MacuSheild
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Let’s hypothetically say the CEO of AIB’s struck a deal with the CEO of Barclays early in 2008 to lend Barclays €30 million for 20 years. The €30 million loan is secured on a building that Barclays owns in Dublin.
€20 million of the €30 million loan is at the floating ECB Rate plus a 1% margin. The prevailing ECB Rate is 4% at the time the deal was signed in 2008, so on drawdown this €20 million part of the loan starts paying interest at 5% (ECB 4% + 1% Margin). However, there is an “option” attached, to AIB’s benefit. An option is the right but not an obligation to trigger a term in the contract. The loan agreement states that the prevailing value of the Barclays building must remain at between €40 million and €60 million during the 20 years. If property prices fall, AIB has the option to get the specific Barclays building independently valued and can revise the 1% margin upward, based on the prevailing value at the time of the valuation.
€10 million of the loan is at a fixed rate of 3%. This fixed rate will stay in place for 20 years unless Barclays chooses to exercise an “option” that has been placed in the loan documentation, for the benefit of Barclays. An option is the right but not an obligation to trigger a term in the contract. If the ECB rate falls sharply and looks likely to stay very low for a lengthy spell of the 20 year loan term, Barclays has an option at a time of their choosing to switch that €10 million to the same terms of interest as the €20 million part of the loan.
Soon after the deal is signed, European interest rates collapse because of a severe economic recession.
What’s the good news for Barclays?
The ECB part of the rate on the €20 million of the loan has collapsed to 0%, so with a 1% margin the new net rate is 1%. On top of that, Barclays has a contractual option to switch the €10 million of the loan to the same interest rate terms as the €20 million, so Barclays has an option to move the fixed rate of 3% on €20 million to 1% (ECB 0% + 1% Margin). Barclays will exercise that option quite soon if they think the recession and low ECB rates could last a long time and that interest rates aren’t likely to be at 5% or 6% for many years in about 10 years time (which would make the 3% fixed rate quite valuable in Years 11-20 of the 20 year loan)
What’s the bad news for Barclays?
If the prevailing value of the Barclays building has fallen below €40 million, AIB can substantially increase the margin in the loan agreement from the level of 1% agreed at the start of the loan. If Barclays exercises its option to switch out of €10 million loan at the fixed rate but the Barclays building can be independently proven to be worth less than €40 million, AIB can sharply increase the margin to rebuild the overall interest rate – on the entire €30 million loan. However, AIB cannot just assume a new prevailing valuation across all mortgaged properties in its loan contracts - it has to actually carry them out, one by one.
What would definitely not happen in this scenario?
1) Unlike AIB’s retail customers (who are not financial professionals and who are protected under Consumer Protection Codes), Barclays would not fail to consider the contractual option to switch from fixed to floating interest rates for part of the loan. It would not take Barclays 7 or 8 years to be alerted to how valuable that option was. If Barclays didn’t notice the option they held, AIB would be under no obligation to warn them in simple language, because Barclays are professionals
2) Unlike a similar contractual dispute with 4,000 of its retail customers (where it would take several years to deploy independent parties to value 4,000 residential properties), there is no way that AIB would not bother to have the prevailing value of one Barclays building assessed
3) Without an independent valuation of the prevailing value of the Barclays building, AIB would not dare to unilaterally advise Barclays that it had increased the standard initial margin on all ECB + Margin loans to 5% for all new deals of this nature with other banks - and retrospectively to Barclays on a specific historical transaction. There could be a catastrophic flight of interbank deposits from AIB if the wider market heard a rumor that AIB had insisted that Barclays would have to accept its prevailing “new business pricing”, regardless of what was specifically written in an individual AIB-Barclays Loan Agreement. Your word is your bond in the inter-bank markets
4) AIB would not be oblivious to the financial value to Barclays of having a 20-year long option to switch an interest rate from fixed to floating. This would be a significant financial risk for AIB over a 20 year period. If AIB was trying to hedge all of this risk by paying Deutsche Bank a fee to take on this risk for 20 years, financial professionals in both AIB and Deutsche Bank would do a lot of probability calculations to assess the value of the option. If Deutsche Bank make errors in their calculations and take on that 20 years of financial risk for a fee that is too low, AIB is under no obligation to warn Deutsche Bank because they are professionals. If AIB was in a contract dispute with 4,000 retail customers who weren’t aware that AIB might have unintentionally but unilaterally removed a very valuable financial option from a contract 7 or 8 years previously, AIB would probably be obliged to ensure that the amateur customers received a retrospective and fair value for a contractual option that (it could be reasonably argued) had been unfairly dishonoured
€20 million of the €30 million loan is at the floating ECB Rate plus a 1% margin. The prevailing ECB Rate is 4% at the time the deal was signed in 2008, so on drawdown this €20 million part of the loan starts paying interest at 5% (ECB 4% + 1% Margin). However, there is an “option” attached, to AIB’s benefit. An option is the right but not an obligation to trigger a term in the contract. The loan agreement states that the prevailing value of the Barclays building must remain at between €40 million and €60 million during the 20 years. If property prices fall, AIB has the option to get the specific Barclays building independently valued and can revise the 1% margin upward, based on the prevailing value at the time of the valuation.
