B.F.

Goodrich – Rabobank
Interest Rate Swap

A Credit Risk Case

Alejandro de los Santos and Luis Seco
University of Toronto
The case
On Monday March 7 1983, Goodrich and Rabobank
simultaneously executed two financings and an
interest rate swap, with the net effect of:
1. Provide US investors with an attractive LIBOR-
based floating rate note.
2. Provide Eurobond investors with an attractive
AAA fixed-rate bond
3. Raising $50M of floating rate Eurodollar
financing for Rabobank
4. Raising $50M of fixed-rate 8-year financing for
Goodrich
Agenda

• Setup
– BF Goodrich position
– Rabobank position
• The game : a Swap
– Fixed and floating legs
– Price
– Risks
• Conclusions
 Setup

The financing problem

The participants and their positions
B. F. Goodrich : situation in early 1983

• American manufacturer of tires and related

rubber products
• Fourth largest U.S. producer of tires
• Largest U.S. producer of polyvinyl chloride (PVC)
• Facing financial difficulties because of 1982 ‘s
recession
• Downgraded from BBB to BBB-
• Goodrich was about to announce a $33 million
loss in the past year
B. F. Goodrich : financials

1979 1980 1981 1982

Operating
$ 117 $ 70 $ 39 ($ 33)
Profits
Other
$ 8 $ 2 ($4) ($ 2)
Income
Total
before Tax $ 131 $ 89 $ 162 ($ 68)

NET
$ 83 $ 62 $ 110 ($ 33)
Income

(In USD Millions)

B. F. Goodrich position

Its credit loan spread

B. F. Goodrich position

• Needs to fix the situation, with a loan ($50M)

– Long term (at least 10 years), so its financials
recover over the long term.
– Wants to pay fixed rate: being in a cyclical
business, they are sensitive to interest rates:
consummers buy fewer cars, and hence fewer
tires in high interest rate environments.
• Its credit quality, coupled with the long dating of
the loan leads to a big spread (~ +180 bps)
The credit loan spread (1)

• Simple default/no-default model

• A 2-state markov chain

No
Default
Default

No
Default
p 1-p

Default 0 1
The credit spread

• An 8-state markov chain.

• Each state is a credit rating
• Transition prob matrix
• S&P, Moody’s
• Etc
Rabobank Netherland
Rabobank Nederland
• A major Dutch banking organization ($42B in assets)
• One of the world’s 50 largest banks
• Services the agricultural sector, dentists and smaller
communities
• Rated AAA
• Not well known outside the Netherlands
• Most of its dollar-denominated assets were loans whose
rates floated with LIBOR to US savings banks
(underwritten by Salomon brothers), to offset fixed rate
pension deposits from the communities it caters to.
Rabobank position

• Conducts only a small amount of dollar-based

business
• Is willing to invest abroad.
• Has good access to the Eurobond market
• Would like to have interests tied to LIBOR
• Can lend $50 millions for long term.
The Credit Market in 1982

Fixed Floating

AAA 10.70% LIBOR+0.25%

BBB- 12.50% LIBOR+0.50%

Credit Spread 1.80% 0.25%

 The Swap

A Salomon Brothers proposal

and how it worked
The proposal

• Goodrich can borrow from US investors and

commits to pay floating rate tied to LIBOR
• Reducing his rate spread
• Rabobank can borrow from European investors
and commits to pay fixed
• Raising the funds from third parties
• Swap payment obligations
• Allowing Goodrich to pay fix in Europe and
Rabobank to pay floating in US
The name of the game : Swap

• Use Morgan Guaranty Bank as intermediary

guarantor
• Fixed and floating legs
– Goodrich would pay fix to Morgan and
receive the LIBOR he has to pay
– Rabobak would pay floating to Morgan and
receive the fixed amounts he has to pay
The game : Play Ball !!

• Appears a Bond in the • Appears a Bond in the

US market Eurobond market
– Issuer: BF Goodrich – Issuer: Rabobank-
– Amount: $50 million Nederland
– Maturity: 8 years – Amount: $50 million
– Coupons: US dollars
• Semiannual – Maturity: 8 years
• LIBOR + 0.5% – Coupons:
• Annual
• 11%
The game

U.S.Savings Banks Belgian dentists

LIBOR + 0.5% ( Semi ) 10.7% annual

5.5 million
(11% fixed) 5.5 million
Once a year Once a year

(LIBOR – x) % (LIBOR – y) %
Semiannual Semiannual
The effect of the swap

Before the swap After the swap

Fixed Floating Fixed Floating

AAA 10.70% LIBOR+0.25% 10.70% LIBOR-0.5%

BBB- 12.50% LIBOR+0.50% 12.00% LIBOR+0.5%

Credit Spread 1.80% 0.25% 1.30% 1.00%

The Price

Default/no default analysis

Transition probabilities of default
The price of the game

• Swap spread under a simple two-state markov

chain
The price of the game (2)

• Pricing of the deal under the S&P (or Moody’s)

markov chain.
The transition probability matrix
AAA AA A BBB BB B CCC D

AAA 0.9081 0.0833 0.0068 0.0006 0.0012 0.0000 0.0000 0.0000

AA 0.0070 0.9065 0.0779 0.0064 0.0006 0.0014 0.0002 0.0000

A 0.0009 0.0227 0.9105 0.0552 0.0074 0.0026 0.0001 0.0006

BBB 0.0002 0.0033 0.0595 0.8693 0.0530 0.0117 0.0012 0.0018

BB 0.0003 0.0014 0.0067 0.0773 0.8053 0.0884 0.0100 0.0106

B 0.0000 0.0011 0.0024 0.0043 0.0648 0.8346 0.0407 0.0520

CCC 0.0022 0.0000 0.0022 0.0130 0.0238 0.1124 0.6486 0.1979

D 0 0 0 0 0 0 0 1
Assignment

• Calculate the credit premium for the swap

• Calculate the exposure of the deal
• Study the impact of market-credit correlation to
this deal
– Correlated auto-sales numbers and interest
rates
– Infer correlation for market-credit risk factors,
and its impact on credit premiums and
exposures.