Leveling the Playing Field

September 28, 2015

______________________________________________________________________________
The family and I attended the PSU vs Rutgers game Saturday night and it was a great experience,
mostly because PSU secured a rare win. It helped that Rutgers was down six players, but it also
helped that they were without their headcoach, Kyle Flood. Flood was suspended for
approaching a professor through email about grade manipulation to keep a player eligible. But
Flood went a step further, writing I am sending it from my personal email to your personal
email to ensure there will be no public vetting of the correspondence. Ouch.
Thats pretty damning, but it raised another question. If a college football coach in Jersey is
aware enough of the laws to intentionally use personal email to avoid public scrutiny, what
excuse does a Yale-educated lawyer turned First Lady turned Senator turned Secretary of State
turned Presidential candidate have? Just a thought
Slightly different newsletter this week. Instead of the standard economic commentary, were
going to dig into some hedging strategies to consider as we approach the first tightening cycle in
a decade. Last weeks rate movements were relatively benign, with the 10T moving lower in the
first half of the week before rebounding Friday and closing at 2.16%. And all eyes this week
will be on Fridays labor data, where a very strong number could bring an October hike back into
play. This felt like a good time in the eye of the storm to discuss some ideas that may make
sense for borrowers as the interest rate environment changes.
Hedging Strategies for the Potential Tightening Cycle
One of the biggest mistakes we made at the bank was treating the hedging strategy like a
snapshot decision at the closing table. We would determine the structure, hedge at closing, and
put it to bed. As a salesperson, I wanted you to hedge as much as possible for as long as possible
so I could make as much revenue as possible. And I certainly didnt want to have to keep track
of your unhedged debt and send monthly rate updates in the hopes of more business. You
should just lock it for the long term at historically attractive rates and go focus on the parts of
your business that you can control. Youre a real estate guy, not an interest rate guy. If the
project works at this fixed rate, why not just lock it up so you can sleep at night? Sound
familiar to anyone?
As advisors rather than salespeople, we believe hedging should be an ongoing, dynamic risk
management dialogue. Perhaps it is better to hedge just a portion of the debt or hedge for a term
shorter than maturity to allow flexibility. As time passes, we will have greater clarity around the
Feds plans for interest rates and the health of the economy, and you will have additional insight
into the disposition plans for the underlying asset or refinancing opportunities. And as time
passes, the effect of rolling down the yield curve can help offset an increase in rates.

Dont get us wrong, there are plenty of times when 10 year fixed rates make sense. Just like
there are plenty of times when staying unhedged makes sense. Were talking about those inbetween times where the water may be a bit muddier. We see this frequently with short term
loans with a required cap.
Buying Shorter Term Cap
Weve spent much of the last year advising clients to buy shorter term caps despite the fact that
we fully expected a rate hike. We believe the market is overcharging for uncertainty and clients
are better off buying a shorter term cap at closing with an eye to buying a cap later for the final
months. The most common example we see is a three year loan with a required cap for the full
term, but we negotiate a two year cap instead with the lender.
For illustration purposes, lets assume a $50mm, three year loan with a required strike of 2.00%
on 1 month LIBOR.
3 Year Cap
Cost: $202,000
Anticipated Protection: $0
2 Year Cap
Cost: $35,000
Anticipated Protection: $0
As you can see, the market doesnt expect either cap to provide any savings to the buyer. And
despite the fact that the market never expects 1mL to exceed 2.00%, the cost for the three year is
over $200k. Lets examine why. Remember that cap prices are driven primarily by two factors:
1. Rate expectations (swap rates)
2. Volatility (uncertainty)
Swap rates are still pretty low and 2.00% is well above the three year swap rate of 0.94%. So the
swap rate isnt what is driving the price of the three year cap up.
That leaves uncertainty. Traders look at the variance of 1mL over a given time period to help
price caps, and the greater the uncertainty, the higher the price.
Over the next twelve months, a trader could be wrong about LIBOR, but probably only by a
small amount. Over the next three years, however, they could be wrong by much more. Its not
inconceivable that they could be off by 2.00% in an extreme scenario, right?

