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Hedging Term Loans: A Practical Guide for

Community Banks

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September 23, 2016 Presenter: Ed Kofman

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https://bankers.confedge.com/ap/eSite/?i=faq

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Risk and ProfitabilityHedging – A Practical Guide for

Community Banks

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HEDGING

This Presentation Will Cover:• Why banks do and do not hedge

• What is a swap

• How to generate hedge fees

• How to price hedge loans

• How to explain symmetrical prepay

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HEDGING• How to set borrower rate expectation

• What is the forward curve

• What are the alternatives to hedging

• Differences between loan and balance sheet hedging

• How to handle existing borrowers

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• Assumable and assignable feature of hedges

• Acceptable loans for hedging

• Hedging compared to FHLB advances and brokered CDs

• What is the borrower's counterparty risk

• How to protect the bank for hedged loans

• Procedures for loan hedging

• Measure of exposure ‐ VAR5

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Historical Bank Behavior• 5‐year interest re‐pricing;

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• Historically, worked as rates decreased;

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• Graph of 5‐year rates;

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• Graph of 5‐year rates;

• Projected rates.

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HEDGINGHistorical 5‐year Rates

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HEDGINGProjected Rate Outlook

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What are Alternatives to Hedging?• Duration gap‐‐mismatch;

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What are Alternatives to Hedging?• Duration gap‐‐mismatch;

• Offer loans that match liability structure.

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Hedging vs FHLB Advance/Brokered CDs• FHLB advances/Brokered CDs:

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– Effective in managing IRR but replaces bank’s low cost of funding with higher cost liability;

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– Effective in managing IRR but replaces bank’s low cost of funding with higher cost liability;

– Intended as source of funding not IRR management.

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Hedging vs FHLB Advance/Brokered CDs• Accounting:

– Fixed rate loan;

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– FHLB borrowing or CD liability;

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– Restricted assets pledged to FHLB;

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– Restricted assets pledged to FHLB;

• Structure Flexibility:

– Limited flexibility.

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Hedging vs FHLB Advance/Brokered CDs• Prepayment:

– Expensive prepayment cost to bank under most circumstances;

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Hedging vs FHLB Advance/Brokered CDs• Prepayment:

– Expensive prepayment cost to bank under most circumstances;

• Liquidity:

– Bank must pledge collateral for FHLB borrowing and future liquidity is jeopardized.

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Hedging vs FHLB Advance/Brokered CDs• Cost:

– Lower starting NIM;

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– Reduces bank’s future liquidity with FHLB or the market;

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– Reduces bank’s future liquidity with FHLB or the market;

– Eliminates bank’s short‐term funding and retail deposit advantage.

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Loan/Balance Sheet Hedge Differences:For Loans

• Description:

– Each loan is hedged individually;

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• Description:

– Each loan is hedged individually;

• Instruments available:

– Swap, cap, floor, cancellable features and combinations.

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• Execution & size:

– For loans as small as $500k, costs borne by client;

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• Advantages:

– Does not require an all‐or‐none decision;

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• Advantages:


– Simpler accounting;

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• Advantages:


– Simpler accounting;

– Ability to generate fees.

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• Advantages: (cont.)– May be added in small amounts as balance sheet, interest rates and marketing opportunities change;

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– Cost of prepayment shifted to borrower;

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– Cost of prepayment shifted to borrower;

– Marketing support for lenders & more disciplined pricing for bank.

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• Disadvantages:

– Not immediately effective for existing balance sheet GAP issues;

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HEDGING


• Disadvantages:

– Not immediately effective for existing balance sheet GAP issues;

– Requires lenders to market and understand product.

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Loan/Balance Sheet Hedge Differences:For Balance Sheet

• Description:

– A set of assets or liabilities are hedged;

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• Description:



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• Description:



– Swap, cap, floor, cancellable features and combinations.

