Interest Rate Risk Management Refresher April 29, 2011 Presented to: Howard Sakin 410-237-5315 Section I Basics of Interest Rate Hedging? 1
What Is An Interest Rate Hedge? Interest rate hedges are contracts between parties designed to minimize or maximize exposure to rate movements. Interest rate hedges come in many forms. Today we will focus on swaps. 3 Swapping from Floating to Fixed The components of a floating interest rate. The credit spread is negotiated between the lender and borrower. Taxable 3.00% Tax-Exempt 1.95% 65% of 3.00% The swap applies to the index market rate..25% Libor.16% 65% of Libor Current floating rate 3.25% 2.11% 4 2
Swapping from Floating to Fixed The components of a floating interest rate. Taxable Tax-Exempt The credit spread is unaffected by the swap. 3.00% 1.95% 65% of 3.00% The swap rate is substituted for the index market rate. 2.60% 5yr swap rate 1.69% 65% of Libor 5yr swap rate Effective fixed rate 5.60% 3.64% 5 Basic Swap Mechanics Libor Swap Counterparty 2.60% 0.25% Borrower Borrower pays 3.25% floating Borrower receives 0.25% floating Borrower pays 2.60% fixed Fixed rate to Borrower is 5.60% 0.25%+3.00%= 3.25% Current Floating Lender 6 3
Basis Risk Basis risk is created when the index for the loan and swap do not match Swap Counterparty 1.69% 0.16% Borrower Borrower pays SIFMA Borrower receives % of Libor Borrower pays % of Libor Rate to Borrower can change as the relationship between indexes change. 0.25%+1.95%= 2.20% Current Floating Lender 7 The Benefits of using a Swap Rate certainty Symmetrical Prepayment Flexibility Amount - You decide how much debt has fixed rates. Term - You decide the maturity of the fixed rates. Timing - You decide when to fix rates. Effective Date You decide when the fixed rate begins. 8 4
Aggregate Swap Market Fixed Rate Lender XYZ Company: Comparative Advantage: Floating rate borrower Desired Rate profile: Fixed Solution: Swap Fixed Rate ABC Company Swap Rate Libor Swap Provider Trading Book Swap Rate PNC Swap Provider Trading Capital Book Markets Libor Swap Rate Libor XYZ Company Wall Street Dealers Libor ABC Company: Comparative Advantage: Fixed Rate borrower Desired Rate profile: Floating Solution: Reverse Swap Floating Rate Lender 9 Swap Value Because a swap is a promise to pay or receive cash in the future it can be valued. Determining the present value requires the cash flows and a discount rate. 10 5
What If the Hedge is Terminated? If a swap is terminated it is cash settled. If the rate at termination is lower than the comparable rate for the remaining term then you will pay a make whole payment to the bank. Swaps offer you a level playing field if you prepay. If the rate at termination is higher than the comparable rate for the remaining term then you will receive a make whole payment from the bank. Traditional fixed rate loans can have only a negative value if prepaid. 11 Hedging and Credit The bank and borrower are relying on each other to make payments under the swap. Because the swap can have negative value the bank has credit risk. In most circumstances the swap counterparty cross defaults and cross collateralizes credit exposure associated with swaps with the same collateral that serves as security for the related loan. Collateral calls. Some swaps are unsecured. 12 6
Hedging vs. Speculation Risk management strategy used in limiting or offsetting probability of loss from fluctuations in the prices of commodities, currencies, or securities. Taking large risks, especially with respect to trying to predict the future. Accepting cash payment up front. 13 Forward Starting Swap The purpose of a forward starting swap is to lock in a rate effective some date in the future. Example: A 5 year swap effective in 5 years. Swap Execution No payments Swap effective 0 1 2 3 4 5 6 7 8 9 10 Year 14 7
Forward Starting Swap A forward starting swap is a commitment to pay and receive cash flows and is valued like a spot starting swap. The rate is usually higher than a spot starting swap with the same maturity. There is credit risk to the swap provider. Entering into a Forward Starting Swap does not guarantee that the lender will extend a loan past its original maturity. If a loan is not extended by the swap provider it is common for the swap to be cash settled. 15 Cancellable Swap A Cancellable swap allows the borrower to cancel a swap on predetermined dates and owe no make-whole payment. Example: A 10 year swap with a negative value at the end of year 5 could be canceled without consequence. If the swap is terminated, customary symmetrical prepayment provisions apply. Rates are higher than comparable non-cancellable swap rates. 16 8
Swaption A swaption is the right but not the obligation to enter into a swap at some date in the future at a rate determined at execution. Example: ABC pays the hedge provider a premium for the right to exercise a 5 year swap 5 years from now at a specific rate. If rates are lower on the exercise date, the option expires. A swaption does have a value and can be terminated. Rates are higher that comparable non-cancellable spot starting swap rates. 17 Key Facts Swaps are separate transactions. Rates are market driven, subject to change until swap execution. Swaps are commitments to pay or receive future cash flows. Swaps have a value which can be positive or negative. The value at maturity is zero. If the swap is for a term longer than the loan and the loan is not renewed the bank has the right to terminate the swap. 18 9
Section II Rates Floating Rates - Libor 20 10
Historical Libor Rates 21 Historical Rates 1 Month Libor Fed Funds Rate Prime 22 11
Forward Interest Rates Forward Interest Rates represent the expectation of future Libor rates. Essentially, the the bond market continually predicts future Libor rates for specific future dates. The curve illustrated here is often referred to as the Forward Interest Rate Curve. 23 Forward Interest Rates The Swap Rate represents the average (present value basis) of the Forward Interest Rate Curve. 10 yr swap rate 5 yr swap rate 24 12
