Market data provided in this post was accurate as of the time of publication, (12:00 p.m. ET on March 30, 2020), but may quickly become dated given current market conditions. Data seen here should not be used for any analysis or transactions.
While the week prior was a big week for monetary policy, with the Fed taking wide ranging policy actions to strengthen liquidity in credit markets, this past week ended with a bang for fiscal policy. President Trump signed a $2 trillion stimulus package into law that includes a mix of direct benefits for households and some corporates, as well as loans and other financing to business including $350 billion in loans to small businesses to help keep workers on payroll. In some respects, we saw signs of more “normally” functioning markets. SOFR remained close to the lower bound of the Fed Funds Target rate, suggesting adequate liquidity in repo market (albeit due in large part to repo operations by the Fed). Treasuries and stocks resumed their historical, inverse correlation, with investors shifting cash into Treasuries on Friday as the stock market declined, pushing rates lower. The U.S. dollar weakened appreciably against a basket of other major global currencies, suggesting some of the “flight to USD” pressure we saw last week abated. We saw little reprieve from the challenges facing our CRE investor clients in this environment, particularly with respect to the financing markets. With a few exceptions, we continued to see tightening credit conditions for borrowers, with bank lenders focusing more and more solely on low risk assets and large sponsors, LifeCos applying higher all-in floors, more non-bank transitional lenders backing out of deals or lending altogether as their funding costs increase, and CMBS remaining largely closed. Spreads on Agency debt did improve slightly with the announcement that the Fed would begin purchasing Fannie Mae DUS bonds.
Several weeks into this market crisis, we’ve now had the chance to speak with a wide range of CRE investors and other market participants, both in the narrow context of transaction-specific work we’re doing with them, and in the broader context of how they should be thinking about investment- and portfolio-level risk in the current environment. In the course of these conversations, we’ve seen several emergent themes. We thought this might be a good forum to speak to some of the most common questions we’re getting from market participants and the considerations we have when answering them.
Why is LIBOR increasing even as the Fed cuts rates?
While we touched on this last week, the question has come up frequently enough that it’s worth discussing again. The Fed Funds rate is the rate at which banks will lend excess reserves to one another on an overnight, unsecured basis. LIBOR is, in theory, the rate at which banks can borrow from one another on an unsecured basis for various terms, with 1-month LIBOR being the most relevant term for most CRE borrowers. In normal market conditions, as the Federal Reserve cuts the Fed Funds Target Rate and the Fed Funds Rate falls lower, LIBOR tends to move down with it (the historical correlation between the Fed Funds rate and 1-month LIBOR is very high). As we’ve observed over the past two weeks, however, 1-month LIBOR has increased even as the Fed cut rates (see graph below). This has occurred due to pressures in the bank funding market and the mechanism by which LIBOR is determined on a daily basis, which relies in part on bank commercial paper rates. As the commercial paper market has come under stress, banks have seen their short-term funding costs rise, which carries over into the daily calculation of LIBOR. If bank funding markets improve, we would expect LIBOR to fall back down to be more in line with the Fed Funds rate. The second graph below, which shows LIBOR and the Fed Funds rate during the period December 2008—December 2015 (the last period during which the Fed Funds Target Rate was 0-25 bps), shows this relationship in more “normal” credit markets.
How has the current market situation impacted the LIBOR transition timeline?
Up until a few weeks ago, the presumed transition from LIBOR to SOFR as an index for floating-rate CRE loans was one of the topics which we found ourselves discussing most recently with market participants, particularly with the announcement in early February that the Agencies would stop purchasing LIBOR indexed loans from their seller-servicers by the end of the year. With the current market upheaval, has the end of 2021 targeted timeline moved? The UK Financial Conduct Authority (FCA) which oversees LIBOR’s administrator (the Intercontinental Exchange, or ICE) says no, publishing a statement on March 25 that market participants should still plan on LIBOR becoming unavailable at the end of 2021. That being said, we’ve seen several key dates related to the LIBOR transition in the U.S. pushed out, In particular, a statement by the ISDA that provisions for dealing with LIBOR transitions in caps and swaps would be delayed by at least until the third quarter. The FHFA also extended the date beyond which the Federal Home Loan Banks can enter into LIBOR indexed products from March 31, 2020 to June 30, 2020. At this point in time, we’re still encouraging market participants to assume that the LIBOR transition may still occur by early 2022, though we believe some of the interim milestones along the way may move.
