March 7, 2011
No doubt you’ve followed the play-by-play coverage of the NFL’s collective bargaining agreement (CBA) negotiations, and how players and owners appear miles apart on demands for next season. The owners want some $1billion in concessions from the players, an 18 game season, and a rookie wage scale. The players, well, they don’t like that. They really like the sweet deal they have now. The problem, according to owners, is that the last negotiated deal turned out to be a little too sweet for the players. The popularity of the sport is at an all time high, and the owners have made a ton of money, but they have also paid out a ton of money to the players. If both sides can’t agree on a new CBA soon, next season will be lost before it begins. The owners would basically ban contact with players, across all levels and activities in the league, including pre-season and regular season games. This dreaded “lockout” that the media has hyped to no end would mean no football next season, leaving fans furious and players precarious without their next paycheck.
It turns out the players are not the only ones facing a lockout. Borrowers face a worse deal yet, and there is no media hype, no star athletes tweeting support, and no clear deadline to stir last minute deal making. The lockout from low interest rates is uncertain in timing and yet unavoidable, and when it finally happens it will mean an end to an economic “sweet deal” that has persisted for more than 2 yrs now. Sure, it would be a stretch to say that borrowers have enjoyed the same prosperity as NFL players in the intervening years. After all, we are still crawling our way back from the Great Recession. But there is no denying that when rates finally do climb above pre-crisis levels, they may very well be high for years to come.
So what are you supposed to do? There is no CBA – Collective Borrowing Agreement – that governs all commercial and real estate lending in the U.S. It’s not like you can negotiate with Mr. Bernanke for 2 more years of near-zero interest rate policy, or for a 3rd round of quantitative easing (though it could be in the works). However, you do have options, and which one you choose will depend on your business preferences and view on interest rates.
Let it Float. The first choice is sometimes called the “do-nothing” option, but the reality is that most clients come to this decision both rationally and deliberately, after much internal debate. If you are taking out a floating rate loan now, or have an existing floating rate loan, one option is to let it ride – simply stay floating for the life of the loan. If you’re view is that rates will stay low for some time to come, then maybe the floating rate option is right for you. However, no one can say with certainty that this will continue. Floating rate loans inherently have interest rate risk, as any future upward movement in rates will directly translate into higher debt service. If you choose to float, understand your decision and establish periodic reviews to reaffirm or reconsider, based on new economic information along the way.
Cap or Swap. Purchasing an interest rate cap, or entering a pay-fixed swap, will limit or lock the debt service on your floating rate loan, and protect you from rising interest rates. The cap requires an upfront premium, but you can set the strike at an appropriate level that can still be affordable and achieve the protection you desire. A pay-fixed swap lets you lock in the curve at execution, and gives you fixed debt service throughout the life of your loan. Both instruments are very flexible, and let you hedge against some or all of the loan principal balance, and some or all of the loan term. These transactions also let you focus more on your business opportunities, and less on managing your interest rate risk. The cap or swap is right for those clients who have a view of rising rates, and want a ceiling or certainty on debt service for a given period of time.
Hedge Future Fixed Rate Financings. If you expect a future fixed rate financing in the next few years, you can lock in the curve today and still benefit from the low rate environment with a forward starting swap. The forward starting is structured to be effective some date in the future to correspond with your expected future financing date, with no payments due until the swap becomes effective. The swap will take on or lose value during the forward period, as interest rates move up and down along the way. You can then cash-settle the forward starting swap when your financing takes place, either paying termination costs if rates have fallen (and entering a lower fixed-rate financing) or receiving payment if rates have risen (and entering a higher fixed-rate financing). You still need to be mindful that a future financing may not materialize as planned, in which case your “hedge” becomes “speculation” and should be handled in accordance with your policies (typically it is terminated if financing falls through). Also, your counterparty may require some form of collateral during the forward period, since underlying loan collateral would not be available to secure the swap until the financing actually closed.
A future lockout from this low rate environment may be unavoidable, but you do have more options and bargaining power than you might have thought. Whether you want to float, cap or swap, or forward start a hedge to take advantage of the low rate environment now, Chatham can help you navigate your choices and keep your business in playing shape for next season!