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• Execution and size:

– Efficiency is created w/hedge size >$10mm;

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• Execution and size:

– Efficiency is created w/hedge size >$10mm;

• Advantages:

– Borrowers/depositors not involved in hedging process.

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• Advantages: (cont.)

– Large and immediate hedge impact;

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– Cheaper execution;

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– Cheaper execution;

– Most effective for existing balance sheet GAP mismatch.

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• Disadvantages:

– Possibly complex accounting;

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• Disadvantages:


– Extensive ALM analysis required to achieve an effective strategy;

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• Disadvantages:


– Extensive ALM analysis required to achieve an effective strategy;

– Transfer repayment and convexity risk from borrowers and depositors to bank.

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• Disadvantages: (cont.)

– More execution risk (one hedge trade vs. many, and management must make one large decision on timing, instrument type, and notional amount).

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HEDGINGFUNDAMENTALS

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What is a Swap?• Interest rate swap is an exchange of cash flows between entity that pays fixed rate, and second entity that pays multiple, short‐term rates;

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What is a Swap?• Interest rate swap is an exchange of cash flows between entity that pays fixed rate, and second entity that pays multiple, short‐term rates;

• At the swap inception, both parties expect to receive and pay equivalent economic value.

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What is a Swap?

Entity A Entity B

Pay Fixed Rate

Pay Variable Rate

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What is a Swap?• The swap rate is determined by market’s expectation of where short‐term rates will be over life of the swap;

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What is a Swap?• The swap rate is determined by market’s expectation of where short‐term rates will be over life of the swap;

• Similar concept applies in the Treasury market —yield on 10‐year Treasury is market’s average expectation of yield on next 40 consecutive 3‐month Treasury Bill yields.

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What is the Forward Curve?

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Back‐to‐Back Swap

Bank Broker/Dealer

Pay Fixed Rate

Pay Variable Rate

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Bank Broker/Dealer

Pay Fixed Rate

Pay Variable Rate

Borrower

Pay Variable Rate

Pay Variable Rate

Pay Fixed Rate

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Bank Broker/Dealer

Pay Fixed Rate

Pay Variable Rate

Borrower

Pay Variable Rate

Pay Variable Rate

Pay Fixed Rate

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Why Banks Hedge• Reduces Interest Rate Risk: Bank accrues on a variable rate—a desirable position in a rising rate environment;

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Why Banks Hedge• Reduces Interest Rate Risk: Bank accrues on a variable rate—a desirable position in a rising rate environment;

• Improves Credit Quality: Bank has an excellent opportunity to stabilize borrower’s cash flow w/lower fixed payments (particularly in extended low interest rate periods).

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Why Banks Hedge• Increase Loan Growth: Majority of commercial borrowers seek longest term fixed‐rate available;

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Why Banks Hedge• Increase Loan Growth: Majority of commercial borrowers seek longest term fixed‐rate available;

• Banks that can accommodate borrower’s demand will improve chances of winning more high‐quality loan business.

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Why Banks Hedge• Protects Relationships: Locking in existing clients for long‐term, fixed rate structures protects those relationships from competitors;

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Why Banks Hedge• Protects Relationships: Locking in existing clients for long‐term, fixed rate structures protects those relationships from competitors;

• Generates Fee Income: Banks have option to generate hedge fee income that may be used as increased revenue, lower loan closing costs, or incentivize lenders.

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Why Banks Hedge• Lender Training: Provides training to educate and empower lenders, so they are comfortable/ motivated to generate loan volume for bank by offering long‐term fixed rate loans.

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Why Some Banks Don’t Hedge• Complexity—accounting, documentation, & prepayment;

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• NIM now;

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• NIM now;

• Intimidation;

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• NIM now;

• Intimidation;

• Previous negative experience.

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Three Types of Loan Swap Programs• Hedge Program:

• Embedded Swap: Loan to borrower is fixed rate, and bank enters into a swap;

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• Back‐to‐Back Swap: Bank enters into two swaps— one with borrower and a mirror swap with a swap dealer.

