The property crash of the 1990′s left many banks and borrowers nursing significant losses. Cash flow was the fundamental issue as rising interest rates meant that the fixed income received from property could often no longer meet loan interest payments, particularly on higher leveraged loans.
Thereafter, the hedging of variable interest rates exchanged for fixed payments through ‘swaps’ became more common and, indeed, often a pre-requisite of a property loan. Roll forward 20 years to today’s low interest rate environment and it is these swap contracts, particularly long-dated swaps, which are acting as a significant constraint on property markets and on bank’s abilities to work through their distressed real estate loan books. Swaps rank above loans in terms of capital repayment and the cost of early termination can be so high it can make many sales currently unworkable.
In addition to the constraint on liquidity, research undertaken by MFL Finance shows that swaps can also be an expensive risk management tool, although they are not intended to be. For 9 out of every 10 days between November 1990 and March 2007 a party choosing a 5-year swap over variable 3-month LIBOR payments paid more interest and on average, 27% more. The trend has continued with more recent analysis to December 2011.
Astute property investors need to balance the benefits of certainty of cash flow provided by swaps over the possible future consequences.