Breakage costs refer to a prepayment penalty on a fixed-rate loan or a fee that a lender charges to keep the borrower from refinancing shortly after closing.3 min read
1. Breakage Costs in Master Repurchase AgreementThe EFC Formula, 2020–2021 1 THE EFC FORMULA, 2020–2021. Might require fees. We encourage applicants to complete the FAFSA electronically, because there are. Sep 01, 2020 Understanding the Lehman Formula. As a provider of global investment banking services, Lehman Brothers needed a way to clearly convey to its potential clients the fees they would charge for their. In the formula =2.(3+2) the first operation Excel completes is the one inside the brackets (3+2), with the result of 5. It then performs the multiplication operation, 2.5, with the result of 10. (The values in the formula could be represented by cell references rather than numbers, but Excel would perform the operations in the same order.).
2. Break Fee
3. LIBOR Breakage
Breakage costs may refer to either a prepayment penalty on a fixed-rate loan or a fee that a lender charges to keep the borrower from refinancing a loan shortly after closing. These charges allow the lender to recoup the cost of the interest rate associated with fixed-rate funding. They are often calculated on a sliding scale, such as a percentage of the outstanding principal at the time the loan is refinanced. Breakage costs are spelled out in the original contract.
Breakage Costs in Master Repurchase Agreement
Breakage costs consist of all the losses and expenses that the lender incurs when employing or liquidating third-party deposits. These costs may result from a loan prepayment on any date but the last day of the interest period when interest is accrued at the LIBO rate (London Interbank Offered), or from the borrower's failure to pay accruing interest by a specified date or amount.
Loans funded at the LIBO rate are subject to a matching deposit in the Eurodollar market for a comparable amount for the purpose of figuring breakage costs. The lender will provide a certificate detailing how its losses are calculated.
Break Fee
When a deal or contract fails, a break fee is paid as compensation. This is common if:
- A contract is ended before its expiration date.
- A mergers and acquisitions deal is terminated for specific reasons indicated in the contract.
In the latter situation, the break fee is negotiated ahead of time as an incentive for the company to complete the deal and to provide security if the deal is not completed. It is calculated by estimating the time that managers and directors spent negotiating the deal, along with the cost of due diligence.
If a no-shop clause is breached, or the target company goes with another company, the break fee will apply. External factors can also trigger the break fee, such as regulatory approval.
Form S-4 is filed with the Securities and Exchange Commission (SEC) as a disclosure of break fees.
Break fees can also be charged to lessees who return equipment or for rented premises vacated before the lease has expired. Some business contracts incorporate a break fee to prevent nonperformance.
For example, in a 2017 proxy filing, Rockwell Collins Inc. filed a Form S-4 regarding its takeover of United Technologies Corporation (UTC). It stipulated a break fee of $695 million if:
- UTC terminated the merger because of a breach of contract.
- Either party terminated the agreement before the end date.
- Rockwell Collins did not obtain shareholder approval.
- Rockwell Collins instead entered an alternative acquisition proposal.
LIBOR Breakage
One of the most common types of interest rates, as noted by Bankrate.com, is the London Interbank Offered Rate (LIBOR). It often serves as a benchmark for loans that have an adjustable interest rate. If the borrower prepays a LIBOR rate advance before it expires, this is what the lender considers a breakage.
Large companies can opt for the LIBOR rate when requesting an advance from a bank or a lender. LIBOR advances cannot be repaid before their expiration like other interest rates can. They carry:
- A fee
- A repayment amount
- Advance notice requirements.
Because breakage is undesirable for the lender, fees are charged to borrowers who prepay.
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Warren Buffet once called these products 'weapons of mass destruction', how do credit default swaps work?
Multi-billionaire Warren Buffet once called these products 'weapons of mass destruction', because he thought they were partly responsible for causing the credit crunch. Despite this remark, there is still a buoyant trade in credit default swaps. Here we discuss how they work, and how they are valued.
A credit default swap, or CDS, is effectively an insurance product whereby the consequences of a bankruptcy (default) of a reference party are transferred in return for a periodic payment. Take, for example, a party that wishes to purchase or has already purchased a bond, but is keen to avoid the (further) risk that the seller will go bankrupt. By concluding a CDS, any loss sustained in the case of default is compensated, or paid off, in return for a periodic payment; the premium for the CDS.
The CDS is valued in much the same way as its cousin, the interest rate swap. In an interest rate swap, the exchange of fixed and variable interest cash flows is valued by estimating the amount of the future cash flows in advance. These cash flows are then discounted at the market interest rate applicable at that time and added up. In the case of a CDS, two types of cash flow are also exchanged. Firstly, a series of cash flows from the risk seller to the risk buyer, including the periodic payment of the premium. These cash flows are then exchanged for a (possible) cash flow from risk buyer to risk seller in the event of a default. The periodic payment ceases immediately if that bankruptcy actually takes place.
rating transition matrix
The greatest uncertainty in valuing a CDS is the moment of bankruptcy. This is generally determined by means of probability distribution and modeled on the basis of the ‘probability of default’ (PD). This probability can be obtained in the market by combining the rating of the bond with the rating transition matrix. These ratings are prepared by rating agencies. A triple-A rating is considered to denote ‘virtually risk-free’, a D rating means that a default event has already occurred. The matrix then indicates how great the probability is that a reference party will migrate from one rating to another.
Table 1 is a fictitious example of a rating transition matrix:
Rpli Default Fee Formula Sample
In order to illustrate the valuation of the CDS, we give an example of a credit default swap with the following assumptions:
- the term is two years,
- in case of bankruptcy, the loss is equal to the entire principal,
- the reference party’s current rating is BBB,
- we take the (fictitious) rating transition matrix from table 1, and
- the premium on the CDS is 4% of the principal.
Table 2 shows the probability distribution when calculating the moment of default:
Explanation of table 2:
In year 1, the probability of default (the probability of migration from rating BBB to D) is: 5%. Taking into account this probability of default in that first year, the robability of bankruptcy in year 2 is 95%, multiplied by the following two-stage default probabilities:
- constant year 1 (BBB), followed by bankruptcy (70% x 5%),
- downgrade to CCC, followed by bankruptcy (20% x 20%), and
- upgrade to AAA, followed by bankruptcy (15% x1%).
Rpli Default Fee Formula Calculation
The anticipated cash flows that are payable are equal to the premium in the first year (4) and 95% of the premium in the second year (95% x 4=3.8). The anticipated cash flows that are receivable are equal to 5% of the principal (5) in the first year and 7% of the principal in the second year (7).
Rpli Default Fee Formula Form
Assuming an interest rate of 2% per year, the following calculations apply:
The market value of the CDS is positive because the discounted present value of the premium payments is lower than the anticipated payments in the case of bankruptcy.