B.F. Goodrich Rabobank Interest Rate Swap A Credit Risk Case Alejandro de los Santos and Luis Seco University of Toronto
The case On Monday March 7 1983, Goodrich and Rabobank simultaneously executed two financings and an interest rate swap, with the net effect of: 1. Provide US investors with an attractive LIBORbased floating rate note. 2. Provide Eurobond investors with an attractive AAA fixed-rate bond 3. Raising $50M of floating rate Eurodollar financing for Rabobank 4. Raising $50M of fixed-rate 8-year financing for Goodrich
Agenda Setup BF Goodrich position Rabobank position The game : a Swap Fixed and floating legs Price Risks Conclusions
Setup The financing problem The participants and their positions
B. F. Goodrich : situation in early 1983 American manufacturer of tires and related rubber products Fourth largest U.S. producer of tires Largest U.S. producer of polyvinyl chloride (PVC) Facing financial difficulties because of 1982 s recession Downgraded from BBB to BBB- Goodrich was about to announce a $33 million loss in the past year
B. F. Goodrich : financials 1979 1980 1981 1982 Operating Profits Other Income Total before Tax NET Income $ 117 $ 70 $ 39 ($ 33) $ 8 $ 2 ( $ 4 ) ($ 2) $ 131 $ 89 $ 162 ($ 68) $ 83 $ 62 $ 110 ($ 33) (In USD Millions)
B. F. Goodrich position Its credit loan spread
B. F. Goodrich position Needs to fix the situation, with a loan ($50M) Long term (at least 10 years), so its financials recover over the long term. Wants to pay fixed rate: being in a cyclical business, they are sensitive to interest rates: consummers buy fewer cars, and hence fewer tires in high interest rate environments. Its credit quality, coupled with the long dating of the loan leads to a big spread (~ +180 bps)
The credit loan spread (1) Simple default/no-default model A 2-state markov chain No Default No Default p Default 1 - p Default 0 1
The credit spread An 8-state markov chain. Each state is a credit rating Transition prob matrix S&P, Moody s Etc
Rabobank Netherland
Rabobank Nederland A major Dutch banking organization ($42B in assets) One of the world s 50 largest banks Services the agricultural sector, dentists and smaller communities Rated AAA Not well known outside the Netherlands Most of its dollar-denominated assets were loans whose rates floated with LIBOR to US savings banks (underwritten by Salomon brothers), to offset fixed rate pension deposits from the communities it caters to.
Rabobank position Conducts only a small amount of dollar-based business Is willing to invest abroad. Has good access to the Eurobond market Would like to have interests tied to LIBOR Can lend $50 millions for long term.
The Credit Market in 1982 Fixed Floating AAA 10.70% LIBOR+0.25% BBB- 12.50% LIBOR+0.50% Credit Spread 1.80% 0.25%
The Swap A Salomon Brothers proposal and how it worked
The proposal Goodrich can borrow from US investors and commits to pay floating rate tied to LIBOR Reducing his rate spread Rabobank can borrow from European investors and commits to pay fixed Raising the funds from third parties Swap payment obligations Allowing Goodrich to pay fix in Europe and Rabobank to pay floating in US
The name of the game : Swap Use Morgan Guaranty Bank as intermediary guarantor Fixed and floating legs Goodrich would pay fix to Morgan and receive the LIBOR he has to pay Rabobak would pay floating to Morgan and receive the fixed amounts he has to pay
The game : Play Ball!! Appears a Bond in the US market Issuer: BF Goodrich Amount: $50 million Maturity: 8 years Coupons: Semiannual LIBOR + 0.5% Appears a Bond in the Eurobond market Issuer: Rabobank- Nederland Amount: $50 million US dollars Maturity: 8 years Coupons: Annual 11%
The game U.S.Savings Banks Belgian dentists LIBOR + 0.5% ( Semi ) 10.7% annual 5.5 million (11% fixed) Once a year 5.5 million Once a year (LIBOR x) % Semiannual (LIBOR y) % Semiannual
The effect of the swap Before the swap After the swap Fixed Floating Fixed Floating AAA 10.70% LIBOR+0.25% 10.70% LIBOR-0.5% BBB- 12.50% LIBOR+0.50% 12.00% LIBOR+0.5% Credit Spread 1.80% 0.25% 1.30% 1.00%
The Price Default/no default analysis Transition probabilities of default
The price of the game Swap spread under a simple two-state markov chain
The price of the game (2) Pricing of the deal under the S&P (or Moody s) markov chain.
The transition probability matrix AAA AA A BBB BB B CCC D AAA 0.9081 0.0833 0.0068 0.0006 0.0012 0.0000 0.0000 0.0000 AA 0.0070 0.9065 0.0779 0.0064 0.0006 0.0014 0.0002 0.0000 A 0.0009 0.0227 0.9105 0.0552 0.0074 0.0026 0.0001 0.0006 BBB 0.0002 0.0033 0.0595 0.8693 0.0530 0.0117 0.0012 0.0018 BB 0.0003 0.0014 0.0067 0.0773 0.8053 0.0884 0.0100 0.0106 B 0.0000 0.0011 0.0024 0.0043 0.0648 0.8346 0.0407 0.0520 CCC 0.0022 0.0000 0.0022 0.0130 0.0238 0.1124 0.6486 0.1979 D 0 0 0 0 0 0 0 1
Assignment Calculate the credit premium for the swap Calculate the exposure of the deal Study the impact of market-credit correlation to this deal Correlated auto-sales numbers and interest rates Infer correlation for market-credit risk factors, and its impact on credit premiums and exposures.