April 11, 2011

With dread, or delight? How do you approach tax day? For many, it depends on whether or not you’re getting that refund check. More than 140 million tax returns will be filed by next Monday (yes, they’re due April 18th this year), and approximately 77% of all taxpayers have lent Uncle Sam a few bucks and are now due a refund. This time of year, there is no shortage of experts to tell you what you should have done last year to help reduce your tax bill, or increase that refund, but that’s little help now. These self-help columns could just as easily be talking about your derivative transaction. No, derivatives are not a “tax” per se, but filing your return or executing a hedge requires a similar level of planning and attention. And, it turns out, there are things you can do this year, right now, to save money on your next derivative transaction.

“Save money on your purchased cap bill now!” You desire or are required by your lender to purchase interest rate protection on your loan in the form of an interest rate cap. That’s what you know. The optimal structure and cost is what you don’t know. Your cap purchase will be a function of the marketable size, the optimal structure, and competition for your business, with appropriate consideration for your counterparty risk.

Marketable size. For starters, there are minimum costs that dealers require to structure and execute these trades. If your transaction has a small notional amount and a high strike, much of the cost may be tied to these minimum fees to cover general operating expenses of the dealer and less to the protection you actually need. Most dealers will put a price on any size deal so do not fear not being able to buy the cap but it is important to know how the price is derived and the true economic value of the cap.

Structure. Structuring the right cap and the least costly cap are not necessarily at odds with one another. In general, within any requirements of your lender, you should consider the cap strike that provides the protection you need, time period you want to cover and within a budget you can afford. Sometimes all three components can’t be achieved and one will have to give. This may be an iterative process, as you review several cap price indications and weigh the possible interest rate expense on your loan over the life of your hedge. Are you still comfortable with that LIBOR can reach your cap strike and it would not cause financial stress with debt service so high? Can you possibly pay a little bit more upfront and buy tighter protection or lastly can you cover a shorter time period in hopes the asset will be cash flowing better in the latter years? Consider carefully and then choose the structure to suit your needs and your wallet.

Competition. Once size and structure considerations have been addressed, the final area of savings is in competing your cap among several dealer banks whenever possible. You will generally find that several banks would be interested in providing your cap. This is good because options more than any other derivative can have a wide price range among dealer counterparties. Chatham routinely auctions interest rate caps among several providers to get you the best price at execution. The savings can be quite large at times, and very satisfying. But before you leap at the lowest price, there is an important consideration about your counterparty.

Counterparty Risk. A purchased cap will always be an asset to you, so your cap provider does not have credit risk to you (short of settlement risk on the cap premium, and a few other nasties like “repudiation” or “illegality.”) You, however, have credit risk to your cap provider. Before the credit crisis, this type of risk was real but often not carefully considered unless required by your lender that the cap counterparty meet a certain ratings requirements. That all changed when Lehman Brothers failed, and many found their cap provider…well…gone! Regardless of lender requirements, you must consider your counterparty’s financial strength, and only pre-qualify those providers that you are comfortable with to compete for your business. Just like so many people had questions about getting their tax refunds with a government shutdown looming (and barely averted), you don’t want to be questioning your cap provider’s ability to perform after you’ve made that purchase!

Ultimately, you will not encounter great difficulty in purchasing an interest rate cap. But just as most taxpayers go to a preparer or use tax software to maximize their return, you will want to consult an advisor that takes marketable size, structure, and competition into consideration. Chatham Financial can’t help you with your taxes, but we can help you weigh your optimal cap again your desired cost. Give us a call!