Understanding Swap Transactions

An interest rate swap agreement is a method for hedging interest rate risk. A swap agreement is essentially a derivative contract, which is an agreement that derives its value based upon a formula which is applied to an underlying asset, rate, or index. Usually, it will be derived from its application to a notional amount, the nominal or face amount that is used to calculate payments made on swaps and other risk management instruments. This amount generally does not change hands, it is simply a representative value utilized in the formula, and is thus referred to as notional.

The agreements are executory in nature, and generally involve, two counterparties, one the ultimate user, the mortgagor, who wishes to hedge or reallocate some asset, liability, or risk, and the other party, a dealer, most commonly a commercial or investment bank. Because the contract is an executory contract, both parties owe duties to one another, as well as future performance obligations at various points in time. Because derivative contracts are based upon changes in the value of an underlying asset, rate, or index, the value changes continuously during the term of the contract. Thus, either party may be “in” or “out” of money, pursuant to the terms of the contract, as to the other counterparty, at any particular moment in time.

A borrower, with a floating rate of interest, may hedge against rate fluctuations, by entering a fixed rate swap agreement with a lender/swap dealer. The difference between the floating and fixed rate, when they are applied to the notional amount, during the interval, results in the borrower being in or out of the money for the period; the net difference, in the amount between the two rates, would constitute a payment liability, either owed to the borrower, or owed to the lender. Where the variable rate exceeds the fixed rate, in the swap, the borrower would be in the money and where it falls below the fixed rate, the borrower would be out of money for the period – here the borrower would be liable for a net payment in accordance with the terms of the swap agreement.

This creates a credit risk; the derivative contract may either constitute a liability or an asset on the balance sheet of the respective counterparties at any point in time. It is this credit risk, the risk to the institutional swap dealer, when the mortgagor is “out” of money on the swap (the swap derivative is now a liability on the mortgagors’ balance sheet) that the swap dealer wishes to secure by a mortgage on the mortgagor’s real property. Essentially, the credit risk, inherent in the possibility of a default by the mortgagor on its obligation to pay, has been collateralized by the mortgage.

The credit risk in a swap transaction is referred to as “breakage.” The “breakage” constitutes damages that the swap dealer/counter party would suffer in the event of a default by the mortgagor in its obligations, or an early termination of the swap, under the swap agreement. The breakage is intended to make the non-defaulting counterparty whole from the loss of its bargain and to cover the costs of entering into a substitute swap. Breakage is not intended to constitute a penalty provision, which courts have shown a proclivity to void, or modify; rather, it is designed to constitute liquidated damages. The breakage fees, in swap contracts, can be very high due to the contingent and variable valuations countenanced in swap instruments; often ranging from about 10 to 20 percent of the principal amount of the loan. 

Absent a default, or early termination, resulting in breakage fees, the contract usually provides for net payments (e.g. the difference between the sums derived from the application of a fixed interest rate and a floating rate applied to the notional amount for the respective swap interval), which are paid, periodically, to the “in” the money counter party by the “out” of money counter party. They can also result from close out netting, under a master agreement, as to multiple transactions. The provisions, providing for these net payments of “swap interest,” are set forth in the swap agreement. The swap payments, and swap interest, are thus an independent obligation from the terms of the mortgage note, and are created by the terms of a separate swap agreement, which is also secured by the terms of the mortgage or deed of trust.

Most swap transactions are created by the use of standardized forms of agreement, an example of which, and probably the largest purveyor of which, is the International Swap & Derivatives Association (ISDA). The ISDA forms, which are copyrighted, are usually comprised of a Master Agreement, an agreement containing the standard terms, conditions, and definitions covering all swap transactions between two counterparties; a Schedule, an agreement designed to modify terms in the Master Agreement; and a Confirmation, which comprises the actual terms and conditions of the particular swap transaction itself. Keep in mind that a master agreement may have multiple swap transactions, evidenced by multiple confirmations, associated with it. A swap contract is comprised of the master agreement, the schedule (if needed), and the respective confirmation- these agreements together constitute the swap agreement. The master agreement standing alone, without the schedule (if needed), and the executed confirmation is not a swap agreement.

Swap transactions generally fall into three categories: direct contingent obligations of the mortgagor to the mortgagee, obligatory advances by the mortgagee to the swap provider (here the swap dealer is not the mortgagee, but purely a third party provider, with no direct interest in the mortgage or deed of trust), and finally, as additional interest.