And that is why the market is charging so much more for the third year. Traders have a much
better sense of what the Fed will do over the next twelve months than they do 24-36 months from
now - the magnitude of being wrong over the longer period of time is much bigger.
But saving $167k just by buying a shorter term cap isnt exactly groundbreaking analysis. If
LIBOR ends up jumping dramatically, the cost to buy a cap for the third year could be far more
expensive than the $167k of savings, right?
Probably not, and here is why. This is where the magic happens, so dont fade on me now. I put
that in italics because if you started to skim I wanted to get your attention. Did it work?
Uncertainty Premium
The market expects LIBOR to average 1.45% in year 3, so a cap with a strike of 1.45% would be
considered At the Money (ATM). Today, this cap would cost about $269k.
If we look at what the market expects LIBOR to average over the next twelve months starting
today, it is about 0.42%. A cap for one year starting today with a strike of 0.42% costs $61k.
It is important to note that these are both one year caps with strikes ATM. In a perfectly efficient
market, these two caps should cost the same because they are both providing the same amount of
protection relative to expectations. But as you can see, a one year ATM cap that starts today
costs $208k less than a one year ATM for the third year. Thats the uncertainty premium traders
are charging because of the larger potential variance of 1mL.
That means even if LIBOR climbs higher and the market expects it to average 1.45% in that third
year, the cost of the cap should be more like $61k than $269k at that time.
We arent suggesting that LIBOR wont climb higher. We are suggesting that even if it climbs
substantially, a cap should cost less in two years because the market will have greater confidence
about the path of LIBOR over the remaining twelve month period. The variance is smaller, so
the uncertainty premium is smaller.

Two Year Cap with Three Year Loan

Lets go back to the example of the three year loan with a strike of 2.00%. If the swap rate for
the third year is 1.45%, then a 2.00% strike is about 38% above market expectations for LIBOR
that year. As a reminder, this cap costs about $202k today.
A comparable cap for the next year starting today would have a strike of 0.58%. In an efficient
market, this cap should cost about $202k, right? But since you stayed awake during the last
section so you know thats a loaded question.
So what does a one year cap with a strike of 0.58% starting today cost?
$37,000
Thats it.
That means the market is charging a premium of $165k just because of variance. And
remember, we arent saying LIBOR wont move higher. We are saying that in two years even if
the market expects LIBOR to average 2.00% for the third year, the cap should cost more like
$37k than $202k.
Think about that for a moment. Even LIBOR is substantially higher in two years, a 2.00% cap
should cost much less than what the market is charging today. Traders arent charging $200k
because they are worried about LIBOR getting to 2.00%. They are charging $200k because they
are worried it could be at 5.00%.
In fact, in order for the cap to cost more in the future than it does today, the market would have
to expect LIBOR to average about 2.50% for that third year. The forward curve today doesnt
have LIBOR exceeding 2.50% until May 2021.
All of those assumptions assume a pretty dramatic move higher for LIBOR. What if the Fed
ends up being on hold for a significant amount of time? What if the Fed has to cut rates? There
are a lot of scenarios where the cost is even less than what we outlined above.
And if you sell or refinance early, you didnt spend money on that uncertainty premium you
didnt even end up using.

Im Intrigued, Whats My Risk?

This is where long time readers jump in and say Yeah, but you are wrong all the time. Whats
my real risk?
Fair point, even if harshly worded. I believe the biggest risk to this strategy is a dramatic shift in
expectations for LIBOR shortly after closing. In other words, Yellen comes out tomorrow and
says the Fed is tightening very rapidly and for an extended period of time.
Remember, that dreaded uncertainty premium is really onerous further down the timeline. If the
Fed is slow and patient for 18 months and then dramatically changes its tune, the variance over
the remaining 18 months is likely still manageable.
But with a dovish and fully transparent Fed, this seems unlikely. We would rather save the
$167k today and take a cautious stance against a dramatic increase in LIBOR over the next two
years.
One last time, from the Department of Beating a Dead Horse we arent saying LIBOR
expectations cant get to 2.00%. We are saying that even if they do the cost should still more
closely resemble the cost of a one year cap today.
Furthermore, because you have been reading this whole newsletter and not just skimming for key
words, you remember that we started this entire newsletter proposing an ongoing, dynamic
hedging strategy whereby we monitor interest rates and cap prices on a consistent basis.
If you are receiving monthly updates on the interest rate market and cap prices, you will be in a
position to move forward with the cap purchase if and when the Fed winds change. By staying
on top of the market changes we can mitigate the risk even if we end up being wrong.
For some clients and lenders, this can all make sense but they still decide to move forward with
the longer cap. That makes sense to us its your risk, not ours. Risk tolerance is an important
consideration for each client and why we approach these situations on a case by case basis. Our
goal is to simply provide you with the necessary information to make an informed decision.

