When Barclays Plc arranged a 918.9 million-pound ($1.4 billion) commercial-mortgage backed security called Gemini Eclipse 2006-3 in 2006, it included 20-year swap contracts to protect the borrower from interest-rate swings.
The cost of getting out of the contract has risen to at least 240 million pounds after the Bank of England cut its benchmark rate to a record low 0.5 percent from 4.75 percent and the shopping centers and office parks across the U.K. backing the transaction tumbled to about half of the mortgage, according to a note sent to investors last month. If the loans can’t be refinanced, the swaps have to be repaid before any principal is returned, according to the loan’s special servicer CBRE Group Inc.
“It was never really envisaged that interest rates would do anything like they’ve done and that anyone would ever have to exit a swap,” said Stephen Clifton, who heads the City of London investment division at real-estate broker Knight Frank LLP. “Many of the big deals that were done in 2006 and 2007 involved a very significant swap position.”
Barclays, Royal Bank of Scotland Group Plc and other banks frequently made buying swaps a condition of lending against real estate at the height of the boom, according to an April report by CBRE. That puts U.K. property investors among small business owners, Italian towns and U.S. municipalities including Jefferson County, Alabama, that exposed themselves to losses after buying derivatives to guard against changes in interest rates and currencies.
“Barclays is satisfied it provided sufficient information to enable real estate companies to make an informed, commercial decision about the products it offers,” the bank’s spokesman Jon Laycock said in an e-mail.
The prospect of multi-million-pound penalties, which fluctuate with borrowing costs, also is stalling property sales by making it more difficult for buyers and sellers to determine the value of a deal when a swap is involved.
The market would have “more transactions and see more liquidity” if the hedges didn’t exist, said Mayad Rassam, head of treasury at commercial real estate broker Mutual Finance Ltd. Instead, there’s a “stalemate.”
To avoid the penalties, borrowers need to refinance at a time when banks are reining in lending amid Europe’s debt crisis and property values have fallen below the amount of the mortgages used to buy them. U.K. commercial real-estate investors may be unable to refinance as much as 100 billion pounds of maturing loans, according to Bill Maxted and Trudi Porter in a survey published last month by De Montfort University.
Banks and other creditors cut U.K. commercial real-estate lending by 6.8 percent to 212.3 billion pounds last year as they bolstered their balance sheets and recapitalized to meet stricter regulations. About 51 billion pounds of loans are due for repayment this year, the university said, with 153 billion pounds due to mature through 2016.
Rate swaps are contracts that allow borrowers to keep payments within a fixed range even if interest rates fluctuate more widely. When rates fall, customers might pay higher costs for the swap to keep payments within the agreed range. Borrowers that exit contracts through default or repayment of the loan are liable for costs running the length of the agreement.
Banks paired swaps contracts of 15 to 30 years with five-year commercial property loans, making the penalties for breaking the agreements “particularly virulent” because they mature long after the loans, said Rob Leach, a director at ratings company Standard & Poor’s.
The Gemini swap expires in 2026, even though the senior loan matures in July 2019. Break costs must be paid in full if the borrower is foreclosed upon and only then can the bondholders receive any return, CBRE, the special servicer tasked with overseeing the bond, said in a February 2011 document.
Gemini investors were advised that the properties on which the loans are secured -- including at the time of origination an office building leased to EMC Corp., the world’s biggest maker of storage computers, and two shopping centers next to each other in Wigan -- were valued at about 437.8 million pounds, compared with outstanding loans of 860.4 million pounds.
The cost of breaking the swap almost doubled to 241.3 million pounds from 126.5 million pounds in January 2010, according to a report to bondholders. The penalty rose after long-term swap rates had the sharpest fall in 12 years. A falling rate increases the cost of breaking a contract and the longer the remaining term, the bigger the penalty.
The loans were made to 31 Guernsey, Channel Island-based limited partnerships whose assets are managed by Propinvest Asset Management LLP.
Propinvest, which manages the properties, didn’t return calls or e-mails about the swap. CBRE spokesman Kieron Smith declined to comment.
Like other products sold by banks in the years leading up to the financial crisis in 2008, swap contracts have prompted legal challenges from buyers who claim they weren’t informed of the risk they were taking. In Britain, hundreds of small business owners, from a fish-and-chip shop to dentist offices, have sued banks after they were sold currency and interest-rate swaps.
“In many cases, the risks were not mentioned, never mind explained,” said Jackie Bowie, a director of financial-risk consultant JC Rathbone Associates Ltd. The swaps were part of a “very aggressive sales culture” in some banks, boosting bonuses by generating upfront profit, she said.
JC Rathbone has been asked by lawyers to act as an independent witness or provide an opinion in about six separate legal actions by borrowers who bought swaps, according to Bowie. Many complaints will be settled before they reach the courts, she said.
The Financial Services Authority is examining claims and has asked banks to provide information about how the products were offered. The U.K. regulator will take action if it finds “widespread evidence of breaches or mis-selling,” spokesman Joseph Eyre said in an e-mail in April.
A 30-year swap taken out in June 2007 now has a penalty of as much as 44 percent of the mortgage, according to an analysis by Rassam of data compiled by Bloomberg.
It may worsen. “A flattening of the U.K. forward LIBOR curve could cause derivative break costs on long-dated hedges to rise from roughly 40 percent of loan amounts to 60 percent,” Chatham Financial Director Mark Battistoni, who heads the hedging team at the advisers’ London office, said in an e-mail.
That increased penalty would be triggered if long-term swaps fell 1 percent from the current rate of just below 3 percent, he said, “which could occur for a variety of reasons, including broader appetite for long-dated gilts, a reduction in swap spreads, or expectations, such as in Japan in the past 15 years, that deflation is on the horizon.”
Holders of the swaps are more vulnerable to the break costs now because loans are maturing and banks, which are selling assets and reducing lending, may be unwilling to roll them over.
The existence of the swaps is also curtailing asset sales. Lloyds Banking Group Plc, Britain’s biggest mortgage lender, was among banks that held back sales where long-dated swaps were involved, according to a person familiar with the matter. The company avoided including loans saddled with the contracts when it sold portfolios last year because the swings in penalties could delay deals, the person said.
The sale of 1.36 billion pounds of commercial real estate loans by RBS to a Blackstone Group LP fund was delayed in part because the swaps penalties changed during talks that ended in December, a person familiar with the deal said. Lloyds spokesman Ian Kitts declined to comment and RBS, the U.K.’s biggest government-owned lender, declined to comment by e-mail.
“More sophisticated buyers, the handful of names we all know and hear about with every large loan deal, are the only ones who are able to price complex swaps correctly in a portfolio deal,” said Chris Mutch, a real-estate director of PricewaterhouseCoopers LLP. “In addition, they know how to manage swap instruments and exposures when they are ultimately transferred over.”
Blackstone, the world’s largest private-equity firm, has set up a specialist debt-management team and is approaching banks looking to advise them on how to maximize recoveries from impaired loans including those affected by swaps, a person with knowledge of the matter, who declined to be identified, said in February.
CLS Holdings Plc, a London-based developer, paid a 24.2 million-pound penalty to break a swap in December. Turbulence in the euro area contributed to the swap rates falling, Chief Financial Officer John Whiteley said in March.
Expectations that interest rates will remain low mean that the troubled investors will face losses on their investments into the medium-term. “With statements being made that interest rates will not materially go up until 2014 and beyond, it’s been pretty catastrophic,” Clifton said.