Salomon Brothers had advised Goodrich that they could borrow in the US public debt market with a floating rate debt issue tied to the LIBOR, and then swap payments with Euro market bank that had raised funds in the fixed-rate Eurobond market.
Note: The reason that Salomon were confident that this could be done is described as follows:
- There was a recent deregulation of deposit markets had allowed deposit institutions to offer new variable rate money market deposit accounts.
- As result of these new offerings large thrift institutions
Rabobank:
Rabobank had AAA debt ratings, and assets exceeding $42.0 billion. Also, Rabobank had never borrowed in the Eurobond market prior to the deal with Goodrich, and Morgan. Since Rabobank conducted only small amount of dollar based business, and most of the dollar denominated assets were loans whose rates floated with LIBOR. Historically, Rabobank was able to fund these loans through the following:
- Interbank deposits at LIBOR.
- Prime Eurodollar CD’s.
This was the first time that Rabobank would venture into the Eurobond market. Note: Because of Rabobank’s AAA rating it would be able to borrow in the Eurodollar market at very competitive rates.
Morgan Guaranty Bank:
Morgan acted as an intermediary guarantor between the Goodrich, and Rabobank to implement the swap. Morgan was merely agreeing to act as a conduit assuming no default payments. In fact, if Goodrich defaulted it could not collect the floating rate stream from Morgan. The swap was a two way or no way transaction. This was true for the bilateral agreement between Rabobank, and Morgan also.
Morgan had an AAA credit rating, and an international reputation, this guarantee effectively lowered whatever credit risk might have otherwise been present in the swap agreement to acceptable levels for Rabobank.
In commissions, Morgan received an initial one time fee of $125,000.00, and an undisclosed annual fee for each of the next 8 years. The going rate for such swap transactions has been between 8 - 37.5 basis points.
Salomon Brothers:
Salomon advised Goodrich to look into the possibility of issuing a LIBOR associated floating rate debt, and eventually underwrote the first part of the Swap transaction by selling the BF Goodrich floating rate note in the US bond market.
Thrift Institutions and Saving Banks:
Due to recent deregulation of the deposit markets, and resulting competition, large Thrift Institutions had aggressively priced their new deposit accounts, and as a result had recaptured large flows of funds. These institutions were looking to invest these funds and had the following alternatives:
- 30 year fixed rate residential mortgages. This investment option was risky because if interest rates continued to increase then the Thrift Institutions would risk losing. They would have to pay out higher interests to account holders while they would receive only fixed payments from mortgage holders.
- Invest in short term treasury bills, large CD’s of commercial banks.
- Floating rate notes of major US banks whose yields were tied to the Treasury bill notes.
- Buy Goodrich floating rate notes with a yield tied to the LIBOR.
Structuring of the Swap:
In the swap depicted above the following can be calculated:
- Goodrich receives the following amount semi annually:
-(LIBOR+0.5%)+(LIBOR-x1)-10.7% = x1+11.2%
- Morgan receives the following amount as fees: -(LIBOR-x1)+(LIBOR-x2)+10.7%-10.7% = x1-x2.
Note: As stated in the case (footnote #2 on page 362) this fee can be anywhere between 8 basis points and 37.5 basis points.
- Rabobank receives following amount semi annually: -(LIBOR-x2)+10.7%-10.7% = x2-LIBOR i.e. it will give out LIBOR – x2.
From exhibit 3 the following is also given:
- Since Goodrich has BBB- credit rating it could raise capital at a fixed rate probably at 12.5% for 7-10 years.
- Also, Rabobank could raise floating rate debt at LIBOR – 1/8% (LIBOR + ¼% - 3/8%) since it is an AAA rated bank.
Therefore,
- From (1), and 4, Goodrich saves the following amount in semiannual interest payments : 12.5% - (x1+11.2%) = 1.3%-x1.
- From (2), and (5) Rabobank saves the following amount in semiannual interest payments: LIBOR – 1/8% - (LIBOR –x2) = x2 – 1/8%.
- For this deal to occur, Rabobank, Morgan, and Goodrich must profit hence the following also must be true:
- (x1-x2) >= F where 37.5 > F > 8 (footnote #2 on page 362).
- 130 – x1> 0 i.e. 130 > x1
- X2 – 12.5 > 0 i.e. x2 > 12.5
Assuming that x2 = 20 basis, and x1 = 100 basis. We can conclude the following:
Goodrich pays a fixed interest of 11.2% + 1% = 12.2% a savings of 20 basis points (after transaction costs).
Rabobank saves a total of 2% - 1.8% = 20 basis points.
And Morgan collects 2% - 1.25% = 75 basis points in fee, in addition to the $125,000 one time fee.
Note: The total savings that this deal provides as a result of the swap is: 5 + 20 + 75 = 100 basis points.
