Avoiding Pitfalls of Covid-19 Modifications for Swapped Loans

Many banks are modifying commercial loans as they and their commercial borrowers grapple with the economic fallout of the Covid-19 pandemic.

Payment relief could include incorporating interest-only periods, principal and interest payment deferrals, and/or loan and swap maturity/amortization extensions. While modifications can provide borrowers with much-needed financial flexibility, they also risk creating unintended accounting, legal and economic consequences.

Don’t forget the swaps
Lenders need to determine whether there is a swap associated with loans when contemplating a modification. Prior to modification, lenders should coordinate efforts with their Treasury or swap desk to address these swapped loans, and ensure that loan and swap documentation are consistent regarding the terms of the modification.

Develop realistic repayment plans
Lenders need to consider how deferred obligations will be repaid when creating a temporary payment deferral plan. The lender may need to offer an interest-only period so a borrower can repay the deferred interest before principal amortization resumes, or deferred interest payments could be added to the principal balance of the loan. Lenders also should consider whether the proposed modification will be sufficient, given the severity of the borrower’s challenges. The costs associated with amending a swapped loan may convince a lender to offer a more substantive longer-term deferral, rather than repeatedly kicking the can down the road with a series of short-term fixes.

Determine whether swap amendment is necessary
The modified loan terms may necessitate an amendment of the associated swap. It may be possible to leave the swap in place without amendment if you are only adding an interest-only period, as long as the borrower is comfortable with their loan being slightly underhedged. But if you are contemplating a full payment deferral, it typically will be desirable to replace the existing swap transaction with a new forward-starting transaction commencing when the borrower is expected to resume making principal and interest payments.

Understand bank or borrower hedge accounting impact of loan modifications
Lenders often hedge the value of their fixed-rate loans or other assets through formalized hedging programs. A popular strategy has been to designate these swaps as fair value hedges using the shortcut method.

This method requires that the economic terms of the asset, such as amortization of principal and timing of interest payments, precisely match those of the hedge. A mismatch due to a loan payment deferral would cause the lender to lose the hedge’s shortcut status. The lender’s hedging program potentially could maintain hedge accounting treatment using the more cumbersome long-haul method if that mismatch scenario was contemplated in the hedge inception documentation.

Borrowers who have taken variable rate loans may have entered into swaps to gain synthetic rate protection. Restructuring  a hedge to defer payments alongside the loan’s deferred payments could jeopardize an accounting-sensitive borrower’s hedge accounting treatment. It is possible for the borrower to reapply hedge accounting under the amended terms, although the restart has additional considerations compared to a new un-amended hedge. If hedge accounting is not restarted, the derivative’s valuation changes thereafter would create earnings volatility per accounting rules. While borrowers should be responsible for their own accounting, lenders’ awareness of these potential issues will only help client relationships in these uncertain times.

Take stock of counterparty derivative exposure
As interest rates plunge to record lows, many lenders have seen their counterparty exposure climb well above initially-approved limits. Hedge modifications may further exacerbate this situation by increasing or extending counterparty credit exposure. We recommend that lenders work with their credit teams to reassess their counterparty exposure and update limits.

Accounting guidance also requires the evaluation of credit valuation adjustments to customer swap portfolios. Lenders should ensure that their assumptions about the creditworthiness of their counterparties reflect current market conditions. These adjustments could also have a material impact on swap valuations.

Hope for the best, plan for the worst
Hopefully, loan modifications will give borrowers the opportunity to regain their financial footing. However, some may face continued financial challenges after the crisis. Lenders should use the modification process to prepare for potential defaults. Loan deferments or modifications should provide for the retention of the lender’s rights to declare a default under the loan documents and any swap agreements. The lender, through consultation with its credit team, may want to take this opportunity to bolster its position through the inclusion of additional guarantors or other credit enhancements.

The economic fallout from the global pandemic continues to have a profound impact upon borrowers and lenders alike. Adopting a thoughtful approach to loan modifications, especially when the financing structure includes a swap or other hedge, may make the process a little less disruptive for all.