Volatility in the valuation of swapped floating-rate positions — a proposed solution

Problem

Fair value is a market-based measurement. As such, it is measured using the assumptions that market participants would employ when pricing an asset or liability, including assumptions about risk¹. Given the fact that a floating-rate loan and associated interest rate swap are separate instruments, the default valuation methodology is to evaluate each component independent of one another. However, this approach does not consider the economic structure established with the addition of a swap that is legally coupled to a specific floating-rate loan, and results in values irreflective of true market risk. See the below example comparing a swapped floating-rate loan with a fixed-rate loan and the resulting differences in the mark-to-market conclusions over time. The prepayment penalty of the fixed-rate loan is also included to demonstrate a direct comparison of the true costs of terminating each position.

As the example depicts, the current market practice of valuing loan and derivative components independently penalizes a borrower by adding mark-to-market volatility relative to a fixed-rate loan, despite the economic impact to the borrower’s cash flows being identical in both structures. Logically, there should not be a gap between the valuation of a fixed-rate loan and swapped floater with identical economics.

Given the current methodology of valuing swapped floaters may create valuations that are inconsistent with how market participants evaluate the impact of the instrument on equity cash flows and performance returns, adjustments are needed to remove this inaccurate volatility and better align with fair value measurement definitions and principles as defined by ASC 820.

Proposed solution

The differences in valuation techniques between a fixed-rate loan and a floating-rate loan with a swap should be removed and replaced with an approach that recognizes the similar impact each structure has on equity cash flows and performance returns. This can be done by treating the loan and swap as a single financial instrument. To apply this methodology, one would value the combination of the two instruments—the floating-rate loan and interest rate swap—as if they were a single fixed-rate loan.

Additional considerations

Applicability: Not all swapped floaters should be valued as a single instrument. Below is a list of criteria for when this methodology is appropriate.

1. The loan and swap are secured by the same collateral
2. The loan and swap are pari passu
3. The loan cannot be prepaid and allow the swap to remain outstanding without lender consent

Valuing floating-rate loans: Floating-rate loans without interest rate swaps typically do not exhibit volatility in their valuations. This comes from a few primary reasons.

1. Floating-rate loans are seldom a liability. Since most floating-rate loans can be freely prepaid without a prepayment penalty, the market assumes that if the costs to borrow dropped low enough to prepay the loan, the borrower would make the economically rational decision and prepay the loan at no cost rather than incur a negative mark-to-market impact.
2. Floating-rate loans generally have shorter duration. The longer the duration an instrument has, the more volatile its valuations tend to be.
3. Floating-rate loan valuations are not impacted by changes to interest rate markets. In valuing a fixed-rate loan, one must consider changes to the underlying interest rate markets and changes to borrowing spreads. For a floating-rate loan, the valuation agent only needs to look at the changes in the borrowing spread.

However, when a floating-rate loan is combined with a swap, the dynamics of that loan are fundamentally changed in the following ways.

1. Since unwinding the swap is a requirement of prepaying the loan, the loan is no longer freely prepayable.
2. This dynamic tends to give the loan a longer expected duration since the cost to prepay a loan is intrinsically tied to the unwind cost of a swap.
3. Whereas a loan that is freely prepayable cannot be a liability, a loan that is not open to be freely prepaid can become a liability.

Unit of account: This is the level at which an asset or a liability is aggregated or disaggregated for reporting purposes⁴, which should not be confused with the appropriate unit of account for the purpose of valuation which should reflect how market participants would evaluate the asset or liability. The following quotes the NCREIF-PREA Reporting Standards on this topic:

“The policy election of unit of account for valuation purposes can be made independently of the election of the reporting framework... Factors for management to consider when making the unit of account election include:

• How a market participant would value the underlying investments.
• The availability of objective and verifiable market evidence to support inputs used to determine the valuation of the underlying investment.

Once management makes the unit of account election, it is management’s responsibility to make sure the real estate investment valuations are reported from the appropriate perspective (net equity or assets and liabilities separately).

If a Fund elects to value its real estate investments using one unit of account and presents its financial statements using the Operating Model, management needs to also determine a consistent and rational methodology to allocate the fair value of the net equity position to the underlying assets and liabilities of its real estate investment.⁵”

If a swapped floater is valued as if it were a fixed-rate loan and needs to be disaggregated for reporting purposes, the value of the swap equals the termination value (i.e., the cost to unwind the swap) and the value of the floating-rate loan equals the value of the hypothetically fixed-rate loan minus the termination value of the swap. The requirement to disaggregate for reporting purposes does not change the net valuation of the position assessed using fair value measurement standards.

¹ FASB ASC 820-10-05-1C

² Mark-to-market of the fixed-rate loan is calculated as the fair value minus the outstanding debt balance

³ Mark-to-market of the swapped floating-rate loan is calculated as the fair value of the loan minus the outstanding debt balance of the loan and then added to the mark-to-market of the interest rate swap

⁴ FASB Topic ASC 820 Glossary: Unit of Account

⁵ NCREIF-PREA Reporting Standards (December 18, 2019). Handbook Volume II: Manuals: Fair Value Accounting Policy 1.04