The B.F. Goodrich-Rabobank Interest Rate Swap Case Study Risk PDF

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The B.F. Goodrich-Rabobank Interest Rate Swap...

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The B.F. Goodrich-Rabobank Interest Rate Swap Case Study

Executive Summary B.F. Goodrich, the fourth largest U.S. producer of tires and the largest producer of polyvinyl chloride resins and compounds, was hit hard by the steep recession of 1982, which led to a downgrade in their credit rating to a BBB- and a $33 million loss. At the beginning of 1983, Goodrich needed to borrow $50 million long-term in order to fund its ongoing financial needs. With interest rates being quite high and Goodrich’s lowered credit rating, they knew that longterm fixed-rate money would be too expensive. Enter Salomon Brothers, who then proposed the idea to Goodrich of them borrowing in the U.S. public debt market with a floating-rate debt issue

tied to the London interbank offering rate(LIBOR) and then swap interest payments with a Euromarket bank that had raised funds in the fixed-rate Eurobond market. Now enters the Rabobank, a major Dutch banking organization that is 1 of the 50 largest in the world and has assets exceeding $42 billion. Fortunately, Rabobank had a credit rating of AAA and emerged as a willing partner to swap, and eventually selected the Salomon Brothers’ Goodrich proposal. In order for this to work, Morgan Guaranty Bank entered as an intermediary guarantor and made swap agreements with the other two parties. Goodrich would pay the Morgan bank $5.5 million annually for 8 years to cover the 11% fixed annual coupon, while the Morgan bank would pay to Goodrich 8 years of semiannual payments at LIBOR - x. On the other side, the Morgan bank would pay the $5.5 million to Rabobank annually for 8 years, and Rabobank would pay them the 8 years of semiannual payment at LIBOR - x. The Morgan Guaranty Bank received an initial fee of $125,000 and an undisclosed annual fee for each of the next 8 years for their role in this transaction. Below is an analysis of the motivations, specific details, and benefits for all of the parties in this interest rate swap.

Reasons for Interest Rate Swap Q1. What are the motivating reasons for the interest rate swap in the current case? Given Goodrich’s recent $33 million loss in 1982 and corresponding lower credit rating, securing the necessary $50 million in long-term fixed US rate funding would prove to be very expensive. At the time, 30 year US treasuries were at 10.30%, meaning that Goodrich would likely have to pay around 13% for a 30 year corporate bond. If Goodrich were to borrow in the US public market (with floating rate + LIBOR) and then swap interest payments with a fixed rate Eurobond market, it would likely prove to be cheaper for the company.

This financing offering also allowed US investors an opportunity to invest in a new LIBORbased bond. As this was a new and different financing for Salomon Brothers, many American investors would be intrigued and excited to invest in the offer. As Morgan Bank held a AAA rating, this also offered Rabobank and other Eurobond investors an attractive investing opportunity. Finally, the interest rate swap also offered Rabobank an opportunity to build a reputation as an innovative and reliable business partner and lender. As the case states that the central Rabobank had never borrowed in the Eurobond market before and few American investors had heard of it, this deal would prove Rabobank to be an attractive partner in the future, while also providing a beneficial offering to the bank.

Swap Diagram

F = .3% X = .525% B.F. Goodrich Savings: .475%

Rabobank Savings: .775% Morgan Bank Fee: .3%

Exchange of Dollar Cash Flows *LIBOR = 2% Goodrich: $50 million bond issued that matures in 8 years, bearing interest at an annual rate of 2.5% (LIBOR + 0.5%) Pays Morgan Bank $5.5 million/year to cover 11% coupon rate Pays Morgan a one time initial fee of $125,000 with an undisclosed annual fee for the next 8 years

Morgan: Pays Goodrich 8 years of semi annual payments of $50 million multiplied by a floating rate which consists of LIBOR minus a discount rate = ($50 million * (2 - 0.525)) / 2 (semi-annual) = $368,750 semi annual payments Pays Rabobank $5.5 million/year

Rabobank: Pays Morgan 8 years of semi annual payments of $50 million multiplied by a floating rate which consists of LIBOR minus a discount rate

= ($50 million * (2 - 0.525)) / 2 (semi-annual) = $368,750 semi annual payments $50 million bond issued that matures in 8 years, with a fixed annual coupon rate of 11%

Swap Transaction Savings F = .3% X = .525%

Rabobank Savings = 0.25% + 0.525% = 0.775% of $50 million. Thus, Rabobank will save $387,500, and since 0.525% is greater than -0.25% and 0.3% is less than 1.55%, there is an incentive for Rabobank in this situation.

B.F. Goodrich Savings = 1.3% - 0.3% - 0.525% = 0.475% of $50 million. B.F. Goodrich will thus save $237,500 and since 0.3% is less than 1.55% and 0.525 is less than 1.3%, this situation also has an incentive for them.

Morgan’s Fee = 0.3%, which is greater than 0. Pair that with 0.525% being less than 1.3%, and Morgan will also have an incentive in this.

When each party’s savings are added together, 0.775% + 0.475% + 0.3%, it equals a 1.55% comparative cost advantage, thus this is how the swap transaction savings could be shared amongst the three parties of Rabobank, B.F. Goodrich, and Morgan....