INTEREST RATE DERIVATIVES IN TODAY'S VOLATILE MARKETS

Transcription

1 INTEREST RATE DERIVATIVES IN TODAY'S VOLATILE MARKETS May 2011 Operator: Alice Dwyer: And with that, let's go ahead and begin our event. Once again, sponsored by PNC Advisory Series. It is my pleasure to introduce our moderator for today, Alice Dwyer (ph), Marketing Segment Manager, Corporate Institutional Banking. Alice, with that, I'll turn the floor over to you. Well, good afternoon and welcome to another PNC Advisory Series web seminar. I'll Alice Dwyer, Marketing Segment Manager for PNC's Corporate and Institutional Banking Marketing. Before we get started with the presentation today, I'd like to briefly address the ads you saw rotating on your screen as you were dialing in. As part of our ongoing commitment to helping our clients achieve, it's important for us to understand what you and your company need to perform on all fronts and we strive to provide you with ideas, insight and solutions to do just that. If you're not familiar with us or are interested in our perspective on the way we go to business, visit pnc.com/ideas to learn more. And now, on to our event. Today's focus is on "Interest Rate Derivatives in Today's Volatile Markets." And after today's session, you'll be able to download a PDF copy of the presentation, as well as a CTP certification credit for joining. We will also post a recording of the webinar at pnc.com/joinus. In addition, we want to let you know about our next webinar, coming up on June 30th. This will be an economic outlook with PNC's Chief Economist, Stuart Hoffman, and we hope you'll be able to join us for that, too. We're building the rest of our calendar for webinars for the remainder of the year and we continue to choose topics based on the input we get from you. So at the end of today's session, please provide the feedback we need to keep focusing on the right content for you. So on to today's topic. We have two industry specialists with us today. Hans Hurdle and Howard Sakin are Managing Directors with the Derivative Products Group of PNC and their detailed speaker profiles are available on the registration page for today's event at pnc.com/joinus. They will be providing an overview of today's interest rate movements. They'll also cover their recommended strategies for addressing risk in today's particularly volatile markets. Today's presentation will run for about 45 minutes and we'll then move into a question-and-answer session for the remainder of the hour. Howard Sakin will be starting us off today, so let me turn it over to the experts. Howard? 1

2 Howard Sakin: rate volatility really is. You can see a couple of definitions in front of you and these are kind of financial definitions and I've heard different things used to describe volatility. Of course, the simple one is volatility is the magnitude in the change in ranges and frequency of change. For a lot of people, what volatility really is, is when will rates go up and by how much and that's what most people are concerned about and they really want to mitigate risk against. Let's take a look at some other kinds of volatility. One is, events. We can see environmental events, political events, economic events and, of course, unknown and unknown can fit into any of those categories. In just the last six months alone, we've seen lots of events occur. We've seen tsunamis and we've seen the things in Japan we've heard to worry about. Certainly in the Middle East we've seen tremendous turmoil. We've seen lots of economic things occur over the last couple of years, including bubbles that have burst in terms of real estate, recession, worries about deflation and now, of course, worries about inflation. All those things have an effect on volatility and an effect of where rates are going to head. I think of those things that we see affecting us the most, of course, are economic issues, but unknowns, which we'd love to be able to list for you today, but certainly don't know what they are. If we did, we'd be in great shape. So as we go through all these, you'll hear us come back to that theme on more than one occasion is we're not quite sure what's going to happen and we need to try to protect ourselves against the risk of those unknowns. As you look at this particular chart, what you'll see there is a history of the Fed Funds Rate and 30-day LIBOR. Basically, that's where short-term rates have been. Actually, that goes back to the mid-'70s. You can see a tremendous amount of volatility, especially if you back here. Some of you probably read about this. Some of you may have lived through it. You see a lot of up and down, jagged edges there, rates moving up and down pretty rapidly back in the early '80s, but that's a long time ago now. That's almost 30 years ago, although people seem to remember it like it was yesterday. We've moved forward since then, of course. We picked out a couple of periods of time we're going to focus on in terms of our discussion to understand the history of rates a little bit. One is that period of the Clinton years and you can see that circled there and that's the mid-'90s when we had what we'll say is some prosperity there and then 2