Other Alternatives
Alternative: Step-Up Cap
Use lower strikes on the front end and higher strikes on the backend to reduce the upfront cost
while still providing the same blended average cap rate. For example, the following structure
might be used to meet a 2.00% cap requirement:
Year 1: 1.00%
Year 2: 2.00%
Year 3: 3.00%
This is most commonly used on required caps where the borrower doesnt really doesnt want
the cap but needs to satisfy the lenders requirement. This structure caps the interest over the life
of the loan at 2.00% just like the plain vanilla cap at 2.00%, but takes advantage of the shape of
yield curve to bring the upfront cost down.
On the loan we used for illustration purposes, this structure would reduce the upfront cost to
about $108k, a savings of about $94k vs the plain vanilla structure.
Im Intrigued, Whats My Risk?
Obviously, the downside is that the cap never actually provides protection despite a rising rate
environment because the strike is highest later in the loan. Again, this structure usually makes
the most sense for a borrower that must buy protection but wants to keep the upfront cost as low
as possible.
We can tweak the strikes to match your requirements and budget constraints, we just wanted to
provide a simple scenario for illustration purposes.
Alternative: Corridors
Corridors (commonly confused with a collar) comes in and out of favor as the rate environment
changes. Corridors are ideal during volatile markets where a buyer expects LIBOR to rise
slower than forecastedif you are among the observers (like us) that thinks the Fed will struggle
to get rates off the zero-bound range, this could be the structure for you.
Before we dig in, please note lenders will usually not agree to this structure on a required cap.
As you will see, it doesnt actually cap your rate if we experienced a dramatic run up on LIBOR.

With a corridor, you buy a cap at one rate and sell a cap back to the bank at a higher rate. For
example, you buy a cap at 2.0% and sell a cap at 3.0%.
This would reduce the cost of the 2.0% cap to just $140k, a savings of $62k compared to the
plain vanilla structure. If LIBOR never exceeds 3.0% over the next three years, it will behave
just like a regular cap at 2.0%.
This is a great way to buy protection in a slowly rising rate environment and is particularly
effective for longer term caps, like four and five years.
Im Intrigued, Whats My Risk?
Heres your downside - if LIBOR exceeds 3.0%, you start making up the difference and your
rate climbs 1-1 over 2.0%. For example, a 4.0% LIBOR would result in your rate being:
2.0% cap + (4.00% - 3.00%) = 3.00%
The key here is that you dont lose all protection if LIBOR exceeds the higher strike, you just
dont keep the 2.0% ceiling (which is why lenders wont usually agree to this structure on
required caps). But if you are considering leaving the loan unhedged, you are already exposed in
that regard and this structure is no riskier than your current position.
These look particularly attractive today because the Fed appears poised for a hike but a dramatic
movement higher seems unlikely.
Additionally, you actually take advantage of high market volatility. The high uncertainty
premium we discussed earlier that makes longer term caps so expensive washes out because you
are both buying and selling an option. A trader is really only looking at the net uncertainty
between the two positions, which helps create a more efficient hedge.

