Swap contracts, famously described as the financial equivalent of "weapons of mass destruction," have continued to evolve since their heyday leading up to the 2008-2009 financial crisis. Most swaps use the standardized (though customizable) agreements created and administered by the International Swaps and Derivatives Association, Inc. (ISDA). Swap contracts are an effective means of transferring risk from one party to a counterparty in exchange for the payment of some form of consideration.

The Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203 (effective July 21, 2010) (Dodd-Frank Act), materially changed the landscape for swaps. Swaps are defined as either commodities or securities based on objective criteria — is the reference portfolio of the swap a single security or that of a narrowly based index or is it a more broadly based asset grouping. Once categorized, the swaps are regulated accordingly — except if an exception applies. The Commodities Futures Trading Commission regulates most swaps, except single name or narrow-based index swaps, which the Securities and Exchange Commission regulates.

The main difficulty of pre-Dodd-Frank Act swap contracts was that swaps were primarily bespoke arrangements, without standardized terms and wholly dependent on the viability of the daisy chain of risk transference. Swap holders assumed that liabilities were "offset" or "closed out" by corresponding reciprocal positions; however, whether those closed-out arrangements were enforceable or efficacious depended wholly on the weakest link in the chain performing as expected.

The Dodd-Frank Act attempts to mitigate that risk two ways. First, the Dodd-Frank Act requires many swaps to be collateralized, whether or not they are cleared swaps. Second, the Dodd-Frank Act forces many swap contracts to be centrally cleared, with minimum margin requirements. Centralized clearing is intended to help address the valuation and liquidity issues that arise in bilateral swap contracts. The legislation also requires parties to have identification numbers called "LEIs" and to meet certain qualifications before they can either act as a dealer in swap contracts or participate in a major way. Certain transactions are exempted, but in almost every case, a swap contract participant still must be a so-called "eligible contract participant." Notwithstanding these changes, however, certain types of swaps are still treated as "over-the-counter" arrangements. These include interest rate swaps.

A February 20 article in the Philadelphia Inquirer, "How bad bets with Wall Street cost two Pa. public school systems and a hospital millions of dollars" (inquirer.com), pointed out that two school districts and a hospital system found themselves to be on the "paying again end" of interest rate swap transactions. At the time that the respective borrowers had issued bonds into the marketplace, they issued them bearing variable rates of interest. In order to ensure that the variable rate would not increase beyond the school districts' or health system's ability to pay, they each had purchased "rate protection" in the form of an interest rate swap. In essence, to ensure that they always paid a rate equal to the fixed rate equivalent at the time that they entered into their lending transactions, they agreed that if interest rates went up, they would be the beneficiary of a payment from the swap counterparty. Correlatively, if interest rates went down, they would be obligated to pay the counterparty. The net effect of these arrangements was that each effectively had borrowed at the original agreed fixed rate.

At the time that they entered into the borrowing transactions, the costs of issuing the variable rate debt was set at the then market rate for variable rate debt. Since that time, however, borrowing costs dropped dramatically, consistent with the Federal Reserve's attempt to keep the economy from sliding into recession due to the pandemic and other financial uncertainties in 2020. In order to close out these transactions, the municipalities, the school districts, and hospital system had to pay sums to their respective swap counterparties.

When homeowners choose to finance or refinance their home using a variable rate mortgage, they make a "bet" that interest rates will stay the same or go down, or that the benefit of paying a lower interest cost in the early years of the lock-up term of the variable rate mortgage will more than pay for the cost of refinancing in the event that interest rates start to creep up materially, and it is necessary to refinance the mortgage. In the alternative, borrowers who obtain fixed rate financing enjoy a degree of certainty — their mortgage financing costs will not increase as long as they hold the mortgage outstanding, and they continue to pay the contractually required amounts.

It is the same circumstance with these municipal and hospital system borrowers. In order to get a lower issuing rate, they used a variable rate on their debt instruments. Had they attempted to issue their bonds using fixed rate financing, the costs likely would have been higher because the bond purchasers would have wanted compensation for shouldering the risk of investing at a rate that was potentially too low for the anticipated future marketplace.

In order to give the borrowers a degree of certainty, therefore, the corresponding banks developed interest rate swaps. The payments in such a swap arrangement are designed to make sure that the borrower always pays a fixed rate. So, if interest rates in the prevailing market place go down, the variable obligation would have gone down; but, under the swap transaction, the borrowers must pay an additional amount to the counterparties to turn the rate paid into a synthetic fixed rate for the lenders' benefit. Had interest rates gone up, those payments would have been reversed, and the counterparties would have paid them to the school district or the hospital system.

