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Guide

Traditional vs. Indirect swaps with correspondent banks

Swaps provide more flexibility for community banks to offer long-term, fixed-rate loan financing to their customers. With traditional interest rate swaps, the bank offers a floating-rate loan and interest swap directly to their customers. Traditional swaps are the most common hedging tool offered by community and regional banks. Alternatively, with an indirect interest rate swap, the community bank introduces a correspondent bank to its customer, who then provides the customer with an interest rate swap.

Below is a comparison of traditional interest rate swaps, a solution we offer at Chatham, and indirect interest rate swaps offered by some correspondent banks.

Topic Traditional swap (Chatham) Indirect swap (correspondent banks)
Credit
  • Your bank
    • Controls the entire credit underwriting process such as deciding on acceptable LTV and collateral
    • Underwrites the swap exposure
    • Retains first lien position
  • Correspondent bank (CB) dictates LTV and allowable collateral for the loan.
  • Your bank becomes a second lien holder on the collateral and should underwrite the swap exposure.
  • Unaccounted for additional credit exposure from the borrower's swap should be continuously monitored by your bank.
Cost
  • 1/4 to 1/3 the cost of indirect swaps.
  • Three to four times the cost of traditional swaps.
Customer
  • Your bank maintains complete control over the customer relationship.
  • Your customer becomes a customer of the CB and the CB takes a first lien in the collateral.
Documentation
  • Market standard to documentation used with your customer.
  • Non-standard documentation used with your customer.
Transparency
  • Your customer understands they are entering a swap with your bank.
  • We disclose our fee throughout the process and invoice your bank directly.
  • The hedging product is not called a swap, and your customer may not understand they have a swap with the CB.
  • The CB is paid in the mark up of the rate quoted to your bank, and your bank will not know how much the CB is compensated.
Accounting
  • There is no hedge accounting required — all swaps are marked-to-market and offset.
  • We provide all accounting entries, financial statement disclosures, and call reporting support.
  • Our team includes a dedicated accounting specialist that will be available to your finance/accounting team(s).
  • There is no specific accounting entries required.
  • Agreement with the CB should be analyzed to ensure it's not a derivative instrument.
  • Your borrower may not realize the accounting implications of their derivative contract with the CB.
Operational ease
  • We have developed a turnkey process for customer hedging program.
  • We continually assist, support, and advise all stakeholders involved in the process.
  • ACH files are used to make the interest rate swap settlements seamless.
  • The loan is set up one time as a floating-rate loan in your loan system.
  • Your bank may need to set up to three loans in your loan system.
  • Reconciliation between your customer payments and net settlements with the CB needs to be performed monthly.
  • There is a risk of a loan payoff and lien release without the swap termination settlement resulting in a loss to your bank.
FTE impact
  • No additional FTE is required.
  • Your bank's operations team books a floating-rate note.
  • We provide settlements that take place monthly via an ACH file.
  • Collateral movements will need to be managed, which we support.
  • No additional FTE is required.
  • Your operations team may need to book up to three different loans in your loan system.
  • Settlements between your bank and the CB need to be checked to payments received from the customer.
Regulatory support
  • Our in-house regulatory team is available for support.
  • Unknown
Liquidity – pledging the loan
  • No limitations
  • Due to your bank being in second lien position, the loan should not be eligible to pledge.
Liquidity – collateral with
  • In order to protect your bank and the swap dealer from credit risk, cash collateral is pledged by the party in a liability position.
  • No requirement to pledge collateral, other than the first lien position noted above.
  • The swap exposure for your customer is unsecured.
Know your customer issues
  • Our dedicated loan-level hedging strategist will prepare slide decks for educating customers and ensuring they understand the product.
  • They will work with your bank's team members to ensure the customer is an eligible contract participant (ECP).
  • Level and depth of educating your customer varies.
  • Potential confusion by the customer if they prepay the loan and have to pay the swap settlement to terminate the swap with the CB.
  • Eligible contract participant (ECP) of your customer is performed by the CB.

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Contact us today to learn more about the value of traditional interest rate swaps.

Disclaimers

Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.

Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.

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