In times such as these when many important interest reference rates (such as Euribor or Libor) are negative, both lenders and borrowers should carefully consider the implications of such negative base rates on their loan agreements.
In many types of leveraged finance transactions, including real estate finance, floating interest rates are based on Euribor or Libor reference rates. If such rates are negative, the interest payable by the borrower will consist of the margin reduced by whatever percentage the base rate is below zero. Should the base rate fall negative in an amount that exceeds the margin, the bank may find that it has to pay interest to the borrower, rather than receive interest from the borrower.
Even if the reference rate is not so low as to eat up the entire margin, the lender may still find that it receives a reduced margin if it is unable to receive interest in the interbank market in an amount corresponding to the negative interest rate. Therefore, many loan agreements nowadays include a "floor" in the definition of the base interest rate, i.e. provide for Euribor or Libor to be "deemed zero" if the rate is in fact negative. If such a provision is included, the borrower will have to pay the (full) margin to the bank, regardless of whether Euribor or Libor is negative.
Such a floor can lead to an increase in the bank's margin by the amount of the negative interest rate, i.e. the bank can make a profit which it (commercially) did not expect, if it can receive interest under its refinancing arrangement which it does not have to pass on to the borrower. From the borrower's perspective, such a floor can cause problems if, like in many leveraged finance transactions, the borrower has entered into a swap and the swap does not contain a corresponding "floor".
Under a swap agreement, the swap counterparty (which is often the lender under the loan agreement or an affiliate of the lender) pays a floating interest rate to the borrower in exchange for a fixed interest rate payable to it by the borrower. Effectively swapping its floating rate commitment for a fixed rate commitment and therefore mitigating the risk of increases in the base rate.
If, however, the floating interest rate is negative and the swap does not contain a "floor", the borrower will have to pay the fixed interest rate and – in addition – the negative floating interest rate to the swap counterparty, i.e. it will have to pay twice. This will not be agreeable to borrowers, and they will push for a corresponding floor in the swap. Such a floor in the swap, however, will usually cost extra and may therefore render the financing unattractive.
The solution for such a mismatch may be found among the following: (i) the bank offers a corresponding floor in the swap and the parties agree to share the related additional costs; (ii) the borrower enters into hedging arrangements which do not involve ongoing payments and which are therefore not affected by a "missing" floor (such as caps); (iii) the parties agree on a fixed interest rate under the loan so that there is no need for hedging; or (iv) the bank agrees to waive the floor in the definition of Euribor/Libor and to pass the benefit of negative interest rates on to the borrower.
In any case, both lenders and borrowers should be aware of the potential mismatch resulting from negative base rates and should agree on potential solutions at an early stage of the transaction, ideally when negotiating the term sheet.