A Hedging Strategy for Commercial Real Estate Lending
June 2012 - The current outlook from the Federal Reserve Board is for two more years of low interest rates. The challenge posed to financial institutions is how to consistently grow earnings in this extended low rate environment. With three-year agency paper at 36 basis points and seven year Treasuries yielding only 1.10%, the typical investment options do not look appealing in the near term.
Consequently, the question frequently posed to FHLBank Atlanta relationship managers is: "I understand that funding is inexpensive, but where am I going to find earning assets so I can make money?" We are beginning to see more institutions looking to hold high quality loans, including residential and commercial mortgages, on their books – loans they may have previously originated and sold, or avoided altogether. New risks arise with holding loans on the balance sheet, such as matching cash flows of interest and principal, loans prepaying early, or loans extending to maturity. FHLBank Atlanta has expanded its advance offerings to provide products that can help hedge all, or some, of the risks associated with holding individual loans and pools of loans.
Commercial Lending Opportunities
Numerous shareholders have discussed current opportunities in commercial real estate lending but are concerned about the highly competitive pricing in the market and the potential risks of lending at a lower spread. Given today’s low investment yields, commercial lending is an appealing source of income, and with the right hedging approach, institutions can hold these loans in their portfolio while mitigating risks. The following example illustrates how a shareholder could take advantage of a commercial lending opportunity using FHLBank Atlanta advances.
An FHLBank Atlanta shareholder has been given the opportunity to originate a $5 million commercial real estate loan. Typically, the shareholder would not originate this type of loan and keep it on their balance sheet. The loan is a 10-year balloon based on 20-year straight line amortization, yielding 4.00%. How can this institution hedge the loan on their books and still earn enough spread to justify keeping it? They should consider using an FHLBank Atlanta amortizing advance, such as the Principal Reducing Credit to hedge all or part of the risk of holding the loan.
Tactic One: Standard Principal Reducing Credit
The simplest way to use an amortizing advance to hedge a commercial loan would be to borrow a 10-year Principal Reducing Credit (PRC) advance based on the same 20-year amortization schedule of the commercial loan. As of the writing of this article, the rate on such an advance is 2.00%, giving the shareholder a 2.00% spread.
The PRC in its base form is subject to a market-based prepayment fee, should the shareholder need to terminate it early due to an early payoff of the commercial loan. The base PRC advance would provide the institution with a favorable hedge, assuming the institution is certain that the loan will remain in the portfolio to maturity. The shareholder also can build a prepayment fee into the commercial loan to protect against early payoff, essentially passing the advance prepayment fee to the commercial borrower.
Alternatively, FHLBank Atlanta can customize a PRC advance in a number of different ways to address the actual cash flows the shareholder expects from the loan over its life. Below are examples of how to use the PRC advance in various ways to achieve different levels of hedge protection.
Tactic Two: 10-year Bermudan Callable PRC
Embedding a quarterly cancellation option in a PRC advance can protect an institution’s balance sheet in the event of the loan being prepaid. In this example, the shareholder purchases an option to cancel that starts three months into the loan and extends for the life of the loan. This feature gives the shareholder the right to cancel, or prepay the advance, at no fee on certain dates. As shown below, the closer the shareholder matches the advance to the commercial loan, the more expensive it is. A PRC advance with a quarterly option to cancel over the life of the advance costs 2.68%. The option reduces the spread to 1.32%, but it better matches the prepayment risk compared to the base PRC.
Suppose the shareholder is confident that the commercial loan will not have accelerated prepayment of principal for the first five years. In this scenario, the shareholder can structure the option to cancel to begin after five years and continue quarterly to maturity. As shown in the graph below, the shareholder earns a higher spread and pays less by giving up the right to cancel the advance in the first five years.
Tactic Three: 10-year European Callable PRC
A lower cost way to purchase prepayment protection would be to embed a one-time (European) option to cancel the advance. For example, the option can be placed halfway through the life of the advance, giving the shareholder the option to prepay the advance on a certain date with no penalty.
Tactic Four: Blended Funding Strategy – 50% PRC Advance and 50% Deposits
A common scenario would be for a shareholder to incorporate some of their own low-cost deposits into funding the commercial loan. The primary risks associated with relying solely on deposits are the uncertainties of availability and costs in the future. The example below illustrates the use of a 50/50 mix of deposits and a PRC advance. The blend of deposits (priced at three-month LIBOR) and advances (PRC at 2.00%) holds the initial cost low (weighted average rate 1.24%), but provides the shareholder with protection when rates rise and/or deposits decline. The initial spread on the funding mix is 2.76%. While deposit costs are low today, there is the general thought that when they do rise, it could be rapid. Blending deposits with an advance helps to reduce the risk of spread compression in the future, while still being able to earn a generous margin today.
There are additional risks associated with holding loans in your portfolio, but you can mitigate these risks by using FHLBank Atlanta products. The Bank now offers nearly 60 variations of fixed-rate, variable-rate, and amortizing advances that can be customized to meet your specific funding and risk management needs in any interest rate environment.
Please contact your Relationship Manager to discuss your current balance sheet risk exposures and allow us to present different options to address your needs.
© 2012 Federal Home Loan Bank of Atlanta, All Rights Reserved. 1475 Peachtree Street NE, Atlanta, GA 30309
The Federal Home Loan Bank of Atlanta is not a registered investment advisor. Nothing herein is an offer to sell or a solicitation of an offer to buy any securities or derivative products. You should consult your own legal, financial and accounting advisors before entering into any transaction.