Christina Ochs, president of The Corporation for Interest Rate Management, shares how to identify and mitigate the risk to returns in a typical warehouse-to-securitization financing structure.
Yield compression can be a pain point for equipment lessors and financing firms, especially in a rising rate environment.
Rising interest rates can negatively impact returns in a typical warehouse-to-securitization financing structure. Let’s explore those risks and how to mitigate them.
The US entered a rising interest rate environment in March 2022 after two years of short-term rates near 0% and historic lows for long-term rates.
The Fed has overseen 6 rate hikes in as many meetings this year. The questions regarding future hikes remain: how high, how fast, and how long?
The most recent minutes indicate continued hikes into 2023 but there remains a high degree of uncertainty and volatility in the markets.
The yield curve becomes downward sloping (inverted) in the second half of 2023, and this inversion has been present in the curve for much of the last 6 months. There is broad-based market consensus that this a strong recession indicator. Historically, the short end of the yield curve tends to be less volatile than the long end but today we are in a unique moment. Since June, both the 2-year and 10-year USD swap rates have moved by 20+bps, intraday. This figure was significantly less volatile over the same period last year. Given relatively large daily movements, it’s very hard to pick the “right” moment to fix your rate.
Your Warehouse Facility
For many firms, a warehouse is designed to provide flexible liquidity to build origination volume – though often at a higher all-in rate than a securitization provides. This has become more expensive in 2022 as rates have risen.
How do you handle short term interest rate risk in a volatile market? How do you preserve flexibility to implement alternative financing decisions? How do you buy yourself time to find the right moment for a securitization?
Options-based hedging is particularly well suited for a warehouse facility. One of the most widely-used options, an interest rate cap, functions like a bespoke insurance policy against a rise in rates. In general, caps are very liquid, and these products can easily be tailored and modified to the risk profile of a given origination pool. The idea is to buy the right amount of coverage for the right amount of time.
You expect originations to amass over a 6-month period with an overall WAL of 40 months. While your target is to pool and securitize semi-annually, spreads in the ABS market have widened. This has made you rethink i) when you want to re-enter the market and ii) if you should evaluate other financing alternatives. You determine that your window is now 6-10 months and that a 100bps increase in rates from current levels would compromise your target NIM (net interest margin) given your existing book.
You purchase an interest rate cap on your forecasted warehouse balances for a 10-month period (the current outside date). Your strike rate of 4.75% is ~100bps over your current index (1M Term SOFR). Over the next 10months, if 1M Term SOFR is below 4.75% you continue to pay your loan interest as always. However, if 1M Term SOFR is 5.00% (for example) you would receive a payment from the cap provider equal to: 0.25% x hedged amount x one month. Netting the payment you receive against your interest bill for that month serves to synthetically reduce your interest rate from 5.00% to the 4.75% cap rate that you purchased.
Benefits: you can only receive ongoing payments so you can enjoy rates below the cap; you can always terminate the cap early and receive any residual value (termination does not cost you anything).
Costs: Your only obligation with an interest rate cap is the upfront premium payment, though in the case of an extension or modification in the future, you may then be subject to additional premiums.
Using an interest rate swap to synthetically fix a warehouse facility is challenging in the current market because of the steepness of the yield curve in the short term, the inversion of the yield curve in the longer term, and everpresent uncertainty around facility balances and securitization timing. A swap rate at any given time is largely comprised of the average of the yield curve for the duration of the swap, plus a credit spread added by the lender. In a rising rate environment, swapping typically means paying a higher rate immediately vs. floating on the prevailing index rate (e.g. SOFR, LIBOR), because forward rates on average will be higher. Additionally, there is an ongoing obligation with a swap, which could lead to material breakage cost should exit be earlier than planned. Options (such as caps or corridors) can provide flexibility and significant overall cost savings compared with swapping to a fixed rate.
Hedging incrementally, over time with an options-based strategy can preserve a desired net interest rate margin and flexibility—enhancing the benefits of a warehouse facility. Swaps are great tools, however, and can be helpful in the context of hedging an upcoming securitization.
Equipment leasing and financing firms typically use the securitizations to access competitively priced debt that is matched to the underlying leases or loans. As you build originations, how do you ensure that a future securitization achieves your desired NIM? How do you buy yourself time to find the right time for a securitization?
Two hedge strategies can be appropriate in this context: forward starting swaps and swaptions. Both work to hedge your future securitization rate so that you can preserve NIM. However forward starting swaps have limited flexibility while swaptions come with an upfront cost (like a cap).
Foundation: an interest rate swap serves to synthetically fix your rate on a specified amount of debt for a specified period of time. In a simplified example, you enter into an interest rate swap on 1M Term SOFR with a rate of 5.00%. If rates are 4.50% you pay your swap provider 0.50%, the difference between your swap rate and the index. However, if rates are 5.50% your swap provider pays you 0.50%. These monthly calculations are based on the amount hedged that month. Because swaps involve a potential future obligation on your part, your swap provider will want some sort of collateral to ensure you maintain your obligations. Swaps are often executed with a lender so that you won’t need to post cash / cash equivalent in order to enter into a swap.
You have amassed an appropriate amount of originations and have determined the ABS market is pricing well. You expect to close on your upcoming securitization in 3-5 months. You determine that that a 50bps increase in rates from current levels would compromise your target NIM given your existing book. That book has a WAL of 40 months.
Path A: Forward Starting Swap. You enter into a forward starting swap with your warehouse facility lender. The swap is structured to mirror your anticipated securitization: swap start date = securitization closing date, swap end date = 40 months; hedged amount = anticipated securitization amount, etc. Your swap rate is 5.00%. Assuming all goes according to plan, on the date you close on the securitization you also terminate the forward starting swap. In doing so, you either make or receive a payment based on the current market rate. That payment, netted with the actual securitization rate would synthetically provide you with a 5.00% index on the securitization. Let’s break down the payments.
Benefits: you can achieve a known future rate without an upfront cash payment.
Costs: you cannot take advantage of falling rates; you may pay to terminate the swap; you may incur an additional fee to extend or modify the swap.
Path B: Swaption. A swaption is used to hedge a future fixed rate. It functions like a ceiling or a limit and provides you with a known, future, worst-case rate. Just like a cap, you would pay for this option upfront. In a simplified example, you enter into a swaption on the future, 40-month swap rate with a strike rate of 5.00%. If the future swap rate is 4.50% you simply benefit from a lower rate. However, if the future swap rate is 5.50% your swaption provider pays you 0.50%. This calculation is based on the amount hedged and the duration. Let’s break down the payments.
Benefits: you can only receive payments, so you can enjoy rates below the swaption rate; you can always terminate the swaption early and receive any residual value (termination does not cost you anything).
Costs: upfront payment for the option; you may incur an additional fee to extend or modify the swaption.
The key to effectively managing your firm’s interest rate risk is to find the balance between your risk tolerance and your hedge budget. The goal is to focus on your investment goals while ensuring your financing decisions enhance (rather than hinder) those returns.
ABOUT THE AUTHOR: Christina Ochs, President of The Corporation for Interest Rate Management, has worked in interest rate risk management for the past 18 years, gaining experience in almost every operational role at the CIRM. Having first earned her bachelor’s degree from New York University she then gained an MBA from St. John’s University of Rome. A passionate leader, Christina is a member of the Women’s Presidents Organization. She also sits on various boards including the Women’s Board of The Museum of Contemporary Art (Chicago), The Chicago Chamber Music Society, the Active Transport Alliance, and CASA (Court Appointed Special Advocates) of Cook County.