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• Back‐to‐Back Swap: Bank enters into two swaps— one with borrower and a mirror swap with a swap dealer.

• Assumable Rate Conversion: Off balance loan hedging program

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ARC Vs. Swap Program• Hedge Program:

• ARC: Bank extends floating rate loan to borrower, ARC provides hedging addendum to borrower.

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ARC Vs. Swap Program• Disadvantages:

• Embedded Swap:

– Bank must comply with hedge accounting;

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• Embedded Swap:


– Bank has regulatory reporting requirements;

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• Embedded Swap:



– Bank must post collateral for derivative.

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• Back‐to‐Back Swap:

– Borrower has two invoices;

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– Borrower signs 45‐page ISDA document;

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– Bank must set up infrastructure for settlement;

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– Bank must post collateral.

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ARC Vs. Swap Program• Advantages:

• ARC:

– No swap accounting for bank or borrower;

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• ARC:


– No ISDA documents for either borrower or bank;

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• ARC:



– Declining balance prepay may work;

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• ARC:



– Declining balance prepay may work;

– No Dodd‐Frank reporting for bank.

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• ARC:

– Borrower must sign a document (addendum to note) with ARC.

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ARC Vs. Swap Program• Best situation use:

• ARC:

– Loans sizes of $500,000 and greater;

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• ARC:


– Banks not willing to commit to large hedge volume;

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• ARC:


– Banks not willing to commit to large hedge volume;

– Bank prefers not to hold derivatives on its balance sheet.

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PRICING

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How to Price Hedge Loans (A+B=C)• Borrower’s loan rate is composed of two inputs: a) rate index, plus b) spread over index;

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• Index:– If borrower wants floating rate loan, index may be Prime or LIBOR;

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• Index:– If borrower wants floating rate loan, index may be Prime or LIBOR;

– If borrower wants fixed rate loan, index is typically a hedge rate (or, occasionally a Treasury rate is used).

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How to Price Hedge Loans (A+B=C)• Index: (cont.)

– Hedge rate would correspond to borrower’s fixed term;

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– For example, if borrower wants 10‐year fixed rate, the index would be 10‐year hedge rate;

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– For example, if borrower wants 10‐year fixed rate, the index would be 10‐year hedge rate;

– The index is a market‐driven rate that cannot be controlled by banks.

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How to Price Hedge Loans• Spread:

– Spread represents the price margin that bank is willing to accept for loan as compensation for possible credit losses, overhead, & the bank’s return on capital (profit);

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How to Price Hedge Loans• Spread:

– Spread represents the price margin that bank is willing to accept for loan as compensation for possible credit losses, overhead, & the bank’s return on capital (profit);

– Subject to competition, bank establishes spread based on loan size, credit quality, & relationship profitability (incl. expected fee income/deposits).

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HEDGINGHedge Rate Example• Table reflects rates at a moment in time for various commercial loan structures.

3yr final 4yr final 5yr final 6yr final 7yr final 8yr final 9yr final 10yr final 12yr final 15yr final 20yr final

3yr Am. 1.15% ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐

5yr Am. 1.19% 1.23% 1.24% ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐

7yr Am. 1.20% 1.25% 1.29% 1.31% 1.31% ‐ ‐ ‐ ‐ ‐ ‐

10yr Am. 1.21% 1.26% 1.31% 1.34% 1.38% 1.41% 1.43% 1.44% ‐ ‐ ‐

15yr Am. 1.21% 1.27% 1.31% 1.36% 1.41% 1.45% 1.48% 1.51% 1.55% 1.60% ‐

20yr Am. 1.21% 1.26% 1.30% 1.36% 1.42% 1.45% 1.49% 1.53% 1.60% 1.68% 1.71%

25yr Am. 1.22% 1.27% 1.31% 1.37% 1.42% 1.46% 1.51% 1.55% 1.62% 1.72% 1.77%

30yr Am. 1.22% 1.27% 1.31% 1.36% 1.42% 1.46% 1.51% 1.56% 1.63% 1.74% 1.79%

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LOAN HEDGINGHedge Rate Example• For example, the 25‐year amortizing, 10‐year fixed hedge index is 1.55%.