3 more recently a time you remember, I think we have a much better memory of this time right here, where we see rates go up and then come back down again. We're going to use those same periods of time to look at long-term rates, as well. Here you can see that same period of time. It doesn't look quite the same. You see a lot more jagged edges there in terms of rates moving up and down. And we're using the 10-year LIBOR swap and U.S. Treasury rates when we talk about longterm rates there and, of course, here's that other period of time we mentioned a minute ago when we saw rates go up pretty quickly, plateau and then come back down. This should be a lot fresher in your memory. And, of course, at the end here, this is where we've been over the last couple of years and you probably remember that, just like you will see where short-term rates have been during that period of time. These are the long-- I'm sorry, we magnified and circled periods here to get a better look at where short-term rates have been. The difference between high and low here is only about 59 basis points, which is not a whole lot when you consider this covers just a little bit under three years. A lot of people look back to these years as being kind of a golden period where unemployment fell to very, very low rates. We had tremendous prosperity. If you wanted a job, you could get one. College graduates were very happy and you can see rates stayed-- hovered somewhere between 5.30% and 6% when we looked at 30-day LIBOR. This was a time we had a very healthy economy and a lot of times when you see a healthy economy these are the kinds of rates and the kind of stability in rates you see. The less stability we have, the more you see rate movements, especially in short-term rates. Also during this time we saw a growth of the subprime market and the large increase of mortgage-backed securities purchased by investors. No one thought about those things at that point in time perhaps sowing the seeds of problems in the future, but yeah that's when a lot of that began. We now move to that same period of time, but look at long-term rates during that period of time. There you can see we've seen movement in rates there. The difference between the high and low of the 10-year LIBOR swap is 1.64%, which is a lot more than we saw in terms of movement of the short-term rates, as people setting rates, borrowing and trying to figure what they wanted to lend, what they thought was going to happen to rates as we moved forward. We did see a small dip in late 1996, only to decline back to 1995 levels by the time we get back here again. It's very similar to where we started. So as the economy picked up speed and started to heat up, there was some concerns, which is why the rates went up here, but we had stability throughout that period. As people look at rates today, they start to look at history to see are we returning to a period like that again at some point in the future? Is that going to drive where 3

4 we'll be in terms of rates and what, exactly, is a good rate in a healthy economy. That's one of the reasons we look back the way we do. Here we look at those short-term rates again, but now we're looking at a different period of time. We're back to that period of time between 2004 and You can see a steady increase in rates there. It's not that jagged flow that we saw a couple of minutes ago, that mountain range we see when we talked about volatility. Instead, it's a steady climb followed by this plateau right here and what's interesting about this is it looks very much like those years we talked about in the mid-'90s. The rates are almost the exact same level there. If you look at that, it's probably because people expected that we had returned to a period of time where the economy was going to hum along, things were going to very well. We had to cool things down. Rates were increased quite a bit. But we had about a year here where rates stayed fairly level. It wasn't until 2007 that we stared the beginnings of the problems facing subprime lenders. As a result of that, the economy started to really get some stress to it and we saw rates start to decline. And then back in December of 2008, LIBOR dropped below 50 basis points for the first time ever and it's been there ever since. So for the last two years or even more than the last two years, LIBOR, except for this bump right here, has been below that 50 basis points. So, I mean starting right here, it's been below 50 basis points. If you look at this period of time right here, of course, that's when Lehman went bankrupt and there was great fear in the market in terms of can banks lend to one another. That's really a credit event that's occurring there as opposed to a-- what I'll call a conventional rate event. While there's a strong reaction to this, you can see it happened very quickly. Rates skyrocketed and plummeted very quickly 'til we got back to these levels and dropped below that 50 basis points for the first time here at the end of Now we can look at that same period of long-term rates, what was happening there. Once again, you can see what's going on. Unemployment was rising during that time period. Lehman filed for bankruptcy and, of course, the stock market dropped quite a bit during that period of time, although we later rebounded, as we all know. What's interesting, as you look at this, there's a big difference between the way short-term rates moved and long-term rates moved. You can't-- a lot of times we'll talk about rates in general, like, hey, these are the rates, rates are moving. They don't move together. While the Fed has a great deal of control over shortterm rates, they do not have as much control over long-term rates. There's lots of variables that affect those long-term rates and it's important to discuss those in terms of how it works, along with your needs in terms of borrowing money and what kind of rate strategy you might want to have. And if you go back and look at the other one again, you can see the differences. Here we see the steady climb in rates with that plateau and then that drop, and then as you go through the long-term rates for that same period of time, the rates stayed -- 4

5 not flat, of course -- but they didn't see that same kind of rise and fall. In fact, it's a very different picture during that period of time. So it's something to keep in mind as you look at what you might want to do in terms of managing interest rates in terms of what makes the most sense when you look at long-term versus short-term rates. That pretty much gives us a brief history of where rates have been over the last 20 years. It gives us some historical perspective. And now Hans is going to address the future. Hans? Hans Hurdle: 5

6 organization's-- that impacts an organization's mission and goals. Note that the outcomes of risk can be both positive and negative. Interest rate risk management specifically is a process where an organization maintains interest rate risk at an acceptable level. Now usually interest rate risk management is handled by a company's treasurer or CFO, but sometimes it can also be managed by the company's owner. Now on the slide on page 22, determining a strategy, one of the things that we advocate is that whoever is determining the interest rate risk management strategy for a company takes a holistic view. In other words, they're not only going to look at interest rate sensitivity as it relates to interest expense, but they're also going to take a look at how changes in interest rates impact the revenues and cash flows of an organization. 6

