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Get Smarter About Using Get Smarter About Using Interest Rate DerivativesInterest Rate Derivatives

Elaine PhilbrickElaine PhilbrickRob PrattRob Pratt

22 DERIVATIVE ADVISORSDERIVATIVE ADVISORS

About the speakersAbout the speakers

Elaine Philbrick has 15 years of experience in the derivatives Elaine Philbrick has 15 years of experience in the derivatives industry. She is formerly a Director with Fleet Bank and industry. She is formerly a Director with Fleet Bank and established Fleet Bankestablished Fleet Bank’’s derivatives sales group in the early s derivatives sales group in the early ’’90s. She has an MBA from Boston University and a BA from 90s. She has an MBA from Boston University and a BA from Colby College.Colby College.

Rob Pratt has 20 years of banking experience, and started the Rob Pratt has 20 years of banking experience, and started the first small business derivative sales effort in the country whilfirst small business derivative sales effort in the country while e at Fleet Bank. Prior to joining Fleet he was the Funding at Fleet Bank. Prior to joining Fleet he was the Funding Manager and derivatives trader for the Federal Home Loan Manager and derivatives trader for the Federal Home Loan Bank of Boston where he managed the $200 billion derivative Bank of Boston where he managed the $200 billion derivative portfolio. He has a BA from St. Michaelportfolio. He has a BA from St. Michael’’s College and an MBA s College and an MBA from Boston College.from Boston College.


What are interest rate What are interest rate derivatives?derivatives?

Definition: Definition: An agreement to exchange interest An agreement to exchange interest payments based on a market index.payments based on a market index.

Examples:Examples:SwapCap

Collar


Interest Rate Swap

A borrower enters into a loan agreement to A borrower enters into a loan agreement to borrow based on a floating rate, and enters borrow based on a floating rate, and enters

into a swap agreement to fix the rate.into a swap agreement to fix the rate.

Two steps to a fixed rate:Two steps to a fixed rate:

Borrower

Loan

LIBOR + Loan Spread

Finance Provider

Fixed Rate

LIBOR + Loan Spread

Borrower

Swap


Interest Rate SwapInterest Rate Swap

4.4%

4.6%

4.8%

5.0%

5.2%

5.4%

Swap

Futures

Swap rate is the Swap rate is the weighted average of weighted average of the Eurodollar futures the Eurodollar futures setssets

No upfront feesNo upfront fees

Potential prepayment Potential prepayment costcost

Requires credit Requires credit approvalapproval


4%

5%

6%

7%

8%

9%

10%

Puts maximum Puts maximum rate on variable rate on variable rate loansrate loans

Upfront feeUpfront fee

No prepayment No prepayment costcost

Does not require Does not require credit approvalcredit approval

LIBOR

Cap

Interest Rate CapInterest Rate Cap


Interest Rate CollarInterest Rate Collar

2%

3%

4%

5%

6%

7%

8%

Cap

LIBOR

Puts maximum (Cap) Puts maximum (Cap) and minimum (Floor) and minimum (Floor) rate on variable rate rate on variable rate loansloans

• Often structured with no upfront fees

• Potential prepayment cost

• Requires credit approval

Floor


Other ProductsOther Products

FEATUREFEATUREPRODUCTPRODUCT

Shorter Floor allows for prepaymentShorter Floor allows for prepaymentPrepay CollarPrepay Collar

Lowers cash flow in early yearsLowers cash flow in early yearsStepStep--Up SwapUp Swap

Allows prepayment at no costAllows prepayment at no costPrepay SwapPrepay Swap

Fixed rate for uncertain draw schedulesFixed rate for uncertain draw schedulesFlexiSwapFlexiSwap

Lowers rate on Swap with some riskLowers rate on Swap with some riskKnockout SwapKnockout Swap

Sets maximum fixed rateSets maximum fixed rateSwaptionSwaption

Sets forward Treasury rateSets forward Treasury rateTreasury LockTreasury Lock


Swap vs. Swap vs. Traditional Fixed RateTraditional Fixed Rate

Swaps offer:Swaps offer:Favorable prepayment termsFavorable prepayment termsControl over the timing of the rateControl over the timing of the rateCustomized pricingCustomized pricing