The disconnect, here, is the implication that the counterparty investment bank is somehow pocketing the difference to the disadvantage of these political subdivisions and hospital systems. Clearly, the investment banks earn a fee for arranging the transactions, but most investment banks run what is a called a "balanced book." That means that the liability posed by the swap is sold to another counterparty. Of course, the investment bank receives a fee from each counterparty for its trouble, but for the most part, the swap contract shifts risk from the first party to the second counterparty. In effect, the borrower swaps the variable rate that it is obligated to pay for a synthetic fixed rate; the other counterparty swaps a fixed rate that it is willing to receive with a variable rate that it wants to earn instead, and as a result, both parties should be happy. If the first party wants to exit the swap, the second counterparty will want compensation for the loss of its investment opportunity.

When a swap is placed on top of an underlying debt obligation, it does not change the interest rate that is payable on the underlying debt obligation. Rather, the swap contract creates a separate line item on the profit and loss statement of the counterparty. For example, assume a borrower is required to pay 3% on a variable rate instrument. When fixed rates or variable rates rise to 5%, then the borrower would still have to pay the 5%, but it would receive a 2% payment under the swap, netting out — on its own income statement — the difference, effectively meaning that they paid 3%. That is the original contractually agreed upon amount. If those interest rates, on the other hand, fall below 3%, then the entity must make up the difference since it agreed to always pay 3%. So, in exchange for certainty, it is possible that these institutions' income statements will show a payment out, but the net of the two should always approximate the rate for which they bargained.

Therefore, it becomes the mission of industry participants to educate not only the swap participants, but also the public, that the purpose of a swap is to ensure that each party receives (and pays) that for which it bargained: This is not an example of Wall Street gaining an advantage over Main Street. The Main Street borrower simply purchased an "insurance policy," and that arrangement is designed to make sure that the borrower always pays the "synthetic fixed" amount it had agreed to pay at the origination of the borrowing. Had it not purchased the protection the borrower might have enjoyed a windfall because of the downturn in interest rates in the larger economy, but it could just have easily been required to pay more had interest rates gone in the other direction — that is the nature of this form of financial protection.

In reviewing ISDA contracts, it is essential that the parties understand several very important points:

1. What is the notional amount of the loan to be hedged? How much will be used as the amount at risk to calculate the swapped interest rate amounts?

2. Have you performed a sensitivity analysis? Have you determined at what point an increase or decrease in prevailing interest rates will make the swap payments seem less of a bargain? Again, remember in these transactions, the one counterparty is simply contracting to pay the amount it feels most comfortable paying. The fact that interest rates in the marketplace have moved against it should not be an issue because it is not paying more than it otherwise would have paid under the swap agreement. The borrower is just paying the exact same amount for which it contracted.

3. What are the exit requirements? The 1992 ISDA Master Agreement uses either "market quotations" or "loss" to determine the termination payments, depending on the election of the parties. If "loss" is chosen, the calculation party determines the losses and costs incurred as a result of terminating or reestablishing related hedge positions: It is in essence an inward-looking model. Market quotations, on the other hand, require a party to seek quotations from four leading dealers and, if "second method" (the most common) is chosen, to net the algebraic amounts to determine if the short or long leg is required to make a payment. Obviously, if the market is in distress, obtaining four quotations is very difficult. Neither method is perfect, and both have undergone extensive litigation in both New York and English courts (the most popular jurisdictions for governing law in ISDA agreements).

At the prompting of the industry, ISDA developed a new method for unwinding a swap called "close-out amount." Close-out amount uses elements of both market quotation and loss, and it requires the parties to act in good faith to make a determination. Legal fees and similar expenses are excluded, at least under the terms of the 2009 protocol that ISDA created to facilitate the amendment of swaps drawn under both the 1992 and 2002 Master Agreements. Understanding the swap counterparty's approach to computing the close-out amount — if that method is chosen — is essential.

The bottom line is that swap contracts are very effective tools for shifting risk. But swaps are not for the dabbler or the faint of heart. What's most important, however, is knowing and quantifying the risk you are shifting, and understanding that if the market moves against your position, are you capable of paying the amount shifted back to you? As such, the sensitivity analysis mentioned above is essential and needs to be part of any decision-making matrix when it comes to taking on a debt obligation and overlaying it with a swap.