3yr final 4yr final 5yr final 6yr final 7yr final 8yr final 9yr final 10yr final 12yr final 15yr final 20yr final

3yr Am. 1.15% ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐

5yr Am. 1.19% 1.23% 1.24% ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐

7yr Am. 1.20% 1.25% 1.29% 1.31% 1.31% ‐ ‐ ‐ ‐ ‐ ‐

10yr Am. 1.21% 1.26% 1.31% 1.34% 1.38% 1.41% 1.43% 1.44% ‐ ‐ ‐

15yr Am. 1.21% 1.27% 1.31% 1.36% 1.41% 1.45% 1.48% 1.51% 1.55% 1.60% ‐

20yr Am. 1.21% 1.26% 1.30% 1.36% 1.42% 1.45% 1.49% 1.53% 1.60% 1.68% 1.71%

25yr Am. 1.22% 1.27% 1.31% 1.37% 1.42% 1.46% 1.51% 1.55% 1.62% 1.72% 1.77%

30yr Am. 1.22% 1.27% 1.31% 1.36% 1.42% 1.46% 1.51% 1.56% 1.63% 1.74% 1.79%

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Hedge Rate Example• If bank prices loan at +2.50% spread, then borrower’s rate would be 4.05% (1.55% + 2.50%).

Three ways to close:1) Lock at close,2) Lock in advance,3) Forward rate lock.

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Hedge Rate Example• The bank will earn 1‐month LIBOR plus 2.50%;

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• If bank wants to earn 1‐month LIBOR plus 2.00%, borrower’s fixed rate would be 3.55% (1.55% + 2.00%);

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• If bank wants to earn 1‐month LIBOR plus 2.00%, borrower’s fixed rate would be 4.18% (2.18% + 2.00%);

• If the borrower’s fixed rate for the same structure is 4.50%, then the bank will earn 1‐month LIBOR plus 2.95% (4.50% minus 1.55%).

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Acceptable Loans for Hedging• Loan amounts between $500k and $50 million;

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HEDGING


• Up to 20 years final maturity, and 30 year amortization;

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• Maximum LTV ratio of 85%;

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• Maximum LTV ratio of 85%;

• Minimum debt service coverage ratio 1.20x.

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Acceptable Loans for Hedging• Property types considered for hedging include CRE, multifamily housing, special use, hospitality, self‐storage, industrial, & retail;

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• Borrower minimum $1mm net worth;

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• Borrower minimum $1mm net worth;

• Excluded asset classes – vary by bank.

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COMMERCIAL APPLICATION

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How to Generate Hedge Fees• Non‐interest Income:

• Future payments to be made by borrower on hedge can be paid to lender upon execution of the hedge;

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How to Generate Hedge Fees• Non‐interest Income:

• Future payments to be made by borrower on hedge can be paid to lender upon execution of the hedge;

• This fee is the economic value of a hedge that’s executed above prevailing market rates.

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How to Generate Hedge Fees• Non‐interest Income: (cont.)

• This hedge fee is paid to bank and may be recognized upfront as non‐interest income.

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How to Generate Hedge Fees• Hedge Fee Math:

• Hedge fee represents present value of a future hedge spread;

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How to Generate Hedge Fees• Hedge Fee Math:

• Hedge fee represents present value of a future hedge spread;

• For example, a $2 million loan may be hedged w/25‐year amortization & 15‐year call.

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How to Generate Hedge Fees• Hedge Fee Math: (cont.)

• The starting hedge rate is 1.72%, and the bank’s required LIBOR spread is 2.50%;

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• The starting hedge rate is 1.72%, and the bank’s required LIBOR spread is 2.50%;

• The borrower’s rate without any a fee is 4.22% (hedge rate plus the spread).