€10 million of the loan is at a fixed rate of 3%. This fixed rate will stay in place for 20 years unless Barclays chooses to exercise an “option” that has been placed in the loan documentation, for the benefit of Barclays. An option is the right but not an obligation to trigger a term in the contract. If the ECB rate falls sharply and looks likely to stay very low for a lengthy spell of the 20 year loan term, Barclays has an option at a time of their choosing to switch that €10 million to the same terms of interest as the €20 million part of the loan.
Soon after the deal is signed, European interest rates collapse because of a severe economic recession.
What’s the good news for Barclays?
The ECB part of the rate on the €20 million of the loan has collapsed to 0%, so with a 1% margin the new net rate is 1%. On top of that, Barclays has a contractual option to switch the €10 million of the loan to the same interest rate terms as the €20 million, so Barclays has an option to move the fixed rate of 3% on €20 million to 1% (ECB 0% + 1% Margin). Barclays will exercise that option quite soon if they think the recession and low ECB rates could last a long time and that interest rates aren’t likely to be at 5% or 6% for many years in about 10 years time (which would make the 3% fixed rate quite valuable in Years 11-20 of the 20 year loan)
What’s the bad news for Barclays?
If the prevailing value of the Barclays building has fallen below €40 million, AIB can substantially increase the margin in the loan agreement from the level of 1% agreed at the start of the loan. If Barclays exercises its option to switch out of €10 million loan at the fixed rate but the Barclays building can be independently proven to be worth less than €40 million, AIB can sharply increase the margin to rebuild the overall interest rate – on the entire €30 million loan. However, AIB cannot just assume a new prevailing valuation across all mortgaged properties in its loan contracts - it has to actually carry them out, one by one.
What would definitely not happen in this scenario?
1) Unlike AIB’s retail customers (who are not financial professionals and who are protected under Consumer Protection Codes), Barclays would not fail to consider the contractual option to switch from fixed to floating interest rates for part of the loan. It would not take Barclays 7 or 8 years to be alerted to how valuable that option was. If Barclays didn’t notice the option they held, AIB would be under no obligation to warn them in simple language, because Barclays are professionals
2) Unlike a similar contractual dispute with 4,000 of its retail customers (where it would take several years to deploy independent parties to value 4,000 residential properties), there is no way that AIB would not bother to have the prevailing value of one Barclays building assessed
3) Without an independent valuation of the prevailing value of the Barclays building, AIB would not dare to unilaterally advise Barclays that it had increased the standard initial margin on all ECB + Margin loans to 5% for all new deals of this nature with other banks - and retrospectively to Barclays on a specific historical transaction. There could be a catastrophic flight of interbank deposits from AIB if the wider market heard a rumor that AIB had insisted that Barclays would have to accept its prevailing “new business pricing”, regardless of what was specifically written in an individual AIB-Barclays Loan Agreement. Your word is your bond in the inter-bank markets
4) AIB would not be oblivious to the financial value to Barclays of having a 20-year long option to switch an interest rate from fixed to floating. This would be a significant financial risk for AIB over a 20 year period. If AIB was trying to hedge all of this risk by paying Deutsche Bank a fee to take on this risk for 20 years, financial professionals in both AIB and Deutsche Bank would do a lot of probability calculations to assess the value of the option. If Deutsche Bank make errors in their calculations and take on that 20 years of financial risk for a fee that is too low, AIB is under no obligation to warn Deutsche Bank because they are professionals. If AIB was in a contract dispute with 4,000 retail customers who weren’t aware that AIB might have unintentionally but unilaterally removed a very valuable financial option from a contract 7 or 8 years previously, AIB would probably be obliged to ensure that the amateur customers received a retrospective and fair value for a contractual option that (it could be reasonably argued) had been unfairly dishonoured
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