Positive fixes for negative interest rates in liability swaps supporting asset-backed securities
Issuers of asset-backed securities (ABS) face an increasinglycommon problem where cash flows under structured swap transactions may not match the payments to noteholders which the swaps are intended to support, due to the treatment (or lack of treatment) of negative interest rates in the swap documents. This article outlines some of the key considerations and practical solutions.
Negative interest has become an increasingly familiar concept in Europe, with the European Central Bank (ECB) and other central banks charging negative rates on their deposits since 2014. The Bank of Japan followed suit in early 2016, and even the US Federal Reserve has commented that negative interest in the US could be "on the table".
According to Moody's Investors Service, there will be around 550 rated residential mortgage based securities (RMBS) or ABS tranches with coupons that are theoretically negative by the end of 2016.
Trends in contractual terms
In our experience, swaps documents entered into before the current negative-interest environment have typically required a fixed-rate payer to pay the absolute value of the floating rate leg. This contractual requirement tends to arise through one of two ways, either through the:
- incorporation of the 2000 or 2006 ISDA Definitions, which apply the "Negative Interest Rate Method" in the absence of express agreement to the contrary, and which requires swap counterparties receiving a floating rate to pay the absolute value of that rate to their counterparty, should it have a negative value; or
- general absence of a specific interest-rate floor provision, in which case it is usually difficult to assert that such a floor should be an implied term of the contractual documents.
Ground zero for securitisation vehicles
This has been a particular challenge for special-purpose securitisation vehicles (and their cash managers) who pay a floating rate of interest to noteholders that is floored at zero. For the most part, this approach is taken irrespective of whether or not the transaction documents expressly provide for such flooring of interests - ABS issuers are not generally seeking to charge negative interest to noteholders, instead electing to floor coupons at zero. Indeed, the ECB eligibility rules for ABS require that interest rates are floored at zero (an implied floor is generally sufficient), and notes with negative interest rates are generally considered to be ineligible for clearing by Euroclear and Clearstream, since there is no mechanism for noteholders to make payments to the issuer.
Negative interest rates may also be an issue for cash deposits in the deal structure, including where collateral is posted by a swap provider. Again, a structural shortfall may arise where the transaction cash flows do not account for payment of negative interest to the bank holding the collateral. Pre-negative interest era legal documents often do not address this issue, with the default position usually being the absorption of any payments due to the collateral bank by the structure (although the specific contractual terms should be examined closely).
The rating agencies are also taking notice of this cash-flow mismatch issue. In a market announcement in July this year, Moody's noted the cash-flow mismatch for issuers having to pay the absolute value of negative interest rates to swap counterparties, although ultimately concluded that the effect on cash flows would be negligible. Among other things, they noted that swap curves indicate that negative interest rates are not expected to last longer than three years. Under its criteria for interest rate stresses in structured finance transactions, Fitch acknowledges that it will take into account negative interest rates on cross-currency swaps, where the swap documentation does not provide for a floor on the swap counterparty's paying leg.
Fixes for new transactions
For new transactions, the fixes are relatively simple. For example, the ISDA Definitions include a "Zero Interest Rate Method", which the parties may expressly elect to apply in the swap documents. This has the simple effect of flooring the applicable floating leg under the swap at zero, although it is likely to increase the price of the swap.
ISDA also provides a solution for transactions where collateral is provided by a swap counterparty, this time through the "Negative Interest Rate Protocol". Parties may adhere to the Protocol, or alternatively agree to set out the language in full in the relevant credit support documentation. Where the Protocol applies, the collateral provider will agree to pay the absolute value of any negative interest amounts to the issuer. The Protocol also introduces supplemental terms, for example in relation to the timing of the absolute value payments (which follows the timing of the positive interest payments).
Parties should be aware that the Negative Interest Rate Protocol does not apply in certain circumstances, for example where credit support is "one-way" i.e. only ever posted by one party. It also does not provide for treatment of negative coupon securities (sometimes known as "nega-coups"), although it is unlikely that these would constitute eligible collateral under the terms of the credit support documentation. Swap providers should also ensure that their operational systems are capable of dealing with negative interest payments on collateral accounts before agreeing to incorporate these provisions.
For existing transactions, there are a few options available to the parties. In some instances, we are seeing parties amending their swap documentation to clarify the treatment of negative interest, although this may have pricing implications where a swap provider is being asked to recognise a floor on the floating leg where no such floor existed previously. Where the negative interest amount is de minimis, a swap provider may agree to waive the payment, although caution should be taken to ensure that this doesn't give rise to a `course of dealing' implied term which could tie the swap provider's hands for future payments. A similar approach may be to settle the negative interest payments outside of the structure.
It should also be noted that many structured swap transactions are entered into on a back-to-back basis with the transaction sponsor, in which case it should be easier for the parties to reach an agreement, as the swap provider is more likely to accept a floor on the floating leg if the impact can be passed on to the sponsor (as back-swap provider).
Our experience to date suggests that the markets are not unduly concerned by mismatch in ABS cash flows caused by negative interest rates. We consider this to be attributable to the relatively small size of the payments, the abilities of transaction parties to come up with pragmatic solutions, and the expectation that negative interest rates are not a long-term phenomenon. In the meantime, we would advise parties that are structuring (or restructuring) ABS transactions to give some consideration as to how negative interest rates should be treated.