NPLA Meeting Recap: Hedge Interest Rate Risk 2024
Recap and Insights provided by James Martin, VP of Operations at GoDocs
The recent NPLA Meeting featured an insightful presentation by Geoffrey Sharp, Managing Director and Head of Product Development & Sales at Eris Innovations, highlighting how private lenders can utilize interest rate swaps to manage risk and protect their net interest margin.
Founded in 2011, Eris Innovations pioneered a unique swap contract design, replicating traditional OTC swaps with the efficiency of exchange-traded instruments. Through strategic partnerships, Eris has expanded access to its products, offering interest rate swap futures in various currencies and credit index futures.
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Understanding the Challenge
Private lenders often face a balancing act. They may offer fixed-rate loans to borrowers while securing funding through lines of credit with variable interest rates, like SOFR. This creates interest rate risk, where fluctuations in variable rates can significantly impact profitability.
Interest Rate Swaps as a Solution
Interest rate swaps are financial contracts that allow two parties to exchange interest rate payments. In the context of private lending, a lender can enter a swap to:
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- Lock in a fixed rate: transfer your funding from SOFR+200bps, for example, to a fixed rate for 3 years, locking in the interest margin.
- Mitigate risk: This fixed-for-floating exchange protects the lender’s net interest margin, regardless of future SOFR fluctuations.
Example
Consider a finance company with a funding cost of SOFR + 200bps (7.3%) and a borrower seeking a 3-year fixed-rate loan at 9.5%. While the initial spread seems attractive (2.20%), the variable funding cost exposes the lender to potential losses if SOFR rises.
By entering a 3-year SOFR swap, the lender pays a fixed rate and receives variable SOFR interest payments back. This effectively cancels out the variable component of the funding cost, locking in a net interest margin.
Benefits of Utilizing Swaps
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- Protection against rising interest rates: The lender’s profit is secured regardless of SOFR fluctuations.
- Preserved loan value: The locked-in margin allows the lender to sell the loan at par value without facing potential losses due to rising rates.
- Flexibility in fixed-rate lending: Swaps allow lenders to offer fixed-rate loans even with variable funding sources.
Accessing Swaps and Considerations
Traditionally, accessing interest rate swaps has been complex and expensive. However, the CME Group now offers products based on Eris Innovations’ methodology, making swaps more accessible to private lenders. There are also other interactive brokerage institutions, such as RJ O’Brien, that can support private lenders in implementing this strategy.
It’s important to note that utilizing swaps requires understanding key concepts like initial margin and daily variation margin. Additionally, swaps have accounting implications as the swap contracts need to be marked to market on financial statements, which could affect warehouse lending financial covenant requirements.
Utilizing interest rate swaps strategically can be a valuable tool for private lenders to manage risk and ensure consistent profitability in an environment of fluctuating interest rates. By leveraging exchange-traded products and collaborating with experienced brokers, even smaller lenders can benefit from this sophisticated risk management technique.
Author Bio:
GoDocs is an innovative leader in automated loan document generation, transforming the commercial lending process. With a fully cloud-based platform, GoDocs provides a flexible digital solution that makes commercial loans more cost-effective to document and faster to close, all while maintaining compliance in all 50 states. GoDocs is a Corporate Member of the NPLA.