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• However, if borrower is willing to pay 4.42% & bank is interested in a hedge fee, then 0.20% spread is embedded into hedge rate;

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• However, if borrower is willing to pay 4.42% & bank is interested in a hedge fee, then 0.20% spread is embedded into hedge rate;

• The borrower pays a hedge rate of 1.92% plus a credit spread of 2.50% or 4.42%.

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HEDGING


• The present value of the 0.20% spread in this $2 million example is approximately $36,396.

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Fee CalculatorBasis points fee 0.20%

Initial balance: 2,000,000$ Amortization Term (yrs): 25

Commitment Term: 15Initial Hedge Rate: 1.92%

Fixed Rate to Borrower: 4.42%

Approximate ARC Referral Fee: 36,396$

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How to Generate Hedge Fees• Fee or Interest Income:

• Given borrower’s willingness to pay acceptable all‐in fixed rate, bank may chose how much income to allocate to fee income and how much to interest income.

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How to Generate Hedge Fees• Fee or Interest Income: (cont.)

• Having the ability to apportion revenue to either interest income or fee income is a powerful tool used by national banks for decades;

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• Having the ability to apportion revenue to either interest income or fee income is a powerful tool used by national banks for decades;

• Recognizing fee income versus interest income has certain advantages to banks.

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HEDGING


• Fee income may be recognized immediately, whereas interest income is recognized over the life of the loan;

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HEDGING


• Fee income may be recognized immediately, whereas interest income is recognized over the life of the loan;

• In a low interest rate environment, this distinction is particularly important for banks.

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• Boosting current income is more important when rates are low, versus in future periods when interest rates are expected to be higher;

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• Boosting current income is more important when rates are low, versus in future periods when interest rates are expected to be higher;

• Furthermore, if loan prepays, as many loans do, interest income ceases, but the hedge fee collected will remain with the bank.

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• National banks have used hedge fees to increase their competitiveness when pricing their swapped loans.

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HEDGING

Hedging Construction Thru Term Loan• Forward‐Starting Hedges:

• Hedges can accommodate future starting loans;

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Hedging Construction Thru Term Loan• Forward‐Starting Hedges:

• Hedges can accommodate future starting loans;

• This tactic provides borrower w/certainty of fixed‐ rate payments on loans expected to fund at a future point in time.

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HEDGING

Hedging Construction Thru Term Loan• Forward‐Starting Hedges: (cont.)

• The lender also eliminates interest rate risk by locking a spread over a variable index;

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HEDGING

Hedging Construction Thru Term Loan• Forward‐Starting Hedges: (cont.)

• The lender also eliminates interest rate risk by locking a spread over a variable index;

• Both borrower & lender are protected from unexpected interest rate changes.

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HEDGING

Hedging Construction Thru Term Loan• When To Use Forwards:

• Forward rate locks are best used when borrower wants fixed interest rate & lender is willing to provide loan, but neither party is ready to consummate transaction.

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Hedging Construction Thru Term Loan• When To Use Forwards: (cont.)

• The intervening forward period most likely is result of requirement to construct project, draft closing documents, or complete other due diligence steps (i.e. environmental or appraisal);

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HEDGING


• The intervening forward period most likely is result of requirement to construct project, draft closing documents, or complete other due diligence steps (i.e. environmental or appraisal;

• Forward hedges can be for as short as a week, up to as long as 24 months.

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• Shorter rate lock periods tend to be less appealing because of added complexity & effort to document, and secure a forward hedge (w/ elimination of only short term interest rate risk).

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HEDGING

Hedging Construction Thru Term Loan• Additional Risks:

• To lock a forward rate, borrower needs to sign interim agreement, or swap that starts in future;

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Hedging Construction Thru Term Loan• Additional Risks:

• To lock a forward rate, borrower needs to sign interim agreement, or swap that starts in future;

• There’s no cost to borrower to enter forward rate agreement, but if they don’t close loan, and consequently doesn’t need a hedge, there will be economic consequences to borrower.