Swap rates are such that I can now swap 1-month LIBOR to a lower fixed-rate, effectively reducing my interest rate expense immediately. Should I consider this transaction?
As the graph below shows, current rates for fixing 1-month LIBOR are well below 1-month LIBOR itself, so entering into a swap allows a borrower to immediately lower their interest expense. While this is certainly a compelling set of circumstances, we encourage borrowers to consider the following when evaluating such transactions:
- Swaps create prepayment risk. They may not always be terminated in conjunction with a sale or refinance at no cost to the borrower. Evaluation of swaps should always include consideration of prepayment risk.
- Swap documentation can create new risks for borrowers. As swaps require ongoing payment obligations by a borrower, a swap provider bank will typically build certain legal protections into swap documentation. If not negotiated, these can create “back-door” default provisions for the underlying loan.
- Swaps do not interact well with LIBOR floors in loans, a common feature in most floaters. Swaps that are not structured to factor in loan floors can result in a borrower’s interest expense increasing as LIBOR decreases.
- Swaps preclude upside from future potential declines in rates. While swap rates are currently less than 1-month LIBOR, it’s possible that this relationship will not persist very long. As per the first bullet, LIBOR may fall much closer to zero if credit conditions improve and the historical relationship between Fed Funds and LIBOR resumes.
- What’s the bigger picture? It’s easy to view current swap rates through the narrow lens of an immediate reduction in interest expense, but a thoughtful investor will ask a number of other questions. What’s the NOI profile of my investment? Is it likely to move in conjunction with LIBOR, creating a natural hedge? What’s my broader fixed/floating mix and how will a swap impact that? How will a JV partner or investor view a swap that looked attractive at the time it was executed but created a prepayment penalty when the asset was sold, or that prevents me from benefiting if rates fall further. Is the risk/reward really symmetric? We encourage our clients to ground any decisions around swaps (and risk management in general) in the bigger picture of the underlying investment and portfolio.
As LIBOR has fallen since the beginning of the year, my interest rate cap is now more “out-of-the-money”. Should I consider restructuring it to have a lower strike or replacing it with a swap?
With LIBOR (and market-implied expectations for future LIBOR settings) lower now than several months ago, many investors that had hedged interest rate risk with a cap may be asking themselves if they should take this opportunity to reduce the strike on their cap or replace it with a swap. We view these inquiries on a situational basis—in some cases this may make sense given the risk profile of the underlying asset and the risk appetite and views of the investor. But in all cases, this should be subject to many of the considerations discussed earlier in this piece. One situation where we’ve seen good reason to consider a restructure is on development deals where the development period may be getting extended due to construction delays. In these situations, there’s often an interplay between the hedge structure and the required interest reserve, and a hedge restructure may impact changes in this reserve.
I have a LIBOR loan that is swapped to fixed. If I receive forbearance on my loan interest expense, how will that work with my swap? Can I restructure my swap to reduce my interest expense?
Many of the CRE investors with whom we speak are currently in cash preservation mode. If you are considering approaching a lender about forbearance on a swapped loan that is secured by the mortgage or deed of trust, it is important to review the application of payments provisions within the loan agreement along with the ISDA documents governing the swap. Most property secured swaps are cross defaulted with the loan, but payment priority waterfalls vary, and a forbearance of interest under the loan may not automatically result in swap payments being deferred or reduced. A borrower looking to reduce their current interest expense on a swapped loan (but remain current on it) may be able to restructure the swap to have lower payments in the near term in exchange for higher payments later in the term (a “step-up” swap). Such a restructure may require additional credit approval from the swap provider and may not be available to all borrowers. There may also be accounting implications that accounting sensitive GAAP filers may need to consider.
Please feel free to reach out to your Chatham representative if any of the themes above resonate or you’d like to discuss them in additional detail.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal/notices/.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved. 20-0092
About the AuthorFollow on Linkedin More Content by Chris Moore