7 For example, if an organization has a fixed cash flow on the revenue side and they have a variable interest expense on the debt side, they are at high risk to rising short-term interest rates if they're a 100% borrower, 100% floating-rate borrower. If, on the other hand, they have-- they can pass all of the costs associated with rising interest rates on to their clients, in other words, get higher revenues during that period of time, then they're internally hedged by their cash flow. So, one of the things that we advocate that clients do is go through an analysis that looks at what happens to an organization's cash flows if, in fact, interest rates do change. There's a couple different tools that are out there for CFOs and treasurers. I'm just going to walk you through a couple different ones. You can do statistical forecasting and stress testing of your specific cash flows based on rise or fall in short-term interest rates. You can do all kinds of market simulations, including value at risk, cash flow at risk and earnings at risk that are more sophisticated. All of these are tools to analyze an organization's risk if rates move based on, once again, their revenue profile, as well as how their interest risk profile is structured. In other words, do they have all fixed rates? Do they have all floating rates? Do they have a mix? And how interest rates are impacted as a result of that. Howard is going to talk a little bit on the next slide about interest rate swaps, but just as a quick introduction an interest rate swap is an interest rate derivative or hedge and are contracts between parties designed to minimize or maximize exposure to rate movements. Howard is going to walk you through interest rate hedges, swaps and other type of interest rate hedges to mitigate interest rate risk. Thank you, Howard. All right. So what we're going to do now is going to look at how a swap works. I know some of you know how a swap works or you think you know how a swap works, but we're going to go ahead and review that very quickly to make sure it works the way you think it does. We try to make it, sometimes, simple, although sometimes it can be complicated. So let's talk about what a swap really is and we're going to focus primarily on a floating to fixed-rate swap. I hope. Okay. Bear with me, please. There we go. When you start to look at interest rates, you start with a floating-rate component, which is the LIBOR-- in this case, we're using 30-day LIBOR. Now the hedge, typically, when you start with a floating rate, is going to apply to that index market rate. In this case, you see 21 basis points for LIBOR. 7

8 That is the part of the rate, the component of your rate, that can float. That's what you have exposure to as we talked about that maximizing or minimizing your exposure to rates. The other component of the rate is typically that spread over LIBOR or whatever index you're using. If it's a tax exempt rate, it could be (inaudible). It could be a percentage of LIBOR. Any of those are indexes. So what you pay over that index is determined between you and the bank through a negotiation. That is something that is fixed as long as you and the bank agree that it's fixed. It's not market driven by the same way that the LIBOR rate is market driven. That's going to change day in and day out. Pretty much every day at 11:30, LIBOR changes. And a lot of rates change either monthly or quarterly or semi-annually, but those rates are going to change and that's the component you're worried about not working. In this particular example, we'd be at a 3.21% floating rate, all in, when you add the 21 basis points to the 3% straight floating rate. Now when we do the swap, all we're really doing essentially with a plain vanilla is substituting a fixed rate for the floating rate. In this case, we're using 2.50 as our example, which would end up in an all-in rate of 5.50%. Now I know I did that quickly, so I'll do it again. All you're really doing is substituting a fixed rate for the floating rate, okay? That's how you're going to end up with a fixed rate. It does not affect-- it does not affect the-- it does not affect this component of your rate up here unless you want to change that. So even if you were to affect the one aspect of it, you were to change the floating rate, you were to change the fixed rate, okay, the 2.50, as long as this stays the same, your rate's going to be fixed. If for some reason that were going to change, then this all-in rate when you go to the fixed rate, could, potentially, change, but only if this changes. Once you've got that swap rate in place, it's going to remain fixed on whatever portion of the debt you have elected to execute a fixed rate swap on. This is the famous box and arrows diagram that you see frequently from folks who talk about derivatives and you can see the same thing is happening. These are the mechanics. Here you see the 21 basis points here and the 3 basis points, added together to give you a That is your floating rate. Like we said over here, that's what you're paying. As part of the swap, you're going to receive back that 21 basis points, because that's LIBOR. If LIBOR was 5, you'd see a 5 over here and you'd see a 5 over here. These two things are going to cancel each other out during the swap. However, in compensation for that, the bank is going to be paid a fixed rate during the period of the swap. In this case, we're using-- in our example, we're using 2.5%. You're going to end up with this 2.5 plus the 3, as we talked about a minute ago. But the mechanics are you're going to pay the floating rate, the 3.21%, receive back the 21 basis points, and then pay the 2.50 to get back to the 5.50%. 8