Cash flow assistanceCash flow assistancePrepayment optionsPrepayment optionsLonger tenorsLonger tenorsPartial fixed ratesPartial fixed rates


ISDA Agreement & Schedule ISDA Agreement & Schedule ““Master Master AgreementAgreement””Confirmation

Corporate ResolutionCorporate ResolutionTrading AuthorizationTrading AuthorizationWW--99Organization Chart with equity stakesOrganization Chart with equity stakesStatement of IncorporationStatement of Incorporation

Needed for Trading Approval:

Standard Swap DocumentsStandard Swap Documents


Master AgreementMaster Agreement

Available through Available through www.isda.orgwww.isda.org1992 and 2002 versions in use1992 and 2002 versions in useAll changes noted in the Schedule All changes noted in the Schedule portionportion90% of the Master is standard90% of the Master is standardOne agreement per legal entityOne agreement per legal entityItIt’’s negotiable!s negotiable!


Standard Credit TermsStandard Credit Terms

References loan agreementReferences loan agreement

No new covenants No new covenants

No new credit entitiesNo new credit entities

Loan should trigger firstLoan should trigger first


Credit Terms DocumentedCredit Terms Documented

Part 1(a): Specified Entity: NonePart 1(a): Specified Entity: None

Part 1(c): Cross Default: Will apply to both Part 1(c): Cross Default: Will apply to both parties, and Threshold Amount should parties, and Threshold Amount should match the loan agreementmatch the loan agreement

Part 5(b): Right of SetPart 5(b): Right of Set--Off should be Off should be includedincluded


Prepayment ComparisonPrepayment Comparison

($2,064,690)($2,064,690)($1,517,550)($1,517,550)($1,185,833($1,185,833Rates Rates -- 200 bps200 bps

($1,433,917)($1,433,917)($896,350)($896,350)($583,764)($583,764)Rates Rates -- 100 bps100 bps

($229,630)($229,630)$0$0$566,035$566,035Rates + 100 bpsRates + 100 bps

$1,114,899$1,114,899

Two Way Two Way Market ValueMarket Value

SWAPSWAP

$345,198$345,198$0$0Rates + 200 bpsRates + 200 bps

DefeasanceDefeasanceYield Yield MaintenanceMaintenance

Prepayment Prepayment Calculation:Calculation:

CONDUITCONDUITLOANLOANProduct:Product:

Swaps compare favorably to conventional fixed rate loans and to conduit financings when it comes to prepayment terms.

Assuming $20 million loan, prepaid with 3 years remaining.


Prepayment CalculationPrepayment Calculation

Present Value of:Present Value of:

(Contract Swap Rate (Contract Swap Rate –– Current Swap Rate) x Current Swap Rate) x Average Balance x Years RemainingAverage Balance x Years Remaining

Borrower can receive payment upon Borrower can receive payment upon terminating!terminating!


Swap PrepaymentSwap Prepayment

Most valued featureMost valued featureAllows borrower to put continual pressure Allows borrower to put continual pressure on lending credit spreadon lending credit spreadLowers switching costs on refinancingLowers switching costs on refinancingBorrower owns economic value of hedge Borrower owns economic value of hedge making his rate portable making his rate portable


Prepayment DocumentedPrepayment Documented

For Events of Default and Early Termination For Events of Default and Early Termination Events (INVOLUNTARY)Events (INVOLUNTARY)

Part 1(e): Automatic Early Termination: Part 1(e): Automatic Early Termination: will not applywill not apply

Part 1(g): Payments on Early Termination: Part 1(g): Payments on Early Termination: Market Quotation (not Loss) and Second Market Quotation (not Loss) and Second Method (twoMethod (two--way payments) should applyway payments) should apply


Prepayment DocumentedPrepayment Documented

Part 1(h): Additional Termination Event: Part 1(h): Additional Termination Event: will not apply (but may concede loan will not apply (but may concede loan termination) termination)

Part 5(f): Consent to Transfer will not Part 5(f): Consent to Transfer will not apply, or will not be unreasonable withheld, apply, or will not be unreasonable withheld, or only if loan transfersor only if loan transfers


Prepayment Language?Prepayment Language?