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HEDGING

Hedging Construction Thru Term Loan• Additional Risks: (cont.)

• Either a net cost or benefit will arise, depending on the interim interest rate movement;

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• To secure obligation for the hedge, borrower must pledge collateral during the lock period to protect against potential cost to unwind hedge;

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• To secure obligation for the hedge, borrower must pledge collateral during the lock period to protect against potential cost to unwind hedge;

• Collateral is returned when the loan funds.

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• Major risk to borrower is if loan does not fund, regardless of reason, then borrower is subject to a prepayment penalty (if rates decreased), or benefit (if rates increased).

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• Forward‐starting hedges are advisable if both lender & borrower are highly certain of loan parameters, such as funding date, credit structure, and dollar amount.

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Enhance Yield: Hedge w/Forward‐Start• The Issue:

• In low‐rate interest environment, when rates are expected to rise significantly, banks give up immediate yield when hedging loans;

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• Trade‐off is to gain more future yields and eliminate interest rate risk;

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• Trade‐off is to gain more future yields and eliminate interest rate risk;

• Yield reduction is painful for most banks.

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Enhance Yield: Hedge w/Forward‐Start• The Solution:

• Instead of hedging every year of loan’s fixed rate coupon, bank accepts interest rate risk for first one‐two years, and hedges tail‐end of loan’s cash flow.

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Enhance Yield: Hedge w/Forward‐Start• The Solution: (cont.)

• For example, on 10‐year fixed rate loan w/4.50% rate, bank earns 4.50% in first year & a spread over LIBOR for next 9 years;

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Enhance Yield: Hedge w/Forward‐Start• The Solution: (cont.)

• For example, on 10‐year fixed rate loan w/4.50% rate, bank earns 4.50% in first year & a spread over LIBOR for next 9 years;

• Majority of interest rate risk is protected, but bank earns full 4.50% for the first year of loan, with no immediate yield reduction.

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Diagram Example

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Explaining the Symmetrical Prepay• Purpose of hedge prepayment provision is to compensate lender for loss/gain incurred as a result of borrower’s prepayment;

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Explaining the Symmetrical Prepay• Purpose of hedge prepayment provision is to compensate lender for loss/gain incurred as a result of borrower’s prepayment;

• For example, bank that issued a 10‐year loan at a specified interest rate did so with intention of earning a projected return based upon that specified rate.

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Explaining the Symmetrical Prepay• When borrower decides to repay loan after five years to take advantage of lower rates, bank’s earnings projections are invalidated;

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Explaining the Symmetrical Prepay• When borrower decides to repay loan after five years to take advantage of lower rates, bank’s earnings projections are invalidated;

• Instead of getting their original (higher) yield, bank can only reinvest its capital at the lower current rate.

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HEDGINGUnwind Cost/Benefit Over Life of a Hedge• $1MM orig. loan balance @4.03% fixed, 1mo. LIBOR + 2.50% floating, 10‐yr. maturity, 25‐yr. amortization.

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HEDGINGHow to Use the Prepayment Calculator

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Assumable/Assignable Hedge Feature• Terms provide ability for new borrower to assume hedge on existing collateral;

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Assumable/Assignable Hedge Feature• Terms provide ability for new borrower to assume hedge on existing collateral;

• Terms provide ability for existing borrower to assign hedge to a new loan on new collateral.

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Assumable/Assignable Hedge Feature• Qualifications for assumability and assignability:

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– Loan size;

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– Loan size;

– Amortization and term;

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– Loan size;


– Underlying collateral type;

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– Loan size;


– Underlying collateral type;

– Credit underwriting requirements.

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Blend & Extend• Convert shorter hedge to longer term for borrower;

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• No out‐of‐pocket fee for borrower to pay;

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• When will it make sense to convert?

