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JP Conklin 704-887-9880 office jp.conklin@pensfordfinancial.com www.pensfordfinancial.

com Leveling the Playing Field October 8, 2012 _______________________________________________________________________ Obama, meet Romneys right hook. Right hook, Obama. If there was one thing I was 100% certain that Obama was better at than Romney, it was speaking. Obamas platform in 2008 was the audacity of hope, but wasnt it really more like a rebound relationship? We had 8 years of dating a guy who struggled with public speaking. After that relationship wound down, the nation was excited about the possibility of dating someone different, someone who could speak eloquently. So Obama got elected because he seemed presidential and he speaks well. So imagine my surprise when he shows up to the first debate and gets his clock cleaned. Im a one trick pony (rates), so I can recognize a fellow one trick pony when I see one. And if Ive learned anything about being a OTP, its that you better be good at it. If I showed up at a client meeting and wasnt able to talk interest rates, Id be fired. I wonder if the same happens with our presidential OTP after his speaking debacle? Nonetheless, my favorite tweet following the debate was this one from Big Bird.

Last week we included a small section about how inexpensive interest rate caps have become, particularly for 3 years and less (construction loans, extensions, bridge financing, etc). Weve had quite a few clients with construction loans say Ive got plenty of cushion built into my draw schedule, taking $20k out to protect against interest rates seems like a no brainer. To be clear, we all agree that the likelihood of these caps coming into play is nearly 0%. But with Eurozone issues and LIBOR lawsuits looming, many clients are choosing to buy some disaster protection for very little money. We received quite a few emails after last weeks newsletter, so we thought wed give some more scenarios from some recent caps weve priced. These costs include Pensfords fee, so they represent a true all-in cost to our borrowers. We have a thoroughly negotiated bid package with all major banks that incorporates quite a few additional credit provisions to protect the borrower/cap buyer. We also coordinate all required documentation such as the Collateral Assignment and legal opinion. Weve placed several billion in caps this year, so we receive pricing discounts in exchange for volume. Option pricing is more subjective than swap pricing, so we also go out to a variety of banks for quotes since the bank that wins today might not be as aggressive tomorrow. And many clients use us to obtain the best pricing and then we go back to the lender and give them the opportunity to win the business. This demonstrates to the bank that the borrower values the relationship while also ensuring the best pricing to the client. Cap # 1 Construction Loan Notional: Fund up from $800k to $8mm over 10 months, then interest only through final 3 year maturity. Term: 3 years Cap on LIBOR: 2.10% Cost: $17,000 Cap #2 Loan Extension Notional: $57.5mm Term: 2 years Cap on LIBOR: 1.25% Cost: $37,500 Cap # 3 Term Loan Notional: $4mm Term: 5 years Cap on LIBOR: 2.50% Cost: $30,500

Cap # 4 Term Loan Notional: $50mm Term: 5 years Cap on LIBOR: 3.00% Cost: $295,000 Cap # 5 Existing Term Loan Notional: $11.5mm Term: 3 years Cap on LIBOR: 3.50% Cost: $21,000 Cap # 6 Term Loan Notional: $20mm amortizing $25k/mo Term: 3 years Cap on LIBOR: 1.50% and 2.50% Cost: 1.50% costs $39,000 and 2.50% costs $23,250 Cap # 7 Extension Notional: $66.83mm Term: 2 years Cap on LIBOR: 4.00% Cost: $11,000 Cap # 8 Extension Notional: $7mm Term: 3 years Cap on LIBOR: 3.00% Cost: $11,000 The caps with terms of 3 years or less are about as close to free as we may ever see. But caps make a lot of sense on term loans as well. The banks will sell suggest swaps make more sense, but do they? Lets look at Cap # 3. To recap, it is a $4mm term loan for 5 years with a cap at 2.50%. Assuming a 2.00% loan spread, they are capping their all-in interest expense at 4.50% for $30,500. If they instead swapped, the rate would likely be around 3.25%. If I were still a swap salesperson, Id show you a graph of how 5 year swaps are at all-time lows and say things like most projects work at 3.25%, why not just put it to bed on focus on your area of business instead of interest rates? Besides, why pay $30k for a cap when you have plenty of other costs to worry about?

Thats what I would have said 4 years ago. And I would have made about $100,000 in swap fees off that structure. And you never would have known it. Maybe you would have said 3.25% seems like such a good rate, I dont want to know what is going on behind the curtain, lets just get this loan closed! And I would have loved you for it. But maybe you would have examined the math a little bit closer. By swapping, you are paying about 1.00% per year while LIBOR remains at current levels (L + 2.00% = 2.25% vs. 3.25% swap rate). 1.00% on $4mm is $40,000/year. The cap cost $30,500. That means the cap has paid for itself within about 9 months and you continue to float well below the swap rate as long as LIBOR remains low. Plus, the bank profit will be around $5k instead of $100k. In fact, the cost of the cap is just a fraction of the cost youll pay to the bank via a higher interest rate. But its an unseen cost, so banks sell swaps as being no cost. Theres also no prepayment penalty with the cap. You may say but rates are so low they are more likely to go up than to go down, right? Maybe, but lets look at what happens if rates dont move at all over the next 3 years: 5 year swap rate at closing: 3.25% 2 year swap rate in three years: 2.41% Penalty: 0.84% Prepayment penalty: $67,200 How did you end up with a $67,200 prepayment penalty if rates are unchanged, shouldnt it be zero? The first reason is the bank profit, which translates into a prepayment penalty carried forward. The second reason is called rolling down the yield curve. As three years go by, you are comparing your 5 year fixed rate to a new 2 year rate. That means swaps naturally move against you over time if rates stay level. And the $67,200 is probably low because the bank will inflate this to make profit at termination as well. Lets pretend you get an offer to sell in three years for $6mm. You call the bank and get a quote of $87,000. You are frustrated, thinking rates havent moved, shouldnt it be $0? You have a firm closing date for the sale and the bank keeps telling you the prepayment is $87k. You arent sure if it should be $87k or $67k or $0, but are you going to walk from a $6mm sale over the swap breakage? Unlikely. The bank wont release the lien on the property until the swap is paid and while you might be frustrated, youll ultimately accept their price because you want to sell the property. And they book another $20,000 swap fees for taking risk off their books. Now imagine they do that hundreds or thousands of times a year. No wonder they sell against caps so hard. And speaking of the cap, what would the prepayment penalty be? $0. And it could have residual value left over to you.

Swaps make sense for the appropriate scenario, but we strongly encourage you to call us to walk through each financing on a case by case basis. Just because the absolute level of interest rates makes it feel like a good deal doesnt mean it actually is a good deal. LIBOR Outlook See above.

Fixed Rate Outlook I received several