If you've financed property with a conduit loan, you have heard the people at your originator of choice talk about swaps, swap spreads, and that they can impact the interest rate you will pay on your loan. I wanted to know more about swaps and now that I have some answers, I thought I'd share with you. The information here is pulled from two sources: an email interview I had yesterday with Damon Reed of Capmark Finance (Capmark bought GMAC Commercial Mortgage over a year ago), and from the Bridger Funding website.
Damon Reed explains the pricing process: "In the past, lenders would determine what breakeven pricing was and then add on [their] profitability to the spread along with any other add on’s (I/O, forward rate lock, etc.) “break-even” would move as deals sold in the market and as swap rates moved up or down. Generally, as swaps increase, your spread increases on a one for one basis. Today, some lenders are quoting deals over swaps [rather than over treasuries] due to the volatile market."
Background on Swaps From the Bridger Funding Website: (See the source here)
Swaps -- also known as interest rate swaps -- are an important determinant in the pricing of most fixed-income instruments, including Commercial Mortgage Backed Securities (CMBS). Swaps are a security that most financial institutions utilize to manage interest rate risk. Interest rate risk reflects the potential impact that movements in general interest rates (e.g., U.S. Government Treasury Securities) will have on the value of fixed-income securities. For instance, as interest rates increase, the price (value) of fixed-rate bonds tends to decrease (at higher amounts for longer term bonds).
Swaps are agreements that reflect the notional exchange of fixed-rate interest payments for floating-rate interest payments. This allows an institution to hold a floating rate security, for instance, but effectively receive a fixed-rate of interest for the like term. Although there may be a cost to hold the hedge in place, the "insurance" premium is worth it to most institutions. While the physical exchange of interest payments doesn't necessarily take place, the market price of a swap contract fluctuates in such a manner as to emulate the exchange of payments. The market for swaps is very deep and liquid, and exists because different investors have different views of the direction of interest rates -- not to mention different exposures to rising or falling rates.
The swap yield, or rate, is the fixed-rate of interest paid (or received) in an interest rate swap contract. This yield is equal to the like-term U.S. Treasury Security yield plus a "risk premium", which is referred to as the "swap spread". Think of the swap spread as a generic risk premium that the market prices in to fixed-income securities to compensate for general interest rate risk. CMBS bonds, like most asset-backed bonds, are priced not just over like-term Treasury Securities, but swap spreads as well (in addition to asset-specific credit spreads to account for perceived risk of the subject asset class).
If swaps are an important determinant of CMBS value, why aren't they used more often as a benchmark in quoting CMBS conduit loans?
While larger CMBS conduit loans are often priced over swaps, the traditional practice of the industry has been to index their loan spreads only over the like-term U.S. Treasury Yield (with an increasing caveat explained in the loan application that allows for adjustments to the interest rate based upon swap spreads). The Treasury yield remains the most popular loan pricing index because it is a very relevant determinant of CMBS bond yields, and tend to be more volatile than swap spreads or CMBS-specific credit spreads. In addition, Treasury yields are better understood by many property investors, who find that it’s easier to locate the current Treasury yield in newspapers and web sites (although a few sites, like BridgerFunding.com, also display swap spreads.) Find swap spreads here.
How can swap spreads affect your mortgage interest rate?
Sustained increases in swap spreads usually result in lenders’ raising their loan spreads (and/or inserting language in the loan application that adjusts the interest rate for future changes in swap spreads). In addition, if your loan’s interest rate has not been locked, an increase in swap spreads could have a material impact on the value of your loan. Accordingly, in rare circumstances the lender may work with you to adjust the interest rate when it is locked to offset some of the decline in value. The impact of changing swap spreads affects all mortgage players equally.
What factors tend to cause swap spreads to increase?
Typically, interest rate swap spreads will rise with Treasury yields. This is especially the case when the market starts to perceive that higher Treasury yields may last for a while. As interest rates start to rise, the value of fixed-rate bonds decreases, which tends to increase interest rate swap spreads. In other words, the generic risk premium expands in the face of expectations for rising rates. In addition, swap spread movements can be exacerbated by the aggregate impact of asset-backed security hedging, which often becomes acute with quick jumps in interest rates.
As Mr. Reed said when he referred me to the Bridger information, "This will give you some color on swaps, but again it doesn’t help you in today’s market because we are just guessing where break-even is today. Until all the stacks of a CMBS sells in the market, spreads will continue to be a guessing game. I expect this to flush out next month as most of the supply will be gone."
In the interest of full disclosure - I've done many deals with Damon, and a few with other originators. I have a sense of what kind of service is standard in the market. Damon and his team go well beyond "standard"; they have executed far better than any lender I've worked with. That's why I went to him to help me with this post. That's why I'm plugging him and his team. And that's why we keep doing deals with him even though we are in California and he is in Birmingham, Alabama. If you are looking to do a CMBS/Conduit loan I suggest you give them a shot at your business.