9 If, for instance, this 21 was 5, we'd be actually paying you the difference between those two, but you'd be paying more here in terms of the floating rate to bring you back to the So no matter what happens during the term of the swap, for the amount of swap you're going to have a fixed rate, assuming that this, the spread, does not change. One of the things that causes the most concern when people talk about doing swaps and we talk about swaps, there's lots of other instruments that are tied to swaps. We're going to talk about a few of those in a minute or two, is what happens if I want to get out of this loan or I just want to terminate the swap. This is the most important thing that we need to talk about when we talk to clients, because it frequently happens. We don't want any surprises. So we want to be very clear about this. Swaps have a value, okay? They have a value because they're nothing more than a series of cash flows. They're a separate transaction. So frequently if a swap's terminated we're simply going to do what's called a cash termination and if the rate at termination is lower than the comparable rate, the replacement rate, we're going to call that, for the remaining term, you're going to make a makewhole payment to the bank. Once again, that replacement rate is simply the swap rate for the term that remains for the existing swap. So if you had originally done a 10-year swap and there's five years remaining, we're going to look at that five year rate and compare it to the original swap rate to determine whether or not you owe us money. On the other hand, if that rate is higher, symmetrical prepayment kicks in and the bank may owe you money. So, once again, you did a 10-year swap. At the end of five years, a swap rate for that remaining five year term is higher, then the bank is going to owe you money to want to terminate the swap. If you look at the math behind it, it's very similar to a bond and the goal here, quite simply, is to make sure that the party who's not receiving its money is going to be compensated for that interest that it's not going to get. If you compare this to a traditional fixed-rate loan with prepayment language in it, typically, a loan can only have a negative value. You don't see it on your balance sheet. No one ever discloses it to you, but if you called the bank and said, hey, I want to go ahead and pay off this loan, they're going to tell you how much you owe them. They're never going to tell you how much they owe you, because that's not the way a conventional fixed-rate loan works. That is one of the benefits of using swaps to get a fixed rate as opposed to using a conventional fixed-rate loan. Here's a display or an illustration of swap value. You can see that we assumed an original swap rate of 3.25%. You can see two replacement rates there, 2.25% and 4.25% and under 2.25% you can see it's got a negative value to you. It's 100 basis points lower than the original swap rate. You can see what the value is and as the years pass by, you can see that value gets lower and lower. That's simply because this is a present value calculation. The less time that remains until the swap matures, the lower the value is going to be, positive or negative. 9

10 Now if you look to the right of that, you can see how much the bank may owe you if you were to terminate a swap early and rates were actually higher, in this case, the 4.25%. Now most people immediately look at this and go, why would I owe more to the bank than the bank would owe to me. It doesn't really seem very fair. Well, if you think about a calculation is done on a present value basis, one of the key elements of that is a discount rate. As rates go higher, the discount rate is higher and the higher that discount rate in doing a present value calculation, the lower the absolute value. And that's what you're going to see as rates rise or go down. You're going to see that same kind of impact from those variables. But the key is what's the replacement rate for the swap and how much time remains in the swap. Of course, if all you is continue to make your payments under the loan and the swap, they'll expire and have no value at all. I want to talk a couple of minutes now about different kinds of swaps. One them is a forward-starting swap and all that means is that you pick a date in the future and I want to know what the fixed rate is going to be, beginning on that date. You make no payments between today and that date, but when that date kicks, you're going to know what your rate is and you'll start making payments under the swap on that date. Now I'm showing a five-year window, which is unusual. Typically, what you'll see with this kind of a swap, if you start looking at it, for example, this is kind of swap, it could be someone who's building something, a real estate developer, someone who's going to occupy their building. It's going to take them 18 months to build this. They don't know what the cash flow is going to be associated with that, so they don't want to do a swap commencing immediately. They want to know what the rate's going to be, though, at some time in the future when they put that building into service. An easy way to get there is to do a forward-starting swap. You can know exactly what the rate's going to be when the loan is fully funded and you're ready for payments to start being made. In fact, you may even want to do a swap like this if you're even going to go ahead and keep the loan with the bank. It may be that your goal is to build something and then go to a different lender who can give you a-- who might give you better terms. We hope not, but you might be able to get better terms that way, in which case, you could actually terminate the swap at that point in time and if rates are higher, the bank will owe you money. So if rates have gone up, you'll be compensated for that. So, I would suggest that you look at your projects, and, as Hans was mentioning doing this needs analysis before, as you look at what you're doing, what you're trying to mitigate, what risk you're trying to mitigate, you've got to look at the specific scenario that you're involved in, in terms of what makes the most sense. And I want to point out there, if for some reason the loan is not renewed, the forward will be cash settled. So it might be you did the loan with the idea that you were going to go ahead and move it to somewhere else, it doesn't happen, we may 10