Yield Curve September 2000 September 1998 May 2003 April 2011 25 Yield Curve 4/14/10 4/14/11 10/4/10 26 13
Speaker Information Howard M. Sakin, is a Senior Vice President and Managing Director in PNC s Capital Markets Group. As part of the Deriviatives Products group his primary role is to advise, structure and execute interest rate hedges. During his 23 year career in banking Howard has worked in corporate finance, commercial loan workouts and mergers and acquisitions. He also worked in public finance where he structured and completed over 170 bond transactions and advised hundreds more on interest rate risk management. His clients consist of borrowers in many industries including healthcare, education, technology, real estate, manufacturing, distribution, government contractors and not-for profits. Howard regularly speaks to professional groups and served, for ten years, as an Associate Professor of Finance at the University of Baltimore. Contact Information: Howard Sakin Managing Director/Senior Vice President PNC Capital Markets Group, LLC Office: 410-237-5315 Email: howard.sakin@pnc.com 27 Appendix Summary of Recent Derivatives Legislation 14
Dodd-Frank Wall Street Reform and Consumer Protection Act Major Provisions: Investor Protection Measures Private Fund Adviser Regulation Regulation of Over-the-Counter Derivatives Financial Stability Special Assessment Resolution Authority Reorganization of Financial Regulators The Volker Rule Consumer Financial Protection Bureau Federal Insurance Office Moratorium on Study on Treatment of Credit Card Banks, Industrial Banks and Trust Banks. Supervision of Bank Holding Companies Payment, Clearing and Settlement Provisions Other Reforms dealing with Broker Dealer Regulation, Municipal Securities market, Investor Advocacy, Short Sales, SEC funding, Mortgage Brokers and Underwriting 29 Dodd-Frank Wall Street Reform and Consumer Protection Act Regulation of Over-the-Counter Derivatives Clearing and trading. The Act authorizes the CFTC and the SEC to mandate central clearing of OTC derivatives that are determined to be appropriate for clearing and capable of being cleared. The CFTC and the SEC may selfinitiate the review of OTC derivatives contracts or make a determination on contracts submitted for review by derivatives clearing organizations, and will take into consideration such factors as outstanding notional exposure, trading liquidity, operational clearing expertise and resources and systemic risk. An OTC derivative subject to mandatory clearing that is also accepted for trading on an exchange or swap execution facility would have to be executed on such exchange or facility. There is an exception to the clearing requirement for OTC derivatives involving at least one counterparty that is not a financial entity, where the counterparty is using the derivatives contract to hedge commercial risk and notifies the CFTC or the SEC how it generally meets its financial obligations under non-cleared OTC derivatives contracts. Reporting. OTC derivatives that are subject to mandatory clearing or are otherwise cleared also will be subject to real-time public reporting, resulting in public access to trade data including volume and pricing as soon as technologically possible after trade execution. Such reporting will not identify parties to the trades and may be delayed for block trades. In addition, each OTC derivatives transaction (whether cleared or uncleared, including those that were entered into prior to the enactment of the Act) must be reported to a swap data repository. 30 15
Dodd-Frank Wall Street Reform and Consumer Protection Act Regulation of Over-the-Counter Derivatives Regulation of market participants. Market participants in the OTC derivatives market that fall within the definitions of swap dealer or major swap participant will be subject to registration, capital, margin, reporting, recordkeeping and operational requirements. The Act generally defines swap dealer as any person who holds itself out as a dealer in, regularly engages in, or makes a market in OTC derivatives contracts. A major swap participant generally is any person who is not a swap dealer but maintains substantial positions in OTC derivatives contracts other than hedging positions, whose outstanding OTC derivatives positions create substantial counterparty exposure that could threaten the stability of the United States financial markets or who is a highly leveraged non-bank financial entity. Each swap dealer and major swap participant also will be subject to heightened business conduct standards. Swap dealers and major swap participants will be required to verify counterparty eligibility standards and to disclose certain information to their counterparties, including risks, any material incentives or conflicts of interest associated with the trades and the daily marks of the transaction (in case of cleared transactions only upon request of the counterparty). The Act also raises the standard of care owed by swap dealers that act as advisor to any federal, state or municipal governmental entity or agency or a retirement plan or endowment (referred to as special entities ) by imposing a duty to act in the best interests of the special entity. In addition, swap dealers and major swap participants may only act as counterparties to such special entities if they have formed a reasonable belief that the special entity has an independent sophisticated representative that acts in its best interests. 