As managing partner of GGG and the Turnaround Authority, I get the pleasure of providing guest posts by our other partners. The following post is by our newest Partner, Vic Taglia.
Have you tried to get a fixed rate business loan lately from a “too big to fail” bank? Has the bank said it only offers variable, floating rate loans? Has it then offered to introduce you to its affiliated company that can help?
No More, My Friends
If you answered yes to these three questions, you are not alone. Many smaller borrowers find that the traditional 15-year fixed rate mortgage on their factories, warehouses, offices, etc. can’t be had from their long-time lender.
With interest rates at all-time lows, you can understand why a banker doesn’t want to fix his return for 15 years, just as much as you do want the fixed rate option. Bankers really need to limit their interest rate risk in these days of aggressive regulation, and avoiding long-term fixed-rate assets is one sure way to do so.
Their Friend Isn’t Your Friend, My Friend
But I don’t write to pity the TBTF banks. I write to alert you to one of the pitfalls of this “affiliated company that can help” offer.
Most banks are part of bank holding companies, and big bank holding companies have investment banking subsidiaries. These investment bank subsidiaries can sell the borrower an interest rate swap contract that effectively swaps the borrower’s obligation to make payments based on variable rates for an obligation to make fixed payments for the life of the contract.
For example, a borrower may get a 15-year floating rate loan at prime plus 2% for his factory. At today’s rate that is 5.25% and will change the day the bank announces a change in its prime rate. For a million dollar, 15-year amortizing loan, the monthly payment at 5.25% is $8,039. If the prime increases to 8.25%, the loan rate rises to 10.25% and the payment increases to $10,900, an increase of 36%.
(For those of you with short memories, the prime rate was 8.25% from June 29, 2006 to September 18, 2007. Yes, four years ago, the prime rate was 8.25%.)
The Pitfalls for My Friends
We can see why no one wants to take the risk of interest rates increasing if he can avoid it. And the banks have a special incentive not to do so — avoidance of regulatory criticism. So their investment banks developed interest rate swaps. Great idea, but beware of a few potential pitfalls.
First the accounting for these derivative contracts is complicated and changes every month. As interest rates increase and decrease and the present values of the cash streams change (as they will as time passes), the differences must go through your income statement and be recorded in your company’s equity. Some borrowers ignore this during the year and have their CPAs figure it out later.
I realize this is just paperwork and has little impact on your business (remember Cash is King), but it will impact your financial ratios, possibly hurt your covenant compliance and give you one more thing to explain in your financial statements.
More potentially troubling is that your obligation to make these fixed payments is for the life of the swap contract, not the life of the loan. So what happens if someone offers you a bunch of money for your business and you want to retire? Great, right?
Not so fast. You must pay off the mortgage note, but you still have the obligation to pay the fixed mortgage payment, every month, for the remainder of the swap contract or buy your way out of the obligation.
So read the fine print, negotiate an early maturity for the interest rate swap or even buyout prices in the swap contract. And ask yourself just how much you are willing to pay to trade one type of risk for another.
Have you gotten involved in one of these situations? What has your experience been?
The Turnaround Authority 