11 still end up having the cash settlement swap, so you have to prepare for that and that value at that point in time could be positive or negative. Another swap that's very popular today is a cancelable swap. All a cancelable swap does is say, hey, pick a date in the future or pick multiple dates in the future and, on that date, if you decide to terminate the swap and rates are lower, you will not owe the bank anything. One of the things I like about a cancelable swap is it allows you to press the reset button. Even if rates are lower and you decide that, you know, you're going to keep your loan with the bank and you like the way things are going and rates haven't gone up, in fact they've come down, it gives you the chance to cancel that swap and do a new swap at a lower rate. It's helpful when companies think they may be doing something in the future, but they're not sure. Once again, you own a piece of property. You're thinking about selling it. You have a date in mind, especially, you know, if you have your own company and you maybe are nearing retirement and you just want to sell the real estate and you think it's going to happen in five years. You may plan to build in the opportunity or the option to cancel that swap in five years. You get to the end of the five years, you don't want to do what you originally planned. You're going to keep the building. If rates are higher, where you're in good shape is now you're protected against higher rates. If rates are lower it gives the opportunity to go ahead and get a lower rate, but in those circumstances you're not going to have to worry about owing the bank anything and that gives you a lot of flexibility in terms of looking at what your options are at that point in time. I think it's important to point out that any option you build in to any swap has a cost associated with it and, in this case, the cost of that option is going to be built into the swap rate. And you talk to a derivatives professional, they're going to be able to give you a lot of detail in terms of, gee, what's the difference between a rate with that cancelable option and without it and they'll be able to give you the details on that. The last one I'd mention here is a swaption. A lot of people like swaptions because they like the name more than anything, but all it really is, is an option to enter into a swap at some point in the future. You think you may want to borrow money and have a fixed rate at some point in the future, but you're not sure. You're not sure. You may want to be able to protect yourself against future rate movements. The difference between this and a cancelable swap is you're going to pay a premium to the bank today with the idea you can execute that swap at whatever point in the future you've already elected. Once again, you buy an option (inaudible) swap in three years. You do that because you may keep a building, you may not or maybe you just think rates are going to go up, but you're not sure and you don't want to be locked in to a long-term fixed rate if something else is available to you. So you buy the swaption. Three years rolls around and you look at where rates are on that day. If rates are lower, you're simply going to let the option expire. If rates are higher, you're going to execute the swap and even if you don't want to keep 11

12 the loan with the bank or you don't even want to keep the swap, because you know that the rights are higher you could terminate that swap and take the cash value of the swap. Okay? So as you look back at those three things, you can see them applying in different ways. We talked about a plain vanilla swap to start with. Then we talked about a forward-starting swap. We talked about a cancelable swap and we also talked about a swaption. Each of those things are a little bit different, but each one of those things allow you to take a look at what your circumstances are and decide what your risks are and what it is you're trying to protect your company against. It's also important to note, though, as we talk about these different structures that there's many, many more that you can use, but, more importantly, you can use a combination of these. You could actually use both a forward-starting swap and a cancelable swap on different amounts of the debt that you're looking at hedging. You could end up with having a floating rate on a third of your debt and you're going to have a forward-starting swap on a third of your debt and you could have a cancelable swap apply to a third of your debt. What's-- anything you can conceive in terms of structure and interest rates can be done. Whether it makes sense or not, that's a different question and one we always have to address. But it's something that typically can be done. If not, we're going to tell you right away, okay? Some things you want to remember in terms of the benefits of using swaps as opposed to conventional fixed-rate loans is the flexibility I talked about, of course, but most importantly is rate certainty. The rate certainty that we're talking about is knowing what's facing you in terms of how much exposure you have to interest rates. It's not, hey, I have a fixed rate on 100% of my debt. It's knowing, I have the interest rate risk management strategy in place that I want. It's not something that just happens from timing like my rate's going to reset on a certain date and there's nothing I can do about. That is taken away and now you can actually actively manage rate risk. You can manage the timing of when you want to fix rates. You can manage the effective dates of that rates. You can manage how long you want those rates to be in place for and the amounts and you can do that all within one structure without having to worry about, necessarily, altering your loan documents. So you can manage that as you move forward. Something that's important to note is that there is credit risk associated with swaps. Remember, the bank and the borrower are relying on each other to make payments under the swap. Okay? A swap can have a negative value for either party, so both parties have counterparty risk, both you and the bank. Now for the bank, what we do to protect ourselves against that, in most circumstances, but not all, is we cross default and cross collateralize credit exposure associated with the swaps, usually using the same collateral that serves as security for the related loan. Whether to secure it or not and how much you 12

