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News

March 21, 2005

Swaps for Small Businesses

by Jake Steiner

Banks have more sophisticated financing options than ever before to offer small -business customers.

As rates continue to climb, customers will become more bullish on fixed-rate financing. One instrument that small-business bankers are increasingly offering is the interest rate swap.

Rate swaps have historically been available only to companies putting together large deals. One reason is that swaps are not off-the-rack products; they can be customized to hedge against changes in market conditions that could raise borrowers cost, and they often include specific pre-payment conditions.

In the past such complexities made swaps fairly expensive, so smaller deals were less attractive. Recently, however, technological improvements have made swaps simpler to structure, and many banks now see view them as a great tool for small businesses, which of course need flexible financing and predictability as much as big ones do.

But many small-business people are unfamiliar with swaps. A rate swap is an agreement to exchange rates, usually to hedge against future marketing conditions. Banks develop swaps for customers that want to convert a variable-rate loan to a fixed-rate loan. A counterparty (usually a derivatives dealer) agrees to pay the difference between the agreed-upon fixed rate and the floating rate, thus providing the customer with a virtual fixed rate.

Swaps are especially effective in real estate financing. Mortgage rate swaps can be used to hedge both interest rates and change in the real estate market. Though customers effectively give up the potential for a windfall on their real estate investment if interest rates fall, they are protected if rates rise.

Bankers should ensure that they or other advisers on the deal convey the following points:

• A small business entering a swap transaction can cap its interest cost but forgoes the benefits a rate drop.
• Some of the advantages of swaps for small businesses relate to prepayments. Unlike some fixed-rate loans, swaps permit partial payments. A borrower can cancel or “break” a swap at any time; whether the borrower must than make a payment or receives one depends on the rates at the time. (With a traditional fixed-rate loan, the best the customer can usually hope for is not to have to pay.)
• Swaps can be formulated to the customers needs. A contract can also be moved from one bank to another at the customer's request. Swaps can generate loyalty but customers' expectations must be realistic from the start .

Mr. Steiner is a partner at RickSteiner Fell & Benowitz LLP, a New York Law Firm.

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