situation is different. “When terminating a swap, voluntarily or involuntarily, there may be ramifications to debt service covenants or bond booking, for example, that are individual to each senior living provider,” Kautz explained. “In addition, terminating a swap and being unable to rebook or replace it could have a negative impact, because hedge protection under the swap has been eliminated.
Involve your legal counsel
Due to the recent market turmoil, financial industry consolidation and major counterparty defaults, investment bankers and advisers throughout the industry are working overtime assisting their clients with interest-rate swaps and investment agreements by helping them gauge risks, examine documents, demystify the termination process, obtain market quotes, explain payment options based on the interpretation of ISDA provisions, and — perhaps most importantly — urging them to seek legal counsel to determine the best course to follow.
Despite very specific guidelines for getting market quotations in default situations, some of the issues in this market include: Does the swap have a reduced or zero value if you can’t get actionable market quotes? Do you then owe Lehman nothing? Is that commercially reasonable and calculated in good faith? Can you justify your methodology and calculation? Or do you then use an alternate method to calculate the swap’s value and potential loss or gain? And can you charge Lehman for any costs related to termination and/or rebooking of the swap?
With respect to the Lehman situation, Ziegler is advising its clients first to involve knowledgeable legal counsel immediately, not only to provide an interpretation of the ISDA provisions as they relate to the swap agreement, but also to work in conjunction with senior management and an experienced swap adviser in deciding the appropriate solution for the organization. If and when a replacement swap counterparty is found, determining the methodology and timing for terminating the Lehman swap becomes the next important decision.
“People are also wondering what to do about the interest payments that they owe Lehman under the swap agreements,” said Kautz, “because they’re getting payment notices. Also, some organizations have swaps and investment agreements with Lehman, having invested bond proceeds in a debt service reserve fund through an FDA or similar investment agreement. Many of those investment agreements are principal-protected with a process to unwind the agreement, but future earnings will be lost due to the nonperformance of the agreement created by the counterparty’s default.” One banker told us he would advise clients not to make any payments to Lehman right now, but to definitely seek payment from Lehman if owed.
Providers should be working with their advisers and bankers for information assistance and guidance about the possible ramifications of a swap termination on their organizations. In particular, providers should pay close attention to the potential impact on their bond covenants, letter of credit covenants, debt service requirements, and anything else that may impact them financially. “Ultimately, though, they definitely must have everything they’re told vetted by counsel and approved by senior management,” Kautz stressed, “because this is not a normal swap situation. This is a bankruptcy default situation unlike any that we’ve ever dealt with before.”
Is there a rush to do something?
“From what we can tell, a lot of organizations with Lehman swap or investment agreements are going through this process slowly and cautiously, but certainly with an understanding that this situation demands immediate attention,” Kautz said. “They want to make sure that they don’t miss anything that could be to their advantage later, that they don’t make a hasty decision and miss an opportunity to move the swap, or that they miscalculate the unwind and have a future liability from a bankruptcy judge. We think it’s at the point now, however, where organizations need to start formulating plans. The first step is to get in touch with your counsel and your adviser or investment banker. Certainly don’t wait for Lehman to announce what’s going to happen.”
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