Interest Rate Caps: Acceptable Counterparties and the New Reality

Interest Rate Caps

An interest rate cap is a derivative product for borrowers to manage floating rate risk (typically 1M LIBOR). Sometimes a lender will require the borrower to purchase a “Swap” for interest rate protection. The technical definition of a “Swap” includes interest rate caps and other types of derivatives.

Most of our readers are familiar with interest rate caps, and if not, just equate a cap to car insurance. Your insurance premium is based upon having a lower or higher deductible or you drive a Corolla or a Ferrari. However, there are other variables involved which impact the cost of the insurance which one has no control over. Your age, accidents, whether you are at fault or not, where you live and so on. The same dynamic exists with interest rate caps.

Counterparty Risk

A quick story about a family member relevant to counterparty risk. The family member purchased car insurance and not long after got into an accident. He called the insurance company and discovered the company had gone out of business. Not sure how it all worked out, but knowing the credit worthiness of your insurance company is just as important when buying an interest rate cap from a bank. Think Lehman Brothers.

Acceptable Counterparty

When contemplating purchasing a cap, a borrower should be concerned with the cap bank’s credit rating, even if the hedge isn’t required. When a cap is required, the lender may mandate the cap bank have and maintain a defined debt rating, e.g. A by S&P and/or A2 Moody’s.

Cap prices amongst banks can vary substantially; recently, we’ve seen variances of as much as 100%. One reason to hire a cap agent is to arrange an auction within which a number of banks can bid. Because of our reputation and the hundreds of millions of dollars in deal flow we facilitate, we receive inter-bank pricing, translating into an opportunity for the borrower to purchase the cap at the lowest price available.

Within the past few months, there has been a wide variance in pricing amongst credit worthy cap banks who are active in the market. There are several reasons for this such as new regulatory-driven reserve requirements, an increase in volatility (wider swings in future LIBOR expectations), and acceptable credit criteria.

The New Reality

Until recently, a lender’s credit rating requirements of the cap banks had little or no impact on a cap’s price. No longer. The banks selling caps have become much more cautious in recent months, choosing to widen their profit margins, and hence increase cap pricing, to compensate them for the possibility they’ll be required to post collateral or replace themselves should their credit rating fall below the lenders required criteria. Another way to view counterparty risk: Your brother has a very high paying job but needs a co-signer to buy a house. You agree and shortly thereafter your brother loses his job. Who is on the hook to make the mortgage payments? Yours truly.

Facing the Challenges

We can all agree the future is filled with uncertainty. This is a new era, not just for the United States, but globally. Have interest rates moved up too quickly, thereby setting the stage for a fall in interest rates or will interest rates continue to rise for the foreseeable future? For the past few years, the Fed and the market provided comfort and a sense of direction. A slow recovery and a Fed that was more than willing to accommodate a low-interest rate environment.

What to Do

A hedger who wants certainty will most likely fix the floating rate even if there are opportunity costs in the event the market over estimated LIBOR’s rise. A hedger who wants flexibility will choose hedges with optionality. Flexibility has a price. However, there are ways to reduce the cost of flexibility by structuring a hedge that still meets the goals and objectives of the hedger, while meeting the hedge requirements of the lender. Whatever a borrower’s inclination, we highly recommend obtaining objective advice.

Hedge Advisory Professionals

We often tell our clients and prospective clients, that even though we’ve worked in the capital markets for more than 30 years, We would never enter into a derivative without the advice of an independent advisor. Due to ultra-low interest rates, most floating rate borrowers have become complacent, however. Take a look at the history of the 10 year Treasury for the past 50 years. Most fixed income traders and many borrowers have never experienced a period of high interest rates. Could this be a reason for the sharp increase in term rates?

This is not the time to make a decision to hedge based on fear. Take a deep breath and give us a call.

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