Page 40

CREFW-Fall2014 10.15.14

Swaps Impact on the UK Lending Market: A Closer Look at the Evidence nterest rate swaps linked to floating rate loans have triggered complications and a significant delay in the UK lending market’s turnaround after the global financial crisis. But, based on new evidence from recent out-of-court settlements, UK borrowers might be able to claim GBP 5-10bn in concessions related to their swaps. Introduction: Interest Rate Swaps Have Created Problems for UK Borrowers and Lenders Interest rate swaps have been widely used for many years in the UK commercial property lending market. This is because UK banks require borrowers to cover the risk of an increase in base rates on the floating interest rate loans they provide. When three-month LIBOR increases, but rents from properties do not, a floating-to- fixed rate swap will prevent the loan from a payment default. Floating rate loans dominate the UK lending market, unlike the US where fixed rate loans are more prevalent. However, the interest swaps put in place have had a significant impact on the UK lending market in themselves. As opposed to functioning as a risk management instrument, some have created problems for borrowers and lender alike. This was especially the case when the swaps were not properly structured. This article looks at some quantitative evidence on how some borrowers have been able to deal with problematic swaps. Key View: UK Borrowers Might Be Able to Claim GBP 5-10bn in Concessions Related to Their Swaps Many borrowers might finally be able to enter into a more productive phase of discussion with their lenders, with respect of their legacy floating rate commercial real estate loans. This will require a close review of the exact swap terms associated with these loans. This review will need to assess whether the swaps were appropriately structured and/or sold. A number of borrowers are likely to have a strong enough case to convince lenders and swap providers to provide concessions in loan re-structuring and/or financial compensation in redress. This view is supported by new evidence from external partners. Based on this evidence and some key assumptions, we estimate that UK commercial real estate borrowers might be able to claim between GBP 5-10bn in loan concessions and/or financial redress related to their legacy swaps over the next few years. FCA Found that SME Swaps Did Not Comply with Regulations, but Expansion of Scheme Is Needed As a result, banks were forced into a full review of their sales of interest rate hedging products (IRHPs) to small businesses in January 2013. This will review individual sales of swaps with CRE Finance World Autumn 2014 38 notional values below GBP 10m and provide redress to private customers based on principles outlined by the FCA and overseen by independent reviewers. Based on this, banks have already provisioned GBP 2bn to cover the scheme’s costs of compensation. But, the current scheme only covers swaps with notional less than GBP10m and parties that meet two of the following criteria: (i) small companies with annual turnover of GBP6.5m or less; (ii) a balance sheet of GBP3.26m or less; and (iii) less than 50 employees. As a result of these limitations, the FCA has faced pressure from legal firms to expand the scheme to include medium sized firms. This would be a welcome move for property investors, as most are excluded from the scheme under its current limitations. The argument that big companies should have sufficient expertise to enter into complex swap contracts seems somewhat misplaced. Of course, many property firms are not waiting for this inclusion and have already started work with specialist advisors and legal firms to make the claim. Swaps Have Been a Key Impediment to the Lending Market’s Turnaround Floating-to-fixed rate swap contracts have been used to manage interest rate risk in the UK’s predominantly floating rate market. But, as LIBOR and base rates came down in 2009 and stayed down (as a result of central bank policies), swap breakage costs started to pose a big problem for many borrowers. The 2004-07 loan vintages show the worst results. This is because both loan and swap contracts were put in place near the peak of the cycle at high Loan to Value ratios (LTVs) and were up for refinancing in 2009-14. At this time lenders are offering much lower LTVs. However, if the swap’s term extended beyond the loan term, the swap breakage costs had become large relative to the collateral value. Also, they ranked senior to the lender’s collateral interest. The reduced property value was insufficient in many cases to pay both the swap breakage costs and the remaining loan balance. In other words, many borrowers could not refinance or restructure their legacy loans due to the swap. This triggered in many cases loan maturity extensions or a stand-still under the loan agreement. Ironically, it has also prevented lenders from enforcements on loan defaults and kept many borrowers in the game. As a result, swaps have become one of the biggest impediments for investors to constructively refinance or restructure their legacy loans. The two court decisions related to swaps in commercial property are not a complete reflection of what has been happening in this area, in our view. Out of court settlements are much more numerous while still each a reflection of the outcome of negotiations between two parties. I Hans Vrensen Global Head of Research DTZ


CREFW-Fall2014 10.15.14
To see the actual publication please follow the link above