Don’t Be Floored By Debt Terms
The tough credit environment and large write offs for banks have spurred new lending practices. On the good side, the less-gloomy economic outlook is encouraging more banks to loosen their credit requirements. But there’s a twist (or two). Banks are shortening the duration of their revolvers to reduce their credit risk. They are also taking steps to limit their interest rate exposure by sometimes requiring corporate clients to include a floor as part of the deal. The floor, an option, gives the banks a guaranteed rate of return. If interest rates drop below a certain level, their results won’t be impacted as their clients will continue to pay a set rate.
There at least two problems with this picture:
- The floor changes the economics of the deal.
- The floor, a derivative, raises thorny accounting issues under FAS 133.
Economics First
Right off the bat, if the banks are pushing for a floor, that means there’s money on the table. It’s important that treasurers understand the banks’ motivation but also the pricing. Not figuring out the cost of the floor is like giving away the store. The cost of a floor, a call option, may be upward of a million dollars, depending on implied volatility, duration and strike price. The price of a floor goes higher particularly during periods of interest rate volatility. By requesting a floor, the banks are protecting their earnings. Corporate treasurers should do the same.
Before agreeing to a floor (i.e., writing the call option), treasury must value the option to monetize the benefit to the bank. Depending on the duration of the debt, the strike price on the floor (the guaranteed minimum return) and the yield curve, the floor can vary substantially in value. Treasury must be able to value the instrument in order to have a productive discussion with the banks.
Recently, a client called to ask about the impact a proposed floor would have on his company’s hedging relationship (very bad impact: see below). At the date of our discussion, the floor in question had a market value of over $1.5 million – a liability for the corporate and an asset for the bank – and asset for which the bank was not offering any compensation. If a company does not have interest-rate option-pricing capabilities, treasury can ask a couple of its banks what they would charge for a floor with a similar strike as the floor required by the lending bank. The price quotes will pinpoint the monetary value of the option, and thus how much the borrowing company would have to pay to “unwind” this feature from its debt.
Once the value is ascertained, the company can have a productive discussion with its bank. One approach would be to require the bank to provide a cap (a put option) of equal value that would offset the value of the floor, i.e., a guarantee that rates won’t rise above a certain threshold. If the put and the floor are of equal value, the result is a “costless collar.”
Even without demanding a put, with the information about the value of the floor in hand, treasurers can shop the deal more effectively and have more productive discussions with other bank counterparts. Finally, if the floor is the difference between getting the loan and not getting the loan, companies can ask the bank to purchase a floor and “roll” the cost into the borrowing spread instead. It may appear to cost more, but it will clearly highlight to all the cost of that embedded floor (and will be hedgeable). It’s also important that companies highlight to their bank any existing interest rate swaps that convert variable-rate borrowings to fixed, which, with the addition of the embedded floor, would cease to be economically effective.
Hedge Accounting
The other and potentially big problem with including a floor as part of a bank lending facility is the accounting. Because of FAS 133, the derivatives accounting rule, the floor may end up creating significant volatility in the income statement. If the borrowing is already covered by an existing swap, adding the floor will likely kick that hedge outside the “highly effective” zone; with the swap no long effective, the company will have to de-designate the swap, discontinue hedge accounting and freeze OCI until the date of maturity. Because of the way the floor changes the economics of the interest rate exposure, it’s not possible to offset the economic risk using a simple swap. A company would need to purchase a floor and designate it in concert with the interest rate swap in the hedge relationship (another good reason to check the value of the floor, before you give it away).
Embedded floors and caps are considered clearly and closely related to debt under FAS 133 paragraph 61 (f) so there is no need to bifurcate and account for the floor as a derivative. If you are successful in asking for a cap, the resultant collar is also scoped out of derivative accounting.