Swap documentation does NOT allow for Swap documentation does NOT allow for VOLUNTARY prepaymentVOLUNTARY prepaymentBorrower can: Borrower can:

TerminateTerminateAssignAssignReverse SwapReverse Swap

Termination amounts are negotiable! Termination amounts are negotiable! (includes a bank profit margin)(includes a bank profit margin)


Additional Swap DocumentsAdditional Swap Documents

Cap Collateral AgreementCap Collateral AgreementCredit Support AgreementCredit Support AgreementTermination AgreementTermination AgreementAssignment AgreementAssignment AgreementDisclosure StatementDisclosure StatementHedge Designation MemoHedge Designation Memo


NonNon--Lender ParticipationLender Participation

Increase competition for each transactionIncrease competition for each transaction

““Cherry pickCherry pick”” best loan and swap pricebest loan and swap price

Widen banking groupWiden banking group

Improve future lending termsImprove future lending terms

Bank lender CANNOT require hedge with itselfBank lender CANNOT require hedge with itself


NonNon--Lender DocumentedLender Documented

Credit Support Agreement (CSA) Credit Support Agreement (CSA) allows a borrower to offer cash allows a borrower to offer cash collateral to a noncollateral to a non--lender hedge lender hedge providerproviderBelow the Threshold Amount, Below the Threshold Amount, unsecured exposureunsecured exposureAbove the Threshold Amount, a cash Above the Threshold Amount, a cash escrow accountescrow account


NonNon--Lender Documented (2)Lender Documented (2)

Escrow amount for monthly call, quarterly Escrow amount for monthly call, quarterly call, or full term (approx. 1%, 3%, or 10% call, or full term (approx. 1%, 3%, or 10% of principal respectively) of principal respectively) Market to markets daily, monthly, or Market to markets daily, monthly, or quarterlyquarterlyUnsecured Threshold Amount usually Unsecured Threshold Amount usually $100,000$100,000Increments to post additional collateral Increments to post additional collateral usually $25,000usually $25,000


Conduit Hedges DocumentedConduit Hedges Documented

Typically Caps onlyTypically Caps onlyAdditional Cap Language requiredAdditional Cap Language required

–– Decreases biddersDecreases biddersLegal opinion of hedge provider typically Legal opinion of hedge provider typically requiredrequiredCredit Downgrade Provision: Transfer or Credit Downgrade Provision: Transfer or post collateral requirementpost collateral requirement


Timing Matters!Timing Matters!

Negotiate execution window Negotiate execution window –– Often determines priceOften determines price–– Affects number and quality of Affects number and quality of

biddersbiddersLeaveLeave--orders and stoporders and stop--losses can be losses can be used very effectivelyused very effectively


Documents Affect TimingDocuments Affect Timing

Master Agreement up to 45 days post tradeMaster Agreement up to 45 days post tradeReview draft prior to tradingReview draft prior to trading

Confirmation up to 48 hours post tradeConfirmation up to 48 hours post tradeEmail statement often can meet Email statement often can meet requirement for closingrequirement for closingVerbatim conduit language often not Verbatim conduit language often not necessarynecessary

Legal opinion up to 60 days post tradeLegal opinion up to 60 days post trade


Documentation Best PracticesDocumentation Best Practices

Review drafts before tradingReview drafts before trading

Negotiate MasterNegotiate Master

Negotiate credit termsNegotiate credit terms

Plan on document turnaround timePlan on document turnaround time


Best practices on executionBest practices on execution

Get transparencyGet transparencyBid it outBid it outObtain credit amount Obtain credit amount Ensure no more than loan returnEnsure no more than loan returnNegotiate an execution windowNegotiate an execution windowEmploy leaveEmploy leave--orders and stoporders and stop--losseslossesCheck the internetCheck the internetHire a brokerHire a broker


Client advocates forborrowers ensuringthe lowest rates andbest terms in thehedging market

Elaine PhilbrickElaine Philbrick 617.283.4088617.283.4088

Rob PrattRob Pratt 617.680.2402617.680.2402

Tom KennedyTom Kennedy 508.523.4891508.523.4891

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