31 Dodd-Frank Wall Street Reform and Consumer Protection Act Regulation of Over-the-Counter Derivatives Margin requirements. For cleared OTC derivatives, any party that accepts initial and variation margin from a customer will have to be registered as a futures commission merchant or broker-dealer and maintain such margin segregated from its proprietary assets. For OTC derivatives that are not cleared, a swap dealer or major swap participant will be obligated to segregate initial margin with an independent third-party custodian if so requested by the counterparty. Segregated assets may not be rehypothecated. Position limits. The Act authorizes the CFTC and the SEC to establish aggregate position limits with respect to OTC derivatives traded on an exchange and nonexchange traded OTC derivatives that perform significant price discovery functions. The position limits restrict the number or size of positions in OTC derivatives that any person can hold. End user exemptions. Dodd-Frank exempts certain derivative contracts from the clearing requirements through an end user exemption. This applies if one or more of the counterparties (i) is not a financial entity (meaning swap dealer, major swap participant, commodity pool, private fund, employee benefit plan, or primarily engaged in banking or financial activities); (ii) is using swaps to hedge or mitigate commercial risk; and (iii) notifies the regulators (in a prescribed manner) of how it generally meets its financial obligations associated with these non-cleared swaps. Swaps trades that are not cleared will be reported to a swap data repository. 32 16
Dodd-Frank Wall Street Reform and Consumer Protection Act Regulation of Over-the-Counter Derivatives Swap dealer spin-off. The Act provides for a modified version of the spin-off clause that was included in the Senate bill. The provision prohibits the extension of any federal assistance, including access to the Federal Reserve discount window or FDIC deposit insurance, to swap dealers and major swap participants. The Act clarifies that FDIC-insured institutions that fall under the definition of swap dealer in the new regime are permitted to spin out their OTC derivatives activities to an affiliate that is controlled by the same bank holding company as long as such affiliate is independently capitalized and its liabilities are not guaranteed by the FDIC-insured institution. In a compromise worked out in the conference committee, the modified version of the spin-off clause in the Act includes an exemption that will allow insured depository institutions to retain their OTC derivatives activities to the extent they are limited to hedging activities directly related to the business of the institution or swaps involving rates or reference assets that are permissible for investment by a national bank (excluding uncleared credit default swaps). Insured depository institutions that would be subject to Federal assistance prohibition due to their existing OTC derivatives activities are granted a transition period of up to 24 months to divest or limit their OTC derivatives activities accordingly. 33 Dodd-Frank Wall Street Reform and Consumer Protection Act Regulation of Over-the-Counter Derivatives Market manipulation. The Act creates a private right of action against any person who employs manipulative devices in violation of CFTC rules and regulations relating to OTC derivatives contracts. Grandfathering of existing trades. OTC derivatives trades entered into prior to the enactment of the Act will not be subject to central clearing and trading requirements or to position limits. The Act also provides that, unless specifically provided for in their bilateral trading agreements, counterparties may not treat the enactment or the requirements of the Act as a termination event or similar event that would permit the early termination or modification of any grandfathered transaction. Many provisions of the Act, including many of the defined terms, position limits and margin requirements, will have to be clarified by regulations to be issued by the CFTC and the SEC. These agencies will have one year from the date of the enactment of the Act to jointly implement the provisions of the Act. Many provisions of the Act, including many of the defined terms, position limits and margin requirements, will have to be clarified by regulations to be issued by the CFTC and the SEC. These agencies will have one year from the date of the enactment of the Act to jointly implement the provisions of the Act. 34 17
Standard Disclosure FDIC-insured banking products and services, lending and borrowing of funds, investment and wealth management, fiduciary services, non-discretionary defined contribution plan services, and investment options are provided by PNC Bank, National Association Member FDIC and subsidiary of The PNC Financial Services Group, Inc. ( PNC ). Investment banking and capital markets activities are conducted by PNC through its subsidiaries PNC Bank, National Association, PNC Capital Markets LLC, and Harris Williams LLC. PNC Capital Markets LLC and Harris Williams LLC are registered brokerdealers and members of FINRA and SIPC. Services such as public finance advisory services and securities underwriting, sales and trading are provided by PNC Capital Markets LLC. Mergers and acquisitions advisory and related services are provided by Harris Williams LLC. Foreign exchange and derivative products are obligations of PNC Bank, National Association. Insurance products and advice may be provided by PNC Insurance Services, a licensed insurance agency affiliate of PNC or by licensed insurance agencies that are not affiliated with PNC; in either case a licensed insurance affiliate will receive compensation if you choose to purchase insurance through these programs. A decision to purchase insurance will not affect the cost or availability of other products or services from PNC or its affiliates. PNC does not provide legal, tax or accounting advice. PNC also does not provide investment advice to vested interest plan sponsors or participants. Information on market rates is gathered from sources believed by PNC to be accurate at the time of publication. Markets do and will change, therefore, PNC makes no representations as to the current yield or market for any security. Investments: Not FDIC Insured. No Bank Guarantee. May Lose Value. 2009 The PNC Financial Services Group, Inc. All rights reserved. 35 18