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– Short term to maturity;

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– More money requested;

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– More money requested;

– Rates are presently lower than when hedge was originally booked.

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MARKETING

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Suitable Borrower Candidates• Hedges make sense for borrowers w/expectations:

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– That interest rates will rise over contractual life of loan;

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– That they will hold loan for substantial portion of contractual loan term; or

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– That they will hold loan for substantial portion of contractual loan term; or

– To have future financing needs on other projects/ properties and want to maintain fixed rate on current loan for those future projects/properties.

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Prospecting for Quality Loans• Meet market demand while enhancing credit quality via stabilization of borrower cash flow;

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• Mitigate interest rate risk by boarding a variable rate asset;

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• Mitigate interest rate risk by boarding a variable rate asset;

• Proactively market a long term, fixed‐rate lending program and drive new business.

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Prospecting for Quality Loans• No longer does bank have to be concerned with aggressive structures from national lenders;

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Prospecting for Quality Loans• No longer does bank have to be concerned with aggressive structures from national lenders;

• Defend & cultivate strongest bank relationships with new long term facilities.

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How to Manage Existing Borrowers• A proactive approach can make it much easier to meet loan volume;

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• Create wider spreads by booking the loan before you are in a competitive situation;

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• Create wider spreads by booking the loan before you are in a competitive situation;

• Substantial non‐interest income through hedge fees.

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How to Manage Existing Borrowers• Simplified documentation, just a change in terms and hedge agreement;

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How to Manage Existing Borrowers• Simplified documentation, just a change in terms and hedge agreement;

• Credit enhancement through stabilization of the borrower’s debt service obligation (fixed payment).

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How to Manage Existing Borrowers• Target borrowers with following characteristics:

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– 2‐3 years to maturity (or rate reset);

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– Above‐market rate for given credit quality &relationship;

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– Above‐market rate for given credit quality &relationship;

– Weak prepayment language.

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Setting Borrower Rate Expectations• Three closing options for hedges:

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– A + B = C established at signing;

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– A + B = C established at the bank’s risk before signing;

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– A + B = C established at the bank’s risk before signing;

– Forward rate lock.

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Setting Borrower Rate Expectations• Prior to signing, hedge rate is established;

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Setting Borrower Rate Expectations• Prior to signing, hedge rate is established;

• Immediately after signing, hedge is executed.

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Setting Borrower Rate Expectations• Contact hedge team early to request a borrower presentation;

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• Email credit memo for formal hedge approval;

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• Provide draft loan documents for review;

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• Generate hedge agreement;

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• Generate hedge agreement;

• Establish signing appointment w/borrower and notify hedge team.

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To Increase Loan Profitability• Increase credit quality;

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• Increase efficiencies;

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• Increase cross‐sells;

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• Increase cross‐sells;

• Mitigate non‐compensated risks.

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CREDIT

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What is Counterparty Risk?• Bank Counterparty Risk to Hedge Provider:

• When using a hedge, bank may be exposed to counterparty credit risk w/hedge provider;

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What is Counterparty Risk?• Bank Counterparty Risk to Hedge Provider:

• When using a hedge, bank may be exposed to counterparty credit risk w/hedge provider;

• If hedge payment were to be interrupted, bank may be exposed to MTM or unwind costs.

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What is Counterparty Risk?• Bank Counterparty Risk to Borrower:

• Borrower & bank may enter hedge agreement to provide borrower w/fixed rate payment;

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What is Counterparty Risk?• Bank Counterparty Risk to Borrower:

• Borrower & bank may enter hedge agreement to provide borrower w/fixed rate payment;

• Borrower & bank are then counterparties to a hedge, and if borrower failed to make hedge payments and interest rates fell, bank would be exposed to credit risk.

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Measure of Exposure—VAR• Loan equivalent amount (LEQ) is standard calculation for potential exposure for a hedge;

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Measure of Exposure—VAR• Loan equivalent amount (LEQ) is standard calculation for potential exposure for a hedge;

• LEQ is determined by calculating a value‐at‐riskmeasure (“VAR”), which represents potential exposure of hedge with interest rate movement.

