- Financing With Interest Rate Swap Agreements
- July 11, 2012
- Law Firm: Steeg Law Firm LLC - New Orleans Office
Today’s fluctuating economy has resulted in some creative financing methods, including interest rate swap agreements, to try to keep the flow of credit available, which benefits both lenders and borrowers. Senior Associate, Lillian E. Eyrich, weighs in on how it works and how title insurance plays a key role for both parties.
Interest Rate Swap Agreements - How They Work
An interest rate swap is a derivative transaction whose value depends on (or “derives” from) the value of an underlying reference rate or index, and is used to manage the risk of interest rate fluctuations. Borrowers can use an interest rate swap to change their interest rate exposure from a variable rate to a fixed rate. Notwithstanding that the primary loan from lender to borrower is at a variable rate of interest, the swap provider may assure the lender that it receives no less than a specified rate, or it may assure the borrower that it pays no more than a specified rate.
Interest rate swaps are purchased from financial institutions, usually using standardized forms of agreement created by the International Swap Dealers Association (ISDA), which follow conventions and use terminology laid down in codes established by the ISDA. Basically, an interest rate swap is a type of real estate interest rate hedge, but it is independent of the loan, although it is an accessory to it.
The bank commonly requires the borrower to secure its obligations under the swap agreement with a mortgage, and the bank also wants to protect itself against loss if the borrower breaches the swap agreement. One of the key obligations secured by the mortgage is the “breakage”—damages to the financial institution that it will suffer as a result of the borrower’s breach of its swap obligations.
Title Insurance - A Requirement by Financial Institutions in Interest Rate Swap Agreements
Banks entering into interest rate swap agreements with their borrowers want a mortgage as security for the borrower’s hedge obligations, and they want the mortgage to be insured with a title insurance policy. A basic title policy excludes coverage for loss sustained by the insured lender in the event a court rules that the mortgage is invalid or unenforceable because the mortgage provides for changes in the rate of interest. Banks want title insurance companies to offer modifications to the basic title policy to cover this risk.
For a long time, title insurance companies have offered endorsements for variable rate or adjustable rate mortgages, and now the companies offer endorsements for interest rate swap mortgages. These were created by the American Land Title Association and adopted by the major title insurance companies in the United States. The endorsements give the lender coverage to protect against losses resulting from a finding that the lien of the insured mortgage is not valid or enforceable as security for interest rate hedging obligations, or does not have the same priority as the date the mortgage was recorded or filed. The endorsements are known as the ALTA 29 Interest Rate Swap - Direct Obligation Endorsement and the ALTA 29.1 Interest Rate Swap - Additional Interest Endorsement.
The ALTA 29 Interest Rate Swap - Direct Obligation Endorsement and the ALTA29.1 Interest Rate Swap - Additional Interest Endorsement
In the ALTA 29 Rate Swap - Direct Obligation Endorsement, the title insurance company gives coverage to the insured lender if the insured mortgage is invalid, unenforceable, or lacks priority as security for the repayment of the swap obligation at the date of the endorsement.
The ALTA 29.1 Interest Rate Swap - Additional Interest Endorsement provides similar coverage to the insured lender as the ALTA 29; however, rather than giving coverage as to the swap obligation, the endorsement provides coverage to the insured lender if the insured mortgage is invalid, unenforceable, or lacks priority as security for the repayment of the “Additional Interest” at the date of the endorsement. “Additional Interest” is defined in the endorsement as “the additional interest calculated pursuant to the formula provided in the loan documents secured by the Insured Mortgage at Date of Endorsement for repayment of the Swap Obligation.”
Before agreeing to issue the ALTA 29 or the ALTA 29.1 endorsement, most title insurance companies will review the documents to verify that several criteria are satisfied: (1) that the mortgage expressly secures the swap obligation and complies with applicable state requirements for disclosure of swap obligation; (2) that the swap obligation is evidenced by an existing master swap agreement and confirmation; and (3) that the mortgage establishes a maximum amount of the swap obligation. The local title agent must receive the approval of the underwriting department of the title insurance company before committing to a bank that the endorsement is available. There is an additional premium charged for the endorsement. In Louisiana, it is a percentage of the basic premium for the title policy being issued, so as the amount of the loan increases, the charge for the endorsement increases.
Limitations on the Title Insurance Coverage
As with any title insurance coverage, there are some important limitations in the ALTA 29 and ALTA 29.1 endorsements. These endorsements do not provide insurance coverage for: (1) changes to the interest rate swap agreement that occur after the date of the endorsement; (2) the stay, rejection or avoidance of the mortgage, or other remedy ordered by a bankruptcy court or state court applying state insolvency or creditors’ rights law; (3) the calculation by a court of the amount of the borrower’s swap obligation; or (4) the invalidity or lack of priority of the mortgage if caused by the failure to pay mortgage recording taxes.
These are similar to exclusions in the basic title policy. The title insurer does not insure that future changes to the swap agreement and mortgage will be enforceable, because they cannot review changes in advance. Swap agreements might come under the power of a bankruptcy court to set aside contracts, so the insurer does not take on that risk. A basic title policy does not insure the amount owed by the borrower, it simply insures that the mortgage is valid as security for the repayment of the debt; similarly, the Interest Rate Swap Endorsement does not insure the amount of the swap obligation or additional interest, it just insures that the mortgage is valid as security for the repayment of the obligation.
The fourth limitation generally will not apply in Louisiana, but in states in which the government charges a mortgage tax based on the loan amount, a mortgage can lose its priority or validity if the taxes were not paid, and the title insurance does not cover that risk.
The Lender’s Perspective
Prudent lenders want to make sure they have as many protections in place as are available and which are commercially reasonable to require of their borrowers. Variable or adjustable rate mortgages have been in use for a long time, and the title insurance industry has offered endorsements to help protect the lender against risk of loss for those mortgages.
Interest rate swap agreements are a more recent development in the lending industry, and can be beneficial to both lenders and their borrowers, but do pose additional risk for the lender of receiving challenges to the validity or priority of the mortgage. The Interest Rate Swap Endorsements offer valuable coverage against that risk.
The takeaway: a lender should consider requesting the additional coverage when planning for an interest rate swap transaction.
The Borrower’s Perspective
An interest rate hedge protects the borrower against fluctuations in interest rates and is a means of securing the lowest possible fixed effective interest rate. Interest rate swap agreements are used when interest rates may unexpectedly rise due to volatility and uncertainty in the market. As part of the agreement from the lender to offer this to the borrower, the borrower will need to pay the title insurance premium and any lender fees for the coverage.
The takeaway: a prudent borrower should do a cost/benefit analysis to determine that the possible savings in interest over the life of the loan outweigh the upfront expenses by a margin that satisfies the borrower.