Alternative: Forward Starting Swap

Some clients ask about swaps that start in the future, hoping to take advantage of low LIBOR.
This is a great strategy for some projects, but not for the reasons most borrowers think.
A forward starting swap is not a rate play, it is a cash flow play. If you want a swap to begin in a
year so that you can float on LIBOR without being exposed to a dramatic movement higher of
fixed rates over the next twelve months, the forward premium represents what the market
expects you to save over the next twelve months by floating. In other words, the market simply
projects your savings and amortizes it over the remaining term of the swap.
A five year swap rate is around 1.25% today. If we keep the maturity the same but have the
swap start in one year, the swap rate increases to about 1.50%. The market takes the projected
savings over the next year and amortizes it over the remaining four years. Look at how simple
the math is:
-

The market expects you to save about 1.00% over the next twelve months by floating
(1.25% fixed rate vs 0.20% LIBOR today)

Divide that 1.00% savings by the remaining term of four years, and what do you get?

An increase of 0.25% per annum in the fixed rate

From a rate standpoint, you are indifferent at any given moment between the two structures.
And that is why a forward starting swap is not a rate play. You cant pull a fast one on the
market.
What this structure is great for, however, is cash flow. The most common scenario we see a
forward starting swap is a property with low occupancy at closing but our client feels confident
they can improve leasing over the next 12-24 months. They need as much cash flow as possible
early on but can absorb a higher rate when occupancy improves. They may enter into a forward
starting swap, saving more than 1.00% at closing by not converting to a fixed rate. In exchange,
they pay a slightly higher rate in the future when leasing is improved.
Im Intrigued, Whats My Risk?
The biggest risk is a prepayment risk. If you prepay the loan, the calculation will be done against
the higher fixed rate, exaggerating the penalty. In reality, you saved this differential over the
first year as long as rates followed their expected path, but no borrower sets aside the savings
into a prepayment escrow account to help defray the penalty in the future.

The other risk is a pricing risk. Some banks (like the one that rhymes with Schmells Bargo)
charge more for forward starting swaps. Its usually only a few basis points and isnt so
egregious that is changes the underlying analysis, but borrowers should be aware of it. Banks
will usually blame the additional exposure created by the higher fixed rate, but the more likely
explanation is that a forward starting swap has a smaller PV01, resulting in less profit for them.
By charging extra for the forward starting swap, the bank makes the same profit regardless of
structure.

Summary
All of these structures can be tweaked based on client feedback, this is simply meant to initiate
the dialogue and get a feel for what might make sense for different borrowers with different
needs. As always, please contact us to provide precise analysis for your particular situation.

This Week
Next week we will return to our normal format of making inaccurate predictions and bad jokes.
In the meantime, the market will be watching Fed-speak to see if Yellen et al look to counter the
market interpretation from the last meeting (incredibly dovish). Yellen spoke Thursday and said
most FOMC member still expect a hike before year end, a thought reiterated by two more Fed
members on Friday. Perhaps they were caught off guard by how strongly the market reacted to
the Feds statement in the week prior, but we think they really just want the market to continue
treating every meeting as a live one for a hike.
There is a lot of significant data this week. Monday kicks off with inflationary data, Tuesday has
housing and confidence numbers, Thursday has manufacturing data (will China continue to
weaken domestic manufacturing?), but Fridays job reports will be the headliner for the week.
A data-dependent Fed has slaved us to economic data and NFP is the biggest of those. You may
recall that last months report was mildly disappointing (173k vs expected 210k) and the BLS
took the highly unusual step of immediately pointing out that August is the most revised month
for NFP. Consensus forecast for NFP is a gain of 202k jobs last month, but the revision to
August will be just as significant. The Unemployment Rate is expected to hold steady at 5.1%,
but there is a chance it pops up to 5.2% based on changes to participation rate.

Generally, this material is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument or as an
official confirmation of any transaction. Your receipt of this material does not create a client relationship with us and we are not acting as fiduciary or advisory
capacity to you by providing the information herein. All market prices, data and other information are not warranted as to completeness or accuracy and are subject
to change without notice. This material may contain information that is privileged, confidential, legally privileged, and/or exempt from disclosure under applicable
law. Though the information herein may discuss certain legal and tax aspects of financial instruments, Pensford Financial Group, LLC does not provide legal or tax
advice. The contents herein are the copyright material of Pensford Financial Group, LLC and shall not be copied, reproduced, or redistributed without the express
written permission of Pensford Financial Group, LLC.