• The liability to pay future credit premiums foregone on early termination of swaps can be reduced or, potentially, eliminated by adoption of an appropriate hedging implementation strategy. • Credit premiums paid in relation to swaps can be reduced by competition. |
Swap prices quoted by banks are based on a combination of the underlying market swap rate and a credit premium to reflect the return the swap provider requires for taking the project risk (that is, the credit risk of the Contractor).
If a swap is unwound, the termination cost (or gain) is calculated using standard ISDA methodology-in summary, the NPV cost of hedging out the swap in the market (cf. §2.5). But if the stream of future payments under a swap includes the credit premium, this means that on termination the bank providing the swap is being paid the NPV of all future credit premiums nder the swap (something which generally does not happen when a bank loan is pre-paid).49 The effect of these extra termination payments-in termination scenarios where the Authority covers swap unwind costs50-is:
- They can reduce the Refinancing Gain available to be shared with the Authority.51
- They give swap providers profits on terminations for Force Majeure and Corrupt Gifts,52 here the Authority should only be making them whole, not paying them future profits. (For bonds, the PFI market practice is that the Spens premium is not paid on Corrupt Gifts and Force Majeure terminations.53)
- They may inhibit long-term PFI Contract flexibility.
Payment of future swap credit premiums on termination is not a universal market practice, and such payments are not always made by major corporations on unwinding their hedges. Therefore, Authorities should consider whether:
- The ITN should specify that the terms on which swaps are to be provided to the Contractor are also set out in the bid along with other financing terms.
- The NPV of future credit premiums should be paid in the cases of Force Majeure termination,or termination for Corrupt Gifts.
- The swap credit premiums should be excluded from the ISDA calculation, or separated out completely under a Swap Premium Agreement. In the latter case (which is probably prefer-able as the documentation is more straightforward), if the swap terminates, the swap is unwound according to the ISDA documentation, while payment of the credit premium simply ceases at that time, as the Swap Premium Agreement terminates. This approach is discussed above in §2.7 in relation to the use of a 'fronting bank' arrangement, and the same principles apply here (see Appendix 1).
All margins and fees charged by providers of finance including swap credit premiums are, of course, subject to market forces. Accordingly, swap credit premiums are more likely to represent value for money if, as for the other terms of finance, they are determined by competitive processes
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49 For bonds this element of future credit margins is effectively included within the non-cancellable premiums payable to the monoline insurer at the outset, and the Spens clause on the bond itself. The Spens clause for bonds is a complex issue in itself and is the subject of separate guidance (see Office of Government Commerce: "Guidance on Certain Financing Issues in PFI Contracts" (July 2002), Section 2: Using the Capital Markets for Finance).
50 The issue thus does not apply in the case of Contractor Default under the Contract, or in any scenario where the Contractor is in default under the financing documents, but not under the Contract. However it does apply in the case of a Refinancing, where the breakage cost is deducted prior to determining the Refinancing Gain available to be shared with the Authority.
51 Unless the same swap provider remains in place as a lender and agrees to 'roll over' the swap into the new financing, which obviously limits competition for the refinancing. Where the swap is 'rolled over' to a new lender, which is also the replacement swap provider, however, care must be taken to avoid a doubling-up of the credit premium.
52 including Breach of Refinancing.
53 Office of Government Commerce: "Guidance on Certain Financing Issues in PFI Contracts" (July 2002), Section 2: Using the Capital Markets for Finance, §2.12.3.