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Short Term Loans for Long-Term Investment

by Jonathan Roe

Overview

With increased risk and volatility in today's marketplace, fewer lenders are willing to offer long-term loans to companies for investment purposes. As this reluctance increased, investment bankers developed new financial products that transformed short-term loans into fixed-cost, long-term loans.
Purpose

Before the advent of interest rate swaps, most companies had to rely upon mezzanine or bridge financing for initial funding of an investment. Mezzanine and bridge financing were short-term, one- or two-year loans that allowed a company to build or buy an asset. Once the mezzanine or bridge financing matured, companies had to go out into the marketplace and arrange long-term financing so they could amortize the cost of the project using the cash flow the investment generated. While this setup helped protect the lender who provided the initial financing, it created a lot of risk and uncertainty for the borrower. As a result, interest rate swaps were created to effectively eliminate the interest rate risk of short-term financing sources and turn them into long-term sources of funding.

Interest Swaps

An interest rate swap is a contractual agreement between two parties. One party agrees to pay a fixed amount of interest on a periodic basis while the other party tries to profit from the differential between the fixed payments they receive and a floating interest rate. If the fixed interest rate payment is more than the floating interest rate, the party who took the floating side of the agreement will profit. If the fixed rate is below the floating rate, then the party on the floating side will lose money. Since short-term funding sources are more easily acquired than long-term funding sources, interest rate swaps insulate the party paying the fixed rate from changes in the floating rate over the life of the long-term investment.
Risks

Using interest rate swaps on short-term financing sources to fund long-term investments is not without risks. The major risk is that the investment does not generate enough cash flow to service the debt and you go into default. The secondary risk is that the source for short-term financing gets cut off and you have to find a new source of funding before you go into default. This can happen because of tighter credit standards or a change in outlook for the investment you are funding. The final risk is counterparty risk. If you are able to go through an exchange or clearinghouse for your interest rate swap agreement, the clearinghouse takes on all of the counterparty risk so you generally don't have to worry about it. Additionally, if your counterparty is a bank such as Bank of America, Wells Fargo, or Citigroup, there isn't all that much counterparty risk. If those three banks fail, the entire system is probably going to collapse so counterparty default is the least of your worries. Counterparty risk is only an issue when the individual or group taking the other side of the swap has limited financial resources. If the other party defaults, it is usually the case that floating rates are higher than your fixed rate and you could potentially be on the hook to your source of short-term financing for the difference.