Underwriting swap exposures

Interest rate swaps have value over the life of the contract. This value creates the potential for credit risk. It is important for a bank to understand the potential credit exposure should their borrower terminate or default on an interest rate swap prior to maturity.

What is peak potential future exposure (PFE)?

When underwriting loans where the borrower is contemplating a swap, a value known as Peak Potential Future Exposure (or PFE) is reviewed and included in the credit approval.

The PFE provides the Bank an estimate of peak credit exposure over the life of the swap contract for a specified confidence level. There are many ways to calculate the PFE, but the one most often used is the confidence interval or standard deviation calculation. For example, assuming two standard deviations, the model based PFE represents the peak credit exposure in 98% of all scenarios given the current assumptions.

The term of the swap, notional amount, amortization and current market conditions will impact the PFE.

Underwriting considerations when reviewing the derivative exposure

The Peak PFE is captured within the loan underwriting as contingent credit exposure to the borrower. Why is Peak PFE important from a credit standpoint?

• The bank takes on contingent credit exposure when the borrower enters into a swap due to the uncertainty around future rate movements.
• Falling rates cause the value of the swap to become an increasing liability to the borrower, which means the bank is exposed should the borrower default.
• The bank uses PFE as a placeholder that forecasts the peak potential exposure given a downward movement in rates.
• If the borrower pays the loan as agreed and maintains the swap contract through maturity, the peak PFE would never be realized.
• Even though peak PFE may not be included in the LTV limits, the bank will review the collateral pool to see if it is adequate. The same collateral will apply to the loan outstanding's and swap obligations.
• Ongoing, through the annual loan review process, a bank will compare the peak PFE that was “approved” to both the current value of the swap also known as mark to market or and the updated peak PFE.

Summary

Remember, the peak PFE is included in the loan underwriting and will be reviewed annually comparing it to the current peak PFE and Market to Market Values. This is soft exposure and a change in the swap value would not warrant asking for additional collateral, however, may impact future credit requests.

The loan and the swap are pari passu with the collateral pool outlined in the loan documents.

Lastly, it is contingent exposure and is only realized if the borrower terminates the swap at a time when rates have fallen significantly.