13 need to secure is going to depend on your individual circumstances and the nature of the transactions that you're involved in with the bank. But as people say, what are the things I have to think about when it comes to swaps, there's two things I always mention. One, like any fixed-rate transaction, there's always a possibility it could have a negative value for you. If you do something at a certain rate and rates go down and you decide to terminate it, there's that possibility. The second one would be this credit risk that we just described a minute ago. Okay, these are the key facts and this all sounds familiar to you by now. One, remember swaps are separate transactions. They're separate from the loan. You could do a loan today and do a swap at sometime in the future. Or even before you do the loan. Rates are market driven, so you may be presented with rates today but they're going to change right up until you actually execute the swap. When you execute a swap, typically you do it over the phone on a recorded line with whoever you're working with from the bank and you get it done that way and they'll tell you exactly what the rates are at that point in time. Remember, swaps are just commitments to pay or receive future cash flows. They are not a separate loan. While we may secure it, it's not a separate loan. Typically, you know, the only way you owe money on a swap is if it happens negative value, which we mention in the next bullet point which is they can have positive or negative values, but at maturity, the value is zero. That way you don't have to worry about it any more. And the last one is important. You can do swaps for terms, sometimes, longer than the loan maturity. That's not always the case, but sometimes you can. When you do, if you were to terminate that loan early for some reason, the swap would probably also have to be terminated, because typically there's collateral considerations. So that's something to think about if you're going to do a swap for a term longer than the loan. Sometimes the question we get is, why would I do a swap for a term longer then the loan, then? Well, frankly, it's because rates right now on long-term rates are very good and a lot of borrowers want to be able to lock in the certainty of those rates, knowing that the economics of the rate apply whether we keep the swap with the bank or not. If you did a 10-year swap and left the bank after five years, because that's what you chose to, and rates were higher at that point in time, the bank would owe you money under symmetrical prepayment. That way you'd be able to buy down the rate if you were to go somewhere else or otherwise you're being compensated for that. So remember, the economics of the swap stay with you for the life of the swap, even if the loan is no longer with the bank. The last couple things I want to mention, of course, is lots of things that we do as part of PNC's derivatives trading group because here we're doing straight swaps, 13

14 there's things listed that are caps, collars, floors and we mentioned swaptions a minute ago. We also do foreign currency, of course. We can only cover a little bit today. We focused on where rates were, where we expect them to go in the future a little bit, how you can analyze what your needs are in terms of doing swaps and some of the different swaps we can do. Clearly, this is not all the things that we-- that one can do when looking at swaps and all kinds of hedges. I think the thing to remember, more than anything, is that as you look at this, that probably what makes the sense is really, since every borrower's situation is unique, to talk to a derivatives professional. We have lot of them. Ask questions to determine which strategy is going to work best for your company. Thanks. Thank you very much, Howard and Hans. We'll now move into the question-andanswer portion of today's event. We already have a lot of great questions coming in and so, time permitting; we'll try to respond to all of them. So the first question here, is now a good time to use derivatives? That's a question people-- that we get all the time, whether it's a good time to use derivatives or not. I think the real question there is now a good time to manage interest rate risk? I think it's always important to look at your interest rate and determine how you want to manage it. Once you determine how you-- what you want to do in terms of risk, using derivatives is certainly the most efficient way of managing interest rate risk. So I think the short answer to that question is, yes, it's a good time in terms of reviewing where you are in terms of your debt. You know, look at your debt as a portfolio of debt, not just as one piece of debt. You may have three or four different loans out there. Look at all of them. See how much is fixed, how much is floating. Does it make sense the way you currently have it structured and then use derivatives to actually manage your rate risk. Okay, thank you. And another question here, is there any special accounting treatment or FASB rules around executing swaps? Yes, Alice. To answer that question, there are. There are a number of different accounting pronouncements that relate to swaps. The one thing that we would advise all of our clients to do is talk to their-- directly to their accounting advisors in regards to that. There are many different rules that apply. The one comment I would make is that if you are doing what we call a highly correlating swap, in other words, a swap that correlates directly to an underlying debt, most often you get favorable accounting treatment. Well, thank you. And I was wondering if you could also talk a little bit about swaps with a cap or a collar option? Yes, not a problem. We mentioned a few minutes ago caps and collars. Caps and collars are certainly different than swaps, because they're limiting how much you would pay on the upside and how much you'd be required to pay on the downside. 14

15 Basically, you're creating a floor, so you're paying never less than that. And a cap, of course, is you'll never pay anything more than that. Caps and collars are-- a collar is basically using a floor and a cap and cap just stands on its own. If you're looking at a cap, you're going to pay a premium and it works like more like insurance. So you're going to pay a higher rate as rates float up, until you get to that cap. Whether that makes sense for you or not really depends on what you're trying to accomplish. Remember, you're going to pay a premium for the cap and then if rates go up, you're going to have to continue to pay those higher rates. So a lot of times, it depends on what your bias is towards where rates is headed. If you believe that rates are going to stay low, but you really got this little inkling that maybe they will go up, it might make sense to buy a cap. If you believe rates are going to rise, then I would say a cap might not make the most sense for you. Once again, there's no right answer. It depends on what your personal biases are. If you look at a collar, and sometimes you'll hear the comment, a no-cost collar, meaning that you're paying for the cap by selling the bank a floor, essentially. That can make sense under certain circumstances, but I think you have to look at what you're trying to do there very closely, as well, and that's-- when you start looking at caps and collars, especially, it's very important to compare them where a swap rate would be if you were only going to swap part of the debt and look through that analysis and consult with one of the derivatives professionals to really help you with that by understanding the pricing involved. Alice, just one point I'd like to add. Generally, we don't see clients doing longerterm caps in the market, because the premiums get very pricey once you get out in duration. Caps are priced largely based on volatility and duration at the end of the day. Longer-term caps are, generally, prohibitively expensive. Okay, thank you. And how much flexibility is there in pricing a swap? In pricing a swap, I'd say that the market, like any other market, has a bid and an ask and a mid. A lot of it depends, frankly, on the credit strength of the counterparties involved. Generally, the stronger the credit quality of the counterparties, the closer to the mid they are. The weaker the credit of the credit counterparty, the farther away they are from the mid. Okay, thank you. I have another question here. What is the current activity or appetite you're seeing with regards to clients doing fixed to floating rate interest rate swaps? Well, certainly we are seeing some of that being done, especially a few months ago when rates really dropped substantially. It really depends on what your fixed rate is and how long the fixed rate is and it's something that can certainly be done. It can be very beneficial. But it would assume, of course, that you're starting with a fixed rate. Most of our borrowers are starting with floating rates. You tend to see fixed-rate borrowers 15

