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Interest rate swaps come out of the woodwork

December 16, 2016

As of last year, universities have had to comply with Financial Reporting Standard 102 and the Statement of Recorded Practice for accounting in Further and Higher Education (SORP 2015).

One change is that universities are now required to declare contractual liabilities in their financial statements and record them at fair value. This brings to the fore the presence of certain financial derivatives like interest rate swaps.

Some institutions, such as London School of Economics & Political Science recorded details about their swap contracts in their statement notes. If you look at Note 16 to their 2014/15 Financial Statement you can see the following:

The School has arranged a £75.0m amortising loan repayable by December 2028 secured over three properties. £24.3m was outstanding with a residual facility of £30.0m remaining undrawn at the balance sheet date.

The School has entered into interest rate swap agreements with a nominal value totalling £65.0m. The effective fixed rate costs of the loans and swaps taken together is between 5.0 per cent and 5.5 per cent. The swap agreements had a negative mark to market value of £25.9m (31 July 2014 – £19.2m) at the balance sheet date.

What this means is that there is a loan with a variable rate and a contract that swaps the annual interest payments associated with the loan for a set of fixed rate payments. When the loan was taken out the university wanted to fix its interest payments to protect itself against adverse movement in interest rates. However since 2008 interest rates have collapsed (Bank base rates went down again in August to 0.25%) and so the fixed rates introduced by the swap have turned out to be unfavourable to the university. Should the university seek to dissolve this swap contract (or get someone else to purchase it) and revert to the original variable terms of the loan it would cost it £25.9m – this is the ‘negative mark to market value’ of the contract.

For 2015/16, LSE will have to revise its valuation of the swap contract to reflect a ‘fair’ value – the estimated value of additional repayments it would have to make until 2028 when the loan ends. It will also have to add a provision for this liability to the balance sheet (alongside other provisions like those for pensions).

Another university, University of East Anglia, has just published its accounts for 2015/16 and declared a similar interest rate swap on loans with Royal Bank of Scotland. There was no mention of a swap, derivative or hedging instrument etc. in its 2014/15 accounts.

The loans themselves come to £79.5m and run through to 2034. The swap contract has left UEA with fixed interest rates of 5.9% on £66m and 5.15% on £12.5m. On its balance sheet, UEA now declares – under ‘Other provisions’ – a liability of £38.14m which the Notes tell us represents the ‘termination value’ on the swap contract.

In the accompanying narrative of the report, UEA states –

The hedging financial instrument (SWAP) that backs the fixed Royal Bank of Scotland loan is … a non-cash transaction and would only crystallise on the occasion of the University seeking to repay the loan early (or in the case of default) neither of which are anticipated.

In response to my queries, UEA provided some additional detail:

The University has a long-term loan with Royal Bank of Scotland which has a fixed interest rate.  The fixed interest rate is backed by a matching SWAP arrangement.  As the loan payments are made both the amount of the SWAP reduces and the amount of the loan balance reduces until the loan is fully repaid.  At that time there will be no SWAP liability either.  The SWAP only crystallises in the event that the loan is repaid early or the University defaults.  The current balance reflects the difference between where interest rates were on the date of our year-end and the rate at which the loan interest rate was fixed.  As interest rates fluctuate the fair value of the financial instrument will change: reducing if interest rates rise and increasing if interest rates fall.

The university originally valued the swap contract on 1 August 2014 at £23m. According to the 2015/16, that value was revised up for July 2015 to £28.9m. This year the figure has moved up again to £38.14m – an increase of £9.2m.

The accounts don’t explain these specific increases in value. I have asked UEA whether this latest £9.2m movement was due to the Bank of England’s summer announcement (although this announcement was made 4 days after the 31 July ‘snapshot’ of UEA’s assets and liabilities given in the 2015/16 statement). As their statement notes, this upwards movement is what you would expect given that the difference between the original variable interest and the swap’s interest would increase. (See update below for new UEA statement).

The final point to make is the following. Now that the provision for the contract has to be stated on the balance sheet as a liability, such changes to provision show up in the income and expenditure statement.

The £9.2m is recorded there in 2015/16 after the operating surplus (deficit) and next to the change in pension provision as ‘change in fair value of hedging financial instruments’.

UEA made a small operating surplus of £4m last year (1.6% of annual turnover) but this turned into a loss of nearly £12m once changes in pension and swap provisions were factored in.

These are arguably paper losses since the fundamentals haven’t changed – UEA’s interest rates are fixed after all. More significantly though, UEA already has a relatively high amount of borrowing. In addition to the RBS loans, it has £40m from the European Investment Bank and a £33m ‘Private Placement’ loan. This means its long-term debt is over £150m, or over 60% of its £250m turnover. This puts it at the indebted end of English HEI’s.

A quick calculation suggests UEA’s EBITDA is roughly £30m. Hefce’s cap on borrowing under the MAA is 5 times EBITDA suggesting that UEA is at its current limit. It would have to win Hefce over to launch on any new investments or improve its “operational performance” significantly.  And that’s before we consider what covenants there may be on its existing lending – as we discussed before, these covenants can limit universities, particularly any plans for new borrowing. If UEA seeks to renegotiate or refinance any of its existing lending, then the termination value of the interest swap would come into play.


Update 20 December 2016

UEA responded to my query about whether the Bank of England’s base rate announcement on 4 August 2016 (lowering base rate from 0.5% to 0.25%) was factored into its ‘termination valuation’ for the swap contract. The answer – surpisingingly – is that it is not.

UEA does ‘not do the calculations: they come to us from the provider of the financial instrument’.

For statutory financial statements then the figure is struck as at the date of the balance sheet (31 July 2016 in this case).  We only receive the information once a year as at that date.  The movement in year is the difference between what the balance sheet would have said on 31 July 2015 and what is says the provision needed to be at 31 July 2016.

All other things being equal (and the wholesale markets work slightly differently from retail banking) as rates move down you would expect our provision to go up and vice versa but we don’t have any actual information on which to base that thought and we only seek the figure annually as at 31 July.

So, in effect, at financial year end, Royal Bank of Scotland tells UEA what the termination value on the contract is. UEA does not have an independent valuation of the contract liability.

UEA’s financial statement makes no mention that this 31 July snapshot will have to revised upwards again as a result of the BoE’s announcement four days later. This change in value will only appear in the 2016/17 annual report in a year’s time.

One Comment
  1. Accountant (says) “I’ve just hedged our interest rate risk”. Banker (thinks) “No you haven’t – you’ve just inserted a large spike up your bottom”. Banks (or anyone who understands derivative risk) don’t just look at the current market value – in the words of Malcolm Tucker, “They’re so much worse than that!”. My book, “The Whole Truth”, explains just that.

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