Interest Rate Swaps and Financial Crisis

The Potential Vindication of Interest Rate Swaps

Could the current financial crisis finally bring vindication to the oft-maligned interest rate swaps? Greenspoon Marder’s Howard Mulligan argues that the answer is yes. Interest rate swaps have been used since the late 1970s as a mechanism for managing risk. They were originally used by large banks to leverage their fixed-rate borrowing capacity and obtain lower-cost floating rate funds. As they became more widely used, swaps were utilized by smaller banks, medium-sized and small businesses to protect their modest lines of credit from interest rate fluctuations.

In 2008, swaps began to dominate financial headlines as a bugbear of a simmering global financial crisis. The current financial turmoil has brought swaps back to the forefront of the national conversation in a completely different way. However, these current events may actually signal the overdue vindication for the much-maligned professionals that inhabit the derivatives space.

Understanding Interest Rate Swaps

An interest rate swap is a contract between two parties that exchanges one stream of interest payments for another over a contractually outlined period. Typically, the swap involves the exchange of a fixed interest rate for a floating rate. Interest rate swaps are a subset of financial instruments known as derivatives, which are traded on over-the-counter exchanges. From a legal perspective, the swap contract consists of the International Swaps and Derivatives Association (ISDA) form, supplemented by a confirmation that reflects the precise terms of the business deal.

In a typical interest rate swap, only interest payments are exchanged, with each counterparty paying the difference in payments as specified. One counterparty obtains risk protection by operating a fixed rate, while the other counterparty garners exposure to potential financial gain from a floating rate. Ultimately, one counterparty will attain a financial profit while the other sustains a loss, depending on the relative rate of the movement in actual prevailing interest rates.

Swaps Evolve and Congress Acts

As the structured finance paradigm evolved in the 1990s, lawyers began to use ISDA swap contracts to mitigate interest rate fluctuation risks confronting securitization trusts. The senior tranche of asset-backed securities being issued by the trust was often AAA-rated, requiring a non-AAA swap counterparty to be backed by a suitably rated guarantor. Gradually, securitization transactions began to use credit default and total return swaps in addition to interest rate swaps to manage risk. By the turn of the 21st century, swaps had evolved into central features of structured finance transactions.

In response to the financial crisis of 2008, Congress passed the Dodd-Frank Act, which imposed greater regulation on the swaps market. As a result, swaps must now be cleared through clearinghouses and traded on electronic platforms, increasing transparency and reducing counterparty risk. These measures have also led to higher costs, which have caused some market participants to return to banks for bilateral swaps.

Vindication for Interest Rate Swaps

Interest rate swaps have been scapegoated for the economic recession of the late 2000s. However, swaps have also played an important role in managing risk and facilitating financing for many businesses. With greater regulation and transparency, the negative perception of swaps may be gradually eroding. In the current economic crisis, swaps have become an important tool for market participants to manage risk and hedge against interest rate volatility. It may be time for the humble rate swap to finally receive its due recognition as a valuable financial instrument.