What are embedded derivatives

what are embedded derivatives

Issue #25 - April 2014

Pairing Your Loan with a Swap:

Embedded Derivatives, CARLA and Prepayment Fees

By Daniel F. Wheeler, Bryan Cave LLP

Banks can chose to make a fixed-rate loan and then hedge the interest rate risk on that loan by entering into an interest rate swap that effectively converts the fixed interest rate into a variable rate. This is an extremely common method of hedging interest rate risk.

As banks are aware, if the interest rate swap agreement is terminated prior to maturity, one of the parties will have to pay a termination or unwind fee to the other. Naturally, banks are concerned that interest rates will have moved against them (typically by decreasing) and the bank (as the fixed-rate payer) will be the party with the payment obligation. Of course, interest rates might increase and early termination would result in an unwind fee being paid to the bank.

A one-way prepayment fee is where the borrower must reimburse the bank for the costs it incurs for early termination of the swap but the bank cannot have a prepayment fee obligation. A two way prepayment fee is where, in addition to the borrower’s agreement to reimburse the bank for its costs, the bank agrees to pass through to the borrower the financial benefit of terminating its swap. (A benefit arises if the swap is “in the money”, which generally occurs if interest rates rise after the date of the loan.) Sometimes, these two-way prepayment fee provisions (and the note or loan agreement in which they appear) are referred to as a “customized loan rate agreement” or CARLA.

There are several issues to keep in mind when crafting either a one-way or two-way prepayment fee. First, a bank’s accountants may require a bank to treat a make whole formula that calculates a prepayment fee by reference to an external interest rate like LIBOR as an “embedded derivative.” If the prepayment fee is deemed an embedded derivative, and if it is not deemed clearly and closely related to the host promissory note or loan agreement, then the prepayment fee would be bifurcated from the host promissory note or loan agreement and not designated as a hedge. The bank would carry the prepayment fee provision (the embedded derivative) at fair value and report changes in its fair value in current period earnings. The bank could report the host promissory note or loan agreement according to other loan accounting guidance. The bank should ensure that it has systems in place to properly account

for and otherwise deal with embedded derivatives and to distinguish between loans that have them and those that do not. To achieve the desired outcome, the bank should also ensure that the language of the prepayment fee provision is carefully drafted and that defined terms are appropriately matched.

Second, the bank obviously needs to decide on a program or transaction basis whether it wants to pass through the benefit of positive breakage costs. A complete or partial pass-through is not legally required. A bank may want to enhance the profitability of a hedged loan relationship by retaining some or all of the upside potential for itself and imposing a one-way reimbursement obligation on the borrower. If a bank is accustomed to using promissory notes, then it will need to consider where it puts a two-way prepayment fee, since a two-way obligation would change a note from being a unilateral instrument into a bilateral agreement, which may require additional drafting and planning, particularly if the bank sells the loan.

Third, placing a one-way or two-way make-whole prepayment fee provision in the loan documents may increase the risk of lender liability. A borrower may argue later that the bank did not adequately disclose the nature and amount of obligations the borrower was incurring by including such provisions in the loan documents. For example, litigation is pending in the U.K. revolving around exactly these sorts of allegations.

A prepayment fee provision that does not use a formula based on LIBOR or other external rates but is instead fixed in advance at least avoids embedded derivative accounting treatment and may reduce the possibility of borrower confusion. A declining balance formula can be structured to require payments that would equal the bank’s maximum potential exposure at various intervals over the life of the loan. Obviously, actual swap unwind costs can be less than such projected maximum amounts, which means a declining balance formula frequently may mean the borrower’s prepayment or default costs are significantly higher than the costs actually incurred by the bank. Refinements to that formula can be used, such as language that reduces the declining balance fee to zero if the bank actually incurs no costs under its hedge.

A bank should understand and use these various methods as appropriate when necessary to secure a good credit and meet its profitability hurdles.

Daniel F. Wheeler is a banking regulatory partner at the Bryan Cave LLP law firm (www.bryancave.com ) and works with community banks throughout the United States. He can be reached at 415-675-3472 or daniel.wheeler@bryancave.com .

Source: www.wib.org

Category: Bank

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