Interest rate caps are purchased to hedge floating rate loans every business day. Cap pricing is driven by economic factors including the notional hedged, term, strike rate, forward curve, and volatility of the underlying index. Other key factors that influence pricing are competitive environment and the documentation/legal requirements of the cap.
Counterparty Ratings Requirements
For the same reason you want a financially sound provider of life insurance - so you can be confident the provider will pay when there is a claim - lenders and borrowers also want a financially sound rate cap provider. This most often manifests itself in credit rating requirements on cap providers. When a lender sets out the requirements of a cap, they often stipulate minimum counterparty ratings requirements. Counterparty ratings requirements can be broken down into two buckets:
- Minimum Counterparty Ratings— are they qualified to provide the cap initially?
- The Downgrade Triggers— at what ratings are they no longer qualified to provide the cap?
Minimum Counterparty Ratings are the lowest credit ratings that a potential cap provider can have in order to qualify as a potential cap provider at the time of purchase, and this is pretty clear-cut—either they qualify or they don’t.
Downgrade Triggers require a cap provider to maintain certain ratings, and if they fail to maintain those ratings, the borrower (or its lender) may have the right to terminate the cap agreement and receive the then current value of the cap in a lump sum, unless the cap provider “cures” the downgrade. Because a rating downgrade is a credit event, cures are essentially a shoring up of credit. The most common cures available to cap providers following a ratings downgrade are:
- Replace themselves with another provider that meets the Minimum Counterparty Ratings
- Post collateral equal to or exceeding the mark-to-market value of the cap
- Obtain a guaranty from an entity that meets the Minimum Counterparty Ratings
Most lenders allow one or more of the above remedies. Both the Minimum Counterparty Ratings and Downgrade Triggers are designed to protect cap purchasers and lenders from counterparty credit risk.
Ratings and Downgrade Triggers Expectations
As S&P and Moody’s are historically the largest ratings agencies, they are the agencies for which cap providers are most often required to have ratings. Historically, Minimum Counterparty Ratings have ranged from as high as AA/Aa2 to as low BBB/Baa2, but the most common levels are in the single “A” range. Downgrade Triggers can also vary, but A- & A3 are the most common levels we currently see in commercial real estate loans.
Given there are many banks that are rated A- & A3 or better, one would think there should be many banks vying to provide caps with these requirements to real estate borrowers. But possessing high ratings is only one component of being a successful cap provider. In addition to having sufficient ratings, management must be confident the bank’s ratings will be maintained, and comfortable with the bank’s processes and procedures should downgrades occur.
Given the implications of counterparty ratings on both the potential availability and cost of interest rate caps, borrowers should carefully review any Minimum Counterparty Rating and Downgrade Trigger language in loan term sheets and make sure they understand the cost of compliance and how those requirements compare to the cost of other alternatives. As noted, these requirements can also vary over time and between lenders; many lenders have some flexibility on the requirements, but it is much easier to have these discussions while negotiating the overall loan terms than to address them just prior to loan closing upon realization of the significant increased cost. If a loan term sheet is silent or vague on the requirements (language such as “as reasonably acceptable to lender” is common), borrowers may want to discuss the lender expectations (if not actually documenting specific requirements) prior to finalizing a loan term sheet.
As a borrower, you likely place a high priority on avoiding material unbudgeted costs at the closing table. Understanding the impact of cap provider rating requirements and downgrade triggers is an important step to avoid an unpleasant surprise on your next floating rate loan.
About the AuthorFollow on Linkedin More Content by Tim Mitchell