Public & private

In recent years, an increasing number of registered social landlords have acted on the Housing Corporation rule change allowing the use of derivative instruments to limit interest rate risk.

There are two reasons for wishing to hedge interest rates outside the terms of a loan agreement: access to a wider market may increase competition and reduce price and, perhaps more importantly, it means – in theory at least – that upon the inevitable refinancing, the hedging instrument can be left in place while only the underlying loan is replaced. This saves on breakage costs, which can be significant.

Difficulties arise, however, when it comes to granting security to support the derivative transactions. Unsecured derivative transactions are rare.

Options for security are cash, investments or properties. Not surprisingly, RSLs will often seek to use properties as security for derivative transactions.

This works very well when the derivative is totally separate from the lending arrangements, to the extent that a separate pool of properties is identified as security for the hedging, over and above the security for the loan. Often, however, that is not the case.

On the contrary, it seems to be becoming almost commonplace for the financial institution providing the loan also to supply the derivative transaction, and for the property security for the loan to double up as security for the derivative as well. In other words, no separate security is identified.

RSLs must try to ensure that security for the hedging transaction is separate from the loan

In such circumstances, it is not surprising to find that the lenders are concerned that, if their loan is repaid and security therefore redeemed, they will be left with an unsecured derivative transaction. Typically, lenders' response to this situation is to include in the derivative documentation a clause stating that the derivative comes to an end if the underlying loan is repaid or prepaid.

At this point, however, we seem to have come full circle.

The reasons for entering into a derivative transaction separate from the loan facility are to get the best possible price from a wider market and to assure "portability" in an event of refinancing. In the scenario described, neither of these aims is achieved.

In that case, what is the point of the exercise? Why not simply undertake an embedded fixed rate within the terms of the loan agreement instead?

RSLs undertaking or proposing to undertake hedging activities, other than those embedded in loan agreements, should consider the issue of security carefully. They must try to ensure that the hedging transaction, and the security for it, is entirely separate from the lending transaction.