A swap is a contract to exchange interest rate payments based on an agreed-upon notional schedule. The most common swap is floating to fixed swap, where a client pays a fixed rate and receives a floating rate, usually LIBOR.
At any given moment, the swap rate is what the market expects LIBOR to average over that term. In other words, you are swapping the projected floating rate for a fixed rate.
In this scenario, the borrower has a floating rate loan at 1mL + 2.00%. He swaps this floating payment out for a fixed rate of 4.50%.
Whether LIBOR goes to 0% or 20%, the borrower will always receive a floating payment on the swap that exactly offsets what he owes on the loan. The net effect is a fixed rate of 4.50%. Here’s an example using LIBOR at 2.00%:
Borrower Pays on Loan2.00% + 2.00%
Borrower Pays Fixed on Swap4.50%
Borrower Receives on Swap2.00% + 2.00%
Borrower pays8.50% – 4.50% = 4.50%.
The bank lays the risk off in the market at the same time the customer locks in the rate over the phone. The swap marketer will usually say “let me put you on hold while I lock this in with the trader”. Unlike with a fixed rate loan, the bank now has no exposure to rising interest rates.
The “market” is really just other trading desks. No one is betting against the client – the desk simply quotes the rate available in the market and passes it along to the borrower.
In this example, the Dodd-Frank mid rate is 4.25%, which is where the bank could execute the swap with another bank using Treasurys as collateral. The swap desk does not offer the same rate to the borrower, however. It increases the rate to compensate for credit risk and execution considerations. In this example, the bank offers a fixed rate of 4.50% to the borrower. The spread between 4.50% and 4.25% is how the bank generates revenue on swaps.
This 0.25% of profit is a per year charge, which has the same impact as increasing the customer’s borrowing spread from 2.00% to 2.25%. Unlike a loan spread, however, the 0.25% is multiplied over the term of the swap, present valued, and recognized as an upfront fee. For example:
$100mm * 0.25% * 5 years = $1,250,000 swap income
If swap rates fall and the borrower defaults, the bank is left with a loss on the value of the swap. Because a swap generates credit exposure, it needs to be underwritten like a loan. And, like a loan, the bank is entitled to charging for this extension of credit. That is why banks charge a fee to execute swaps.
The real estate securing the loan also typically secures the swap exposure.
Frequently, the biggest risk on a swap is in the event of a prepayment. While it is true that swaps can be an asset if rates climb enough, this happens less frequently than expected. Here is the back of the envelope calculation for a swap breakage.
For illustration purposes, we assume a 10 year swap that is prepaid after 7 years and rates have not moved at all since the time the swap was locked.
Average Remaining Notional * (Fixed Rate Locked – Replacement Rate) * Time Remaining
$100,000,000 * (3.75% – 2.85%) * 3 years = $2,700,000
If rates don’t move, the swap will have a breakage of about $2,700,000 in seven years. Much of this is attributable to the effect of rolling down the yield curve. Three year rates are lower than ten year rates, so the swap naturally moves against the borrower over time.
The initial profit made by the bank becomes an imbedded prepayment penalty that is carried forward. This would compound the effect from rolling down the yield curve.