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Measure of Exposure—VAR• VAR exposure to bank is contingent on two concurrent events: 1) interest rates falling, and 2) borrower stops making loan payments.

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Measure of Exposure—VAR• Industry standard for calculating this exposure is to run hedge through a Monte Carlo simulation numerous times;

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Measure of Exposure—VAR• Industry standard for calculating this exposure is to run hedge through a Monte Carlo simulation numerous times;

• Each pass taking a different interest rate path based on existing rates & market’s expectation of future rates, based on implied market volatility.

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Measure of Exposure—VAR• Each path is then measured for dollar exposure to the hedge provider in the process of a hedge;

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Measure of Exposure—VAR• Each path is then measured for dollar exposure to the hedge provider in the process of a hedge;

• To run the Monte Carlo simulation, the various possible interest rate paths are predicted & the cost/benefit of the swap unwind are measured.

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Measure of Exposure—VAR• Each outcome (cost or benefit) are ranked in ordinal sequence, w/greatest exposures deemed worst case scenarios, & probabilities assigned to each pass;

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Measure of Exposure—VAR• Each outcome (cost or benefit) are ranked in ordinal sequence, w/greatest exposures deemed worst case scenarios, & probabilities assigned to each pass;

• Exposure under a hedge is deemed the ‘LEQ Amount,’ and is measured by the VAR over the life of the underlying loan.

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Measure of Exposure—VAR• Banks generally use the ‘5% or 10% confidence’ for VAR scenarios and then use this amount in their prudent underwriting process as the LEQ;

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Measure of Exposure—VAR• Banks generally use the ‘5% confidence’ for VAR scenarios and then use this amount in their prudent underwriting process as the LEQ;

• ‘5% confidence’ assumes that if loan defaults, it’s expect that cost to unwind hedge will exceed LEQ only 5% of the time, but exposure will be lower than the LEQ for 95% of the time.

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Measure of Exposure—VAR• A VAR model output is presented below.

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How to Protect Bank for Hedged Loans• When hedge is used on a loan and interest rates decline, bank would incur a cost to unwind the hedge;

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How to Protect Bank for Hedged Loans• When hedge is used on a loan and interest rates decline, bank would incur a cost to unwind the hedge;

• This unwind expense must be recovered from proceeds from foreclosure on collateral.

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How to Protect Bank for Hedged Loans• On the other hand, when rates increase, the hedge would be in the money for the borrower, and this fee would increase the banks recovery from the borrower (or offset deficiency in loan recovery).

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How to Protect Bank for Hedged Loans• Banks mitigate credit risk for hedge program by offering it only to better credit quality borrowers, such as rated risk level 4 or higher;

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How to Protect Bank for Hedged Loans• Banks mitigate credit risk for hedge program by offering it only to better credit quality borrowers, such as rated risk level 4 or higher;

• Also limit LTV, such as no more than 90% for owner‐occupied borrowers & no more than 85% for investor borrowers.

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HEDGINGPractical Applications:

1. Existing loans

2. Construction through perm

3. Forward rate locks

4. Zero cost closing

5. Take advantage of the curve

6. Blend and Extend

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HEDGINGPractical Applications:Dunn Tire

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Team Email Distribution: 800‐481‐2443 [email protected]

Chris Nichols Chief Strategy Officer 925‐202‐8944 [email protected]

Ed Kofman Managing Director 925‐765‐8701 [email protected]

Rick Ruso Managing Director 415‐815‐8599 [email protected]

Scott Carter Vice President 205‐968‐2906 [email protected]

Whitt Stone Analyst 205‐968‐2927 [email protected]

Sim Cheema Analyst 716‐930‐4806 [email protected]

ARC Team:

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Q&A

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END OF PRESENTATION

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