A savings and loan’s credit rating has just slipped, and half of its assets are long term mortgages. It offers to swap interest payments with a money center bank in a $100 million deal. The bank can borrow short term at LIBOR (3 percent) and long term at 3.95 percent. The S&L must pay LIBOR plus

Question

A savings and loan’s credit rating has just slipped, and half of its assets are long term mortgages. It offers to swap interest payments with a money center bank in a $100 million deal. The bank can borrow short term at LIBOR (3 percent) and long term at 3.95 percent. The S&L must pay LIBOR plus 1.5 percent on short term debt and 7 percent on long term debt. Show how these parties could put together a swap deal that benefits both of them.

Accepted Answer

This SWAP agreement would have the form:

	Fixed Rate the	Floating Rate	Potential
	Borrower Pays	the Borrower	Interest-Rate
	if They Issue	Pays on Short-	Savings of Each
	Long-Term Bonds	Term Loans	Borrower
S&L	7.00%	LIBOR + 1.50%	2.50%
Money- Center Bank	3.95%	LIBOR (3%)	0.95%
Difference in Rates Due to Differences in Credit Ratings	3.05%	1.50%	1.55%

If the money-center bank borrows long-term at 3.95 percent and the S&L at LIBOR + 1.50 percent (which is currently 3.00 + 1.50 or 4.50 percent) and they exchange interest payments, both would save if the S&L agreed to pay a portion of the bank’s basic borrowing rate. For example, the S&L could pay 260 basis points to the bank which would more than cover the difference. After the exchange in payments and basis points the S&L would pay 3.95% +2.6% or 6.55% which is lower than the S&L’s long term rate and the bank would pay 5.45%-2.6% or 2.85% which is less than the bank’s short term rate and each party would get the type of payment they want.

Question 8.P.15: A savings and loan’s credit rating has just slipped, and hal...

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