16 who have bonds or other kinds of public debt outstanding who are looking to advantage of where short-term rates are. So, we're seeing quite a bit of that, when the circumstances are right for it. Once again, like anything else, it comes back to the pricing and what your goals are and what your biases are towards rates and how long your current fixed rate is for. As we get into these kinds of questions, they get more and more client specific and as they get more client specific, we need a lot more information to say, hey, this makes sense for you. I will say this, that doing fixed to floating rate swaps can make a tremendous amount of sense. I can give you examples of where we have one client who did a fixed to floating rate swap and is actually receiving a payment from the bank every month because their fixed rate was so low to begin with. So there are opportunities like that that will apply. So I think it's a great question to ask, but you will need to review your individual circumstances. Thank you, Howard. Can you, either of you, speak to the prepayment aspect when seeking a swap? Yes. As we outlined in the symmetrical prepayment pages, the way swaps are valued is based on the replacement rate, in other words, the rate to maturity at the time that you're looking to potentially prepay or terminate the swap. So if rates have gone up, the swap has value and if rates have gone down, the swap has a negative value. So it's very simple bond math, once you've gone through it. I think the key consideration to think about it is, when you're comparing it to a conventionally fixed rate debt, a conventionally fixed rate debt is generally asymmetrical. In other words, the worst you can do is break even-- excuse me, the best you can do is break even and the worst you can do is actually pay that same negative valuation that you would on a swap. Thank you. I have another question here. How many basis points might it cost for a cancellation feature, roughly? A ballpark? That really depends, of course. What we're seeing nowadays is, depending on how long-- it depends on how long the swap is and when you want to put the cancelability option in there. So there's no one right answer to that question, of course. But, you know, to give you an example of something we looked at just today and someone was doing a 10-year swap and they wanted to have the ability to cancel at the end of five years and the difference in rate was about 15 basis points. That could be very different, though, tomorrow or the next day, so I don't think I should be using it, as something we're going to as, hey, that's what the guy said on the line the other day during the webinar. It's going to move around. There are times when that could be very low and there's times where it could be higher. That's why it's important to look at the options to see if it makes a lot of sense and examine why the difference is whatever it is. 16

17 As a general rule, the more optionality you have built into a trade and the longer you have that optionality, the more expensive it's going to be. But once again, as Howard has mentioned, those premiums fluctuate moment to moment. Thank you. Another question here, is now the time to lock in interest rates for loans which will not be repaid for two to three years? That's a great question. It really depends on the fixed rate and where that's priced currently. The long and short of it is, if you have a fixed rate that's higher than prevailing market rates and that's going to run for another two or three years and you have a view that rates are going to move up, it's a great time to potentially take that higher rate and refinance it or defease it and restructure it with a lower term rate. A lot of it depends on the specific facts at hand. What I would suggest anyone that has a debt that's financing anywhere from one to three years out that you're talking to the PNC hedging desk and we do an analysis to determine whether it's worth your while. Okay, thank you. I have another question here from someone in the audience. If rates move against a lender, dramatically, how does the lender protect itself to meet all its obligations? I want to make sure I understand the question. I think this refers back to something-- I think this goes beyond swaps. If I understand correctly, it's like, what does the bank do to protect against, you know, meeting all of its obligations and, obviously, a bank has many obligations, not only to counterparties in terms of swap risk, but we have obligations to all of our depositors, to whom we all owe money and, of course, to all of our constituency and all of our stakeholders when it comes to the bank. And I think the best way to look at that is, what does the bank do in general in terms of making sure that the bank stays strong by looking at the various ratios, the capital requirements and so forth. I don't have the information in front of me, unfortunately, but I think one of the things we-- what they can look to and talk to either the relationship or a derivative professional and get that information directly from them in terms of how is the bank rated and what is our capital position, which is very strong. And it's a good question, because there is counterparty risk there. But that's what we worry about every day in terms of the bank is how do we make sure we can always meet our obligations and remain a very strong and a very sound bank to everyone. So we're happy to provide that information. I think that whoever's asking the question, it's a very important and good one, but the detail, actually, I think we need to get to you later. Alice, just to follow up on that, I mean, what the demise of Lehman taught us is that counterparty risk is real. It can happen and the swap counterparty can fail. To follow on Howard's comments, you know, a lot of firms and companies have multiple bank relationships. I think it's really important that you pick a bank that is very strong from a credit perspective when you're asking someone to take on counterparty risk, especially for an extended period of time. 17

