Once upon a time, an interest rate swap was a simple transaction. Party A (aka the “Fixed Rate Payer”) and Party B (aka the “Floating Rate Payer”) would agree, in a relatively simple document, that each month they would pay each other amounts determined with reference to interest accruing on a nominal principal amount. The Fixed Rate Payer would pay the other party an amount equal to interest for the period on the nominal principal amount at an agreed-upon specified fixed rate. The Floating Rate Payer would concurrently make a payment to the Fixed Rate Payer of an amount equal to interest for the period on the nominal principal amount calculated based upon an agreed-upon rate (such as the prime rate) which could vary. This would go on for an agreed-upon number of months or years.
The arrangement did not require that either party actually have any corresponding debt, although usually at least one of the parties was protecting against the risk of interest rate increases. Thus, the Fixed Rate Payer could have a five-year $10 million term loan bearing interest at a floating rate (such as prime plus 1 percent) and be protecting itself against increases in the prime rate by swapping into a corresponding fixed rate transaction. Assuming a similar nominal principal amount for the swap, the Floating Rate Payer’s payment to the Fixed Rate Payer would approximate the amount of interest that the Fixed Rate Payer had to pay to its lender on its term loan each month so that the Fixed Rate Payer would be assured that it would have to pay at the fixed rate for the period of the swap.
Variations on this arrangement were available, depending on the kind of loan, principal amortization, interest payment frequency, and some other factors. Collars and caps were common.1
There were, of course, some problems. Credit risk was a big one. Many of these transactions were for multiyear periods, and the financial health of a party could (and sometimes did) deteriorate over time, such that the other party found itself with a contract that might not be performed. A party’s obligation could be secured by granting a lien on assets to the other party. But the party that found itself granting security might also later find that the grant was not necessary because rates had moved favorably to its position. And liquidity and value of the collateral could be issues. The party taking security wanted the collateral to be cash or cash equivalents or readily marketable securities, not real estate or other collateral that would take time to sell and have value that could change substantially.
Sometimes the credit risk issue was addressed by having one party make an up-front payment to the other. Thus, if Party A wanted to fix the rate on its $10 million term loan, Party B might insist on a flat payment up front as compensation for taking the floating rate risk. This was an acceptable solution if Party B was sufficiently creditworthy that Party A wasn’t worried about Party B defaulting later, and if Party A had the funds to make the up-front payment, which could be sizable. It also depended on there being a Party B willing to agree to be paid a flat fee up front for taking the risk.
Another problem was early termination. If one Payer became insolvent or otherwise defaulted, the other Payer might want to terminate the transaction. This required some method of determining the liabilities of the parties if the transaction was terminated. It was relatively simple to come up with the liability of the Fixed Rate Payer if that was the side that was under water on the swap, but when the floating rate side was out of the money, determining the liability of the Floating Rate Payer was more troublesome.
And the parties could differ over what constituted an acceptable basis for early termination. If a party’s position was in the money, could it intentionally default in order to terminate the swap and collect? And what if a parent guarantor had problems and filed bankruptcy but the actual party to the swap was not consolidated into the bankruptcy and not otherwise in default?
All of this led to the creation of ISDA, the International Swap and Derivates Association, and to ISDA’s plethora of forms, the most significant of which is the Master Agreement. Although the issues continue to be part of swap transactions, the ISDA documents provide a standardized approach to the means for setting forth the parties’ understandings.
The Master Agreement constitutes the foundation upon which any number of potential transactions can be based. Before two parties actually agree upon a swap or other derivatives transaction, they will negotiate and sign the Master Agreement and the Schedule thereto. If security is to be provided, they will also negotiate and sign the Credit Support Annex. If either party is required to provide a parent or affiliate guaranty, that will also be executed and delivered. These steps provide a framework under which any swap or other derivative transaction can be entered into by the parties.
The Master Agreement sets out provisions that would apply to any interest rate swap transaction, such as netting of payments, gross up for taxes, specified representations by each party, covenants of each party to furnish specified information to the other (such as financial reports and authorizing resolutions), events of default and termination events, early termination provisions (including valuation and settlement procedures), restrictions on transfer, contract currency provisions, definitions, and miscellaneous boilerplate. The variables in the deal—the terms that get negotiated—are covered in the Schedule to the Master Agreement, and in the Confirmations of specific “Transactions,” and in any supplemental documents, such as the Credit Support Annex. In effect, these documents amend or supplement the Master Agreement.