The swap lender is seeking to have the swap breakage insured as secured by the insured mortgage. The breakage, as we have discussed, constitutes liquidated damages owed to the swap provider, incurred as a result of a default by the mortgagor of its obligations under the swap agreement, or an early termination of the swap agreement. The local law of the jurisdiction determines the ability to insure against loss or damage, occasioned by reason of a final decree of a court of competent jurisdiction finding that the lien of the insured mortgage, as it secures the breakage, is invalid or unenforceable, or does not, share the same priority, in relation to other claims, or liens, as is afforded the principal of the loan secured by the insured mortgage. The transaction must always be structured so that it comports with the local law. In some jurisdictions title insurance over the interest rate swap will be unavailable; in others, it will be less expansive and subject to more exceptions. The direct contingent obligation is the riskiest structure, and is only employable where the mortgagee is the swap provider. The swap provider must have an interest in the mortgage or deed of trust to afford this coverage. Here the swap obligation is an obligation owed directly to the mortgagee, who has an interest in the mortgage or deed of trust, and not an obligation owed to a third party, be that a related third party, or otherwise. In some jurisdictions, mortgages or deeds of trust may only secure determinate non-contingent obligations.

The doctrine of obligatory advance is recognized in most jurisdictions, and is a familiar feature in many commercial mortgage loans. The issue of what is or what is not deemed obligatory is a question for local law- in many jurisdictions,  obligatory means obligatory- the advance obligation is absolute. The swap provider should be an unrelated party; this is to preserve the three party structure found in an obligatory advance scenario- lender, borrower, beneficiary. The concern with a related party arises due to a concern of whether the advance between related parties is obligatory (can the relationship between lender and beneficiary affect the obligatory nature of the advance needed to preserve priority). Again, a related party’s affect on the obligatory nature of the advance will be a matter of local law. It should be noted that an obligatory advance structure, in jurisdictions where mortgage or intangible taxes on mortgages have application, may result in additional mortgage taxes; since, the maximum amount of the advance for the breakage may have to be stated, in both the swap agreement and the mortgage securing it, which will result in a higher mortgage tax. The mortgage or intangible tax likely will need to be paid on the maximum amount stated for the advance.

In jurisdictions where mortgage taxes or intangible taxes on mortgages, or deeds of trust are in effect, the breakage under a swap agreement is secured as additional interest. The breakage is characterized in the mortgage or deed of trust as additional interest, payable pursuant to the terms of the rate swap agreement, which is one of the referenced loan documents. The mortgage or deed of trust provides that it secures the additional interest, as provided for in the loan documents. Usually the additional interest is defined as a defined term in the mortgage or deed of trust and its method and manner of calculation are set forth as well. The swap provider must have an interest in the mortgage, i.e., it must be the mortgagee, to derive interest on the swap obligation.

Any payments under the swap agreement are characterized as additional interest under the loan documents, usually as a defined term, and the additional interest is secured by the terms of the mortgage, as provided for in the loan documents. In some jurisdictions, particularly New York, it may be necessary to add a clause indicating the maximum principal sum that is secured by the mortgage – a capping clause. This clause is necessary to preserve the mortgage tax benefit- no mortgage tax on the additional interest and  to make it clear that the mortgage does not secure an indefinite amount; the mortgage tax is owed only on the maximum amount of principal indebtedness secured by the mortgage, which is clearly stated. The maximum amount of principal indebtedness would not include interest, additional or otherwise. It is the principal sum due under the mortgage. Interest is not subject to the mortgage tax.

Title insurance over interest rate swaps contained in secured mortgages and deeds of trust is provided by use of one of four ALTA 29 series endorsements. The ALTA 29-06 is used when there is a direct obligation swap agreement, and the maximum amount of the swap is undefined. The ALTA 29.1-06 is used when the maximum amount of the swap obligation is undefined and the swap obligation is characterized as additional interest. When there is a direct obligation swap with a defined amount, the ALTA 29.2-06 is the endorsement that most often used. The ALTA 29.3-06 is used when the maximum amount of the swap obligation is defined and is treated as additional interest. 

Practice Tips: which title insurance endorsement is right for your transaction?

 ALTA 29 and 29.1

• Available for Loan Policies only.
• Verify the mortgage secures a Swap Obligation and complies with any applicable state requirements.
• Verify the Swap Obligation is evidenced by an existing master swap agreement or interest rate exchange agreement and confirmation.
• Verify the mortgage secures a maximum amount of the Swap Obligation.
• If the endorsement is issued subsequent to the Date of Policy, add applicable date down exceptions in section 3.e. of the endorsement.

ALTA 29.2 and ALTA 29.3

• Available for Loan Policies only.
• Verify the mortgage expressly secures a Swap Obligation and complies with any applicable state requirements.
• Verify the Swap Obligation is evidenced by an existing master swap agreement or interest exchange agreement and confirmation.
• Verify the Insured Mortgage states the additional amount to be secured under the Swap Agreement or Interest Exchange Agreement, in addition to the loan amount.  Insert this value in the Additional Amount of Insurance in Section 1.c. of the endorsement.  Collect the appropriate title insurance premium and any applicable mortgage tax on this additional amount.
• If the endorsement is issued subsequent to the Date of Policy, add applicable date down exceptions in section 3.e. of the endorsement.