18 So the strength of an individual bank who's providing not only depository and lending services, but also counterparty services is absolutely critical to individual companies out there. Thank you. And I have another question. We've got several questions coming in about where do you see rates trending in the short and long term? In regards to where we see rates trending, we can only tell you what the market sees, which, as we showed you on that implied curve it tells you that the market believes short-term rates, 30-day LIBOR specifically, are going to rise over the next year, retrench, and then, after two years, go up dramatically. If we had a better handle on that, frankly, we would be traders. I think the comment that we would take away from all this is that when we look at rates, we can take a look at where-- what the market believes longer-term rates are going to be right now and then integrate that into an interest rate risk management strategy. Thank you very much. And we have time for one last question here regarding how might the 2012 election affect rates? Well, that's anybody's question. That's a guess. You know, what's funny is, you look historically at the impact of elections, it's usually not the election itself, in terms of who gets elected, but how able they're going to be to create the kind of legislation that they're hoping for and how is that going to affect the economy. Certainly, if you look at things like healthcare reform after Obama took office, his ability to do that and to get that through and was it going to continue to go through and how is it going to affect the economy and American businesses is what's very important, not so much whether there's a Democrat or Republican in the White House. As we've seen, anybody in the White House is able to expand government and spend more money. I would say that looking at a specific election, we've seen if we go back into the numbers, that itself does not necessarily impact where rates are headed. But certainly have biases towards that. Just like if you look at the stock market, you can often see a correlation between who won the Super Bowl one year versus the next. The correlation may exist, but there may not be any cause and effect. So as we look at the elections in 2012, certainly we're way too far away, but the things to focus on are those events that are more economic in nature that may affect the election. So if you have an improving economy, that will probably affect the election and that would be more important than who actually gets elected. Thank you very much. I think we might actually have time for one more question, just looking at the clock here and then conscious of the hour. But I think we've got time for one more. A question here from someone who says I understand that banks do not hold the swaps but sell them at the time of the transaction. So is the bank guaranteeing the counterparty? Is the bank the guaranteeing counterparty? 18

19 We can't speak to any one particular trade. I would tell you every bank handles it differently. I know that at PNC we have a much more global view on rates. We do not take every individual trade and do another counterparty-facing trade to hedge that risk. So I would say that we keep trading risk on our books. We do hedge, kind of from a portfolio perspective, but that's more of a treasury function than an individual transaction function. And the last part of that, Alice, is that when someone does a swap with us at PNC, we are their counterparty and remain their counterparty for the life of the swap. So the risk they have, from a counterparty perspective, does remain between them and PNC. That's an important point. We are a market maker in swaps. There are other banks, generally smaller banks, who, frankly, lay off all of their risk and aren't market makers. We are market makers in interest rate swaps. Well, thank you very much. Well, we're just about time for today, but we'd like to thank our panelists for a great presentation this afternoon and we'd especially like to thank you for attending. A PDF of today's presentation, as well as a CTP certification credit will be available to you to download now via the handouts icon in the upper right portion of your screen. This is the icon that shows the three pieces of white paper. It's to the left of the feedback button. You'll also see a link to a short survey on your screen. Again, your feedback is important to us and we greatly appreciate your thoughts. This concludes our presentation for today and thank you very much for joining us. The materials or video that you are going to view were prepared for general information purposes only and are not intended as legal, tax or accounting advice or as recommendations to engage in any specific transaction, including with respect to any securities of PNC, and do not purport to be comprehensive. Under no circumstances should any information contained in those materials or video be used or considered as an offer or a solicitation of an offer to participate in any particular transaction or strategy. Any reliance upon any such information is solely and exclusively at your own risk. Please consult your own counsel, accountant or other advisor regarding your specific situation. Any opinions expressed in those materials or videos are subject to change without notice. Investment banking and capital markets activities are conducted by PNC through its subsidiaries PNC Bank, National Association, PNC Capital Markets LLC, Red Capital Markets, Inc., and Harris Williams LLC. Services such as public finance advisory services, securities underwriting, and securities sales and trading are provided by PNC Capital Markets LLC and Red Capital Markets, Inc. Merger and acquisition advisory and related services are provided by Harris Williams LLC. PNC Capital Markets LLC, Red Capital Markets, Inc., and Harris Williams LLC are registered broker-dealers and members of FINRA and SIPC. Harris Williams & Co. is the trade name under which Harris Williams LLC conducts its business The PNC Financial Services Group, Inc. All rights reserved. 19