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Swaps 101 and the Death of LIBOR

There are many types of swaps: commodity swaps, foreign exchange swaps, but of primary interest to real estate lawyers are interest rate swaps. Interest rate swaps are colloquially thought of as contracts by which a naturally floating rate interest rate contract (a loan agreement or promissory note) is “converted” into a fixed-rate contract. Still, this understanding is fundamentally in error, as will be discussed below.

Further, it is commonly assumed that all interest rate swaps are governed by an ISDA (International Swaps and Derivatives Association) agreement, and while that too is not completely accurate, the overwhelming majority of interest rate swaps are governed by ISDA documentation, and accordingly, this discussion focuses on both how the ISDA system works (and doesn’t work) and the vocabulary used in ISDA documentation. But to emphasize how the common understanding of swaps is inaccurate, an ISDA interest rate swap transaction is not governed by an ISDA agreement. It is governed by at least three, and often four or more, agreements that have to be read together to understand the terms of the transaction the parties have entered into. Welcome to “ISDA land.”

For this discussion, we will use an example which can be described as a plain vanilla interest rate swap transaction (called here merely a “swap”). A single borrower is entering into a floating-to-fixed rate swap with the same lender (a bank for purposes of discussion and simplification only, but not necessarily always or even often the case). This single borrower is also entering into a loan transaction that is based on a floating, LIBOR-based interest rate convention. Both legs of the transaction (loan and swap) are being secured on a parity basis, with a mortgage or deed of trust on the asset being financed.

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