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COVID-19 Pandemic – Issues Relating to Interest Rate Hedges for Real Estate and Other Loan Borrowers
Friday, April 10, 2020

Borrowers under variable rate commercial loans commonly enter into interest rate hedge agreements to eliminate or reduce their exposure to the interest rate risk of their variable debt service obligations. While much recent commentary has been devoted to modifications, waiver and defaults under commercial mortgages and other commercial loans, careful attention should also be paid to how any contemplated action under the loan affects the hedge agreement and whether any corollary action needs to occur with respect to the hedge. The following are some issues to bear in mind with respect to interest rate hedges in the current market environment, particularly if the borrower and lender are considering any waiver or modification to the loan agreement or if a loan event of default may be triggered.

Types of Hedge Agreements

There are generally two categories of hedge agreements that borrowers utilize in this context. The first is an interest rate cap, which is technically a series of interest rate options that correspond to the payment dates under the loan. The borrower pays a premium up front and receives a payment if interest rates are above the strike or cap rate at the time of determination, with any such payment offsetting the borrower’s debt service payment in excess of the cap. The second is a fixed for floating interest rate swap, where the borrower pays a periodic fixed rate in exchange for receiving a floating rate payment aligned with its variable rate under the loan. Because interest rate caps are fully paid up front, they generally do not  involve the hedge provider having credit exposure to the purchaser, whereas interest rate swaps involve the potential for bilateral credit exposure. That distinction becomes important in contexts of loan default or a waiver or modification that may require a modification of the hedge. Since interest rate swaps involve credit exposure, the hedge provider (who is usually also the lender or one of the lenders) typically takes a pro rata security interest in the loan collateral and may require any guaranty of the loan to be extended to the interest rate swap.

Separate Legal Agreements

Borrowers may think of their variable rate loan plus hedge agreement as an integrated capped interest rate obligation (in the case of a hedge that is an interest rate cap) or as a synthetic fixed interest rate obligation (in the case of a hedge that is an interest rate swap). However, the documents governing these transactions are generally explicit that the loan and the hedge are separate and distinct legal agreements. While the borrower may in practice make a single payment reflecting its net debt service and hedge obligation, the borrower  has two sets of legal contracts with two sets of rules that govern how the instruments may perform in extraordinary circumstances.

Issues to Consider When Contemplating Waivers or Modifications of the Related Loan

  • Since the hedge agreement and loan are separate legal contracts, any waiver or modification to the loan will not automatically pass through to the hedge agreement and the borrower and lender will naturally be most focused on the loan and loan documentation. Parties should review the hedge agreement in the context of any such waiver or modification and specifically reference the contemplated effect on the hedge in the written agreement related to any such waiver or modification.

  • If the modification changes the economic terms of the loan, consider whether the economic terms of the hedge will need to be modified as well. Interest rate caps and fixed for floating interest rate swaps are generally tailored to match the loan being hedged and hedge providers should be able to restructure the hedge to match any contemplated modification to the loan. In fact, in loan agreements that require the existence of a hedge agreement and mandate certain criteria that hedge must meet, modification to the hedge agreement may be required to stay in compliance with loan requirements.  However,  any restructuring of the hedge agreement may require an out of pocket payment by the borrower even if there is not a corresponding cost to restructure the loan.

  • For loans that are intended to go into forbearance for some period, the parties may wish to restructure the hedge to similarly toll payment requirements for the forbearance period. This may not be relevant for interest rate caps, since they are not likely to pay out during this period due to recent decreases in market interest rates. However for interest rate swaps, this may mean restructuring the swap to lower or eliminate the current fixed payments of the borrower and correspondingly increasing the payments that the borrower would make in later periods of the swap. Note that any such change would increase the credit risk that the hedge provider is taking to the borrower and in addition to a cost related to the restructuring, the hedge provider may require additional collateral, guaranty or other credit protection.

  • As always, in connection with any modification to the hedge agreement, it is wise to consult tax and accounting advisors to consider any tax or accounting implications that such a modification may have on the borrower.

Issues to Consider in Potential Loan Defaults

  • Many agreements governing interest rate swaps in this context provide that an event of default under the loan or related documents becomes a termination event under the hedge agreement—even if the lender waives or does not exercise remedies in respect of that event of default. While we would not expect a hedge provider (usually in this case the lender or one of the lenders) to exercise its right to terminate the hedge agreement while it is waiving or not exercising similar rights under the loan agreement, borrowers should be aware of this potential and seek, where possible, to have the effect of a contemplated loan default and/or waiver on the hedge agreement memorialized in writing to limit the possibility of later disputes.

  • Similar to the prior bullet, many such interest rate swap agreements provide that a sale of the loan by the lender becomes a termination event under the hedge agreement. If the distressed nature of the loan makes it more likely that the loan would be sold to another lender, borrowers should be aware of the potential that their hedge agreement may be subject to termination in connection with any such sale.

  • In each of the contexts above, note that termination of an interest rate swap ordinarily involves a termination payment that is a function of the current market rates relative to the fixed rate in the agreement, as well as the remaining maturity and other terms. For borrowers that entered into interest rate swaps before  the recent period of lower market interest rates, their interest rate swap likely has  significant negative value that they would be required to pay in connection with an early termination.

Hedge Agreement Provisions Applicable to Extraordinary Circumstances

Interest rate hedge agreements are typically documented under an International Swaps and Derivatives Association (ISDA) Master Agreement, including a termination event for “Illegality” and, for the 2002 version of the ISDA Master Agreement, a termination event for “Force Majeure”. In interest rate hedge agreements, the primary performance obligation is the exchange of payments rather than the performance of any physical obligations that are more likely to be impeded by the current pandemic or related governmental stay at home orders. While we do not believe the current situation in the U.S. would be viewed as rising to the level of these provisions for interest rate hedge agreements, it would be possible in more severe disruption scenarios that communication or payment mechanisms would be interrupted in a way that could potentially give rise to these events under the Master Agreement. In that event, one or both parties may be entitled to terminate the hedge agreement.

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