Increasingly, some banks have been including a provision in their commercial loan agreements that deems the variable interest rate on a loan to be zero, if the reference rate on the loan (for example, LIBOR) goes negative.  This type of a provision is sometimes referred to as a “deemed zero” clause.  This blog posting looks at issues that banks and borrowers alike may want to consider with respect to the documentation of an interest rate swap that is used to hedge the borrower’s interest rate exposure on a loan that contains a “deemed zero” clause.

Typically, a variable rate loan will be hedged with a fixed-for-floating interest rate swap that is structured on the basis of the 2000 ISDA Definitions or the 2006 ISDA Definitions (collectively, the “Definitions”).  In that situation, there is a potential mismatch between the loan’s reference rate and the swap’s floating rate, because the Definitions default to what is known as the “Negative Interest Rate Method,” unless the counterparties to the swap elect otherwise.  In short, under the Negative Interest Rate Method, the fixed rate payer (usually the borrower) would owe the floating rate payer (usually the bank) a payment to account for the negative interest rates.  This payment would be in addition to the fixed amount owed on the swap.

How do the parties avoid this mismatch?

By including provision in their swap confirmation that elects for the Zero Interest Rate Method under the Definitions.  As a result of that election, if the reference rate on the swap goes below zero, then the floating rate amount is deemed to be zero and the fixed rate payer would only be obligated to pay the fixed rate payment amount on the swap (i.e., there would be no gross-up for the effect of the “negative rates”). 

It really is that simple, but unfortunately so is the potential mismatch.

In closing, a few points are worth noting.

First, we recommend that an accounting professional be consulted about the accounting implications of any “deemed zero” elections, as well as the effect of a potential mismatch, on the treatment of the hedge for accounting purposes.

Second, if the swap provider bank (in our example, the lender) wants to use a cleared swap to hedge its exposure on the swap with the borrower, then it would need to give consideration to the effect of the “deemed zero” provision on the abiilty of the bank to clear its hedge.

Thrid, a “deemed zero” clause may have an effect on the pricing on the loan or the swap, so the parties may want to give specific consideration to pricing issues as part of the structuring of the lending arrangements.

Fourth, this posting was based on the assumption that the swap did not include a spread above or below the reference rate. However, many swaps do contain a spread.  Both the Negative and Zero Interest Rate Methods give consideration to the spread, in determing the effect of a negative interest rate on the payments owed under the swap.

Finally, the documentation of every loan and swap is unique, while the observations in this posting are of a general nature.  So, this posting is qualified in its entirety by the obvious caveat that the actual documents and particular terms that actually govern the lending and hedging relationship must be read carefully, since this posting may or may not be applicable to any particular “deal”.

Good day.   Good to hedge as intended. DR2