Derek Hogg

Scottish registered social landlords (RSLs) can be a cautious breed. Indeed, when it comes to exposure to interest rate fluctuations, they are positively risk averse, as you might expect from highly regulated bodies, often run by a board of charity trustees who have a duty to look after the organisation’s assets. Now that we seem to have moved away from the historically low interest rates of the last few years for the foreseeable future, interest rate management has resumed its importance for RSL finance directors, who need to ensure that their organisation is fully-funded to deliver its business plan and development programme, and that debt servicing costs will remain within business plan assumptions.

When it comes to managing interest rate exposure, for many RSLs this was normally a straightforward process, often involving no more than agreeing a fixed rate loan with their bank. Such loans are often referred to as being “embedded”, where the bank quotes a fixed interest rate to the RSL borrower, and then the bank itself enters into an interest rate swap with another hedging counterparty, behind the scenes. If the RSL wanted to explore anything slightly more adventurous, then that usually required the RSL to enter into an ISDA master agreement (the template agreement published by the International Swaps and Derivatives Association), which gives the RSL greater flexibility to deal with other hedging counterparties (the RSL could have as many different ISDA agreements in place as it wished) and also, at least in theory, to consider a broader range of “over the counter” derivative products.

There are only a handful of Scottish RSLs who currently have ISDA agreements in place, but that situation is likely to change, since the appetite of the main lenders to the RSL sector to directly enter into hedging arrangements has significantly reduced, due to the constraints and implications of IFRS 9 (International Financial Reporting Standard 9). RSLs will therefore have to consider other forms of hedging, with counterparties who are not the main lender, based on entering into an ISDA agreement.

When being quoted new lending terms, RSL borrowers are being offered the alternatives of either (a) a completely stand-alone ISDA agreement, which could be with any hedging counterparty the RSL chooses (but see comments below) but, for convenience, may be with a counterparty proposed by the lender. For example, if the lender is Royal Bank of Scotland, RBS will propose that its subsidiary, NatWest Markets, can be the hedging counterparty. Alternatively (b), a “loan-linked ISDA”, which still involves an ISDA agreement, but expressly acknowledges a contractual link to the underlying loan or facilities agreement. The most important difference between the two is that, with the loan-linked ISDA, no additional security is likely to be required to support the hedging arrangements, whereas, with a stand-alone ISDA, the borrower may be asked to put up additional security to secure its obligations to the hedging counterparty, in addition to the security which is being provided to the bank to support the initial lending. This difference is likely, therefore, to nudge borrowers towards the loan-linked ISDA.

Regardless of which option the RSL wishes to go with, it is important to remember that, before entering into the ISDA agreement and then specific hedging transactions, the RSL may need to amend its rules (convening a special general meeting of its members in order to do so). Since the mid-1990s, the regulatory expectation has been that RSLs who are registered societies should have an express power contained in their constitutional rules to enter into derivative products, which should also set out the parameters within which this power could be exercised. The housing regulator of the time – Scottish Homes – published a guidance note with recommended wording to be incorporated into each RSL’s rules, which on the one hand made clear that the RSL had the power to enter into stand-alone derivative transactions, but on the other hand applied a series of controls and limitations, in relation to the types of permissible derivatives (basically, just caps, collars and swaps), the nature of the hedging counterparties (just the main UK clearing banks), and the need for the RSL to take advice from an informed person.

RSLs who already have, or are considering adopting, this wording should therefore be mindful of then operating within the terms of the wording, when considering any actual derivative products in order to manage their interest rate exposure – particularly the need to take informed treasury management advice. And, slightly frustratingly, even if you already have the wording in your rules, if your rules only permit you to transact with a hedging counterparty which is a UK clearing bank, you may need to change the wording in the rules if a proposed hedging counterparty is not in fact a clearing bank – for example, RBS is, but NatMarkets isn’t.

The matters covered in this article, and many more, will be discussed on day one of Harper Macleod’s National Housing Conference in a conversation between partner Derek Hogg and Michael Leslie of Chatham Financial. For more information and to register for the National Housing Conference, visit here.

Derek Hogg is a partner at law firm Harper Macleod