The hedge sits in the same waterfall as the loan. Whether rates have fallen or risen since it was struck decides whether it takes from the recovery or adds to it.
When a hedged commercial real estate loan defaults, the swap is terminated and its mark-to-market joins the waterfall: a liability of the borrower if rates have fallen since it was struck, an asset if they have risen. On an illustrative £50,000,000 loan swapped at 4.00 per cent with three years left, a fall in the swap rate to 2.50 per cent creates a £2,142,018 termination payment that cuts the lender's recovery out of £42,000,000 of sale proceeds from 84.0 to 80.5 per cent if the hedge ranks pari passu, and to 79.7 per cent if it ranks ahead.
Worked in full in The Real Estate Workout by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Workout recovery analysis usually starts from the property: sale value, costs, time. The hedge is often missing from the first draft, because it sits in a separate ISDA, is sometimes provided by a different bank and is valued by someone else. Yet it is secured on the same building, and in most facilities it ranks at least equally with the loan. A swap struck when rates were higher than at default carries a close-out amount the borrower owes, and that amount comes out of the same pot.
| Input | Value |
|---|---|
| Loan outstanding | £50,000,000 |
| Swap: borrower pays fixed on a notional equal to the loan | 4.00% |
| Remaining term of the swap | 3 years |
| Net sale proceeds available to secured creditors | £42,000,000 |
| Market swap rate at termination, falling case | 2.50% |
| Market swap rate at termination, rising case | 5.00% |
Accrued interest, default interest and enforcement costs are left out so that the hedge effect stands alone; the property-side comparison is worked in consensual sale vs enforcement. Swap payments are taken as annual for clarity.
Close-out value to the borrower = (market swap rate − fixed rate) × notional × annuity factor at the market rate
Annuity factor = (1 − (1 + r)−n) / r; in Excel =PV(2.5%,3,-1) = 2.8560
Falling case: (2.50% − 4.00%) × 50,000,000 × 2.8560 = −2,142,018, owed by the borrower
Rising case: (5.00% − 4.00%) × 50,000,000 × 2.7232 = +1,361,624, owed to the borrower
A rough guide: on this notional and term, each 100 basis points between the fixed rate and the market rate is worth about £1,414,306. A real close-out amount also includes the hedge provider's bid-offer and funding adjustments, so it is usually somewhat worse for the borrower than the mid-market figure.
Pari passu: lender's recovery = proceeds × loan / (loan + termination amount) = 42,000,000 × 50,000,000 / 52,142,018 = 40,274,621
Hedge ranks first: lender's recovery = proceeds − termination amount = 42,000,000 − 2,142,018 = 39,857,982
Swap in the money: the close-out amount is paid into the security, so recovery = 42,000,000 + 1,361,624 = 43,361,624
| Case | Swap value to borrower, £ | Lender recovers, £ | Hedge provider recovers, £ | Recovery rate | Change vs no hedge, £ |
|---|---|---|---|---|---|
| No hedge | 0 | 42,000,000 | 0 | 84.0% | 0 |
| Rates fell, hedge pari passu | −2,142,018 | 40,274,621 | 1,725,379 | 80.5% | −1,725,379 |
| Rates fell, hedge ranks first | −2,142,018 | 39,857,982 | 2,142,018 | 79.7% | −2,142,018 |
| Rates rose, swap assigned to lender | 1,361,624 | 43,361,624 | 0 | 86.7% | 1,361,624 |
Pari passu, the hedge provider takes 4.1 per cent of the proceeds, its share of the £52,142,018 of secured claims. Where the intercreditor terms put hedging first, the lender bears the whole termination amount. In the rising case, the in-the-money swap is collateral: provided the hedging agreement is assigned to the lender, as it usually is in a property facility, its value goes into the recovery and the loss shrinks from £8,000,000 to £6,638,376.
| Market swap rate | vs 4.00% fixed, bp | Swap value to borrower, £ | Recovery, pari passu | Recovery, hedge first |
|---|---|---|---|---|
| 2.00% | −200 | −2,883,883 | 79.4% | 78.2% |
| 2.50% | −150 | −2,142,018 | 80.5% | 79.7% |
| 3.00% | −100 | −1,414,306 | 81.7% | 81.2% |
| 3.50% | −50 | −700,409 | 82.8% | 82.6% |
| 4.00% | 0 | 0 | 84.0% | 84.0% |
| 4.50% | 50 | 687,241 | 85.4% | 85.4% |
| 5.00% | 100 | 1,361,624 | 86.7% | 86.7% |
The hedge works against the lender in exactly the scenario where defaults are likeliest to have been caused by something other than rates: a tenant failure or a valuation fall in a market where central banks are cutting. It works for the lender when rising rates caused the default in the first place, which is the case the swap was bought to cover. A purchased interest rate cap has no downside of this kind: it can only be an asset, worth something or nothing at termination.
Leaving the hedge out of the recovery model, or carrying it at a stale value from the last quarter's statement. In the falling case, leaving it out overstates the lender's recovery by £1,725,379 to £2,142,018 on a £50,000,000 loan, more than the difference between many of the workout options a credit committee is asked to choose between. The second mistake is assuming the swap will be terminated at default. A hedge provider that is also the lender may prefer to keep it running through a consensual workout, in which case the out-of-the-money position becomes part of the debt to be restructured. The valuation mechanics are in how to value an interest rate swap after rates move.
Value the hedge at the expected termination date, read the intercreditor ranking, and put the result in the same waterfall as the property proceeds. Here a 150 basis point fall in swap rates takes 3.5 points off the lender's recovery, and a 100 basis point rise adds 2.7. The four ways out of one broken loan, each priced against the others, are in the free workbook for this case.
It depends on the facility and intercreditor terms. Hedging liabilities usually rank pari passu with the loan and sometimes ahead of it. In the illustrative case a £2,142,018 termination amount leaves the lender 80.5% of its £50,000,000 loan pari passu and 79.7% if the hedge ranks first, against 84.0% with no hedge.
Its close-out value is owed to the borrower, and because property facilities normally take an assignment of the hedging agreement, it goes into the lender's security. With rates at 5.00% against a 4.00% fixed rate, the swap is worth £1,361,624 and recovery rises from 84.0% to 86.7% of the loan.
Multiply the gap between the fixed rate and the current swap rate for the remaining term by the notional and by the annuity factor at the market rate. For £50,000,000 over three years, each 100 basis points is worth about £1,414,306. Actual close-out amounts add the dealer's spreads and adjustments, which usually work against the borrower.
This article is one calculation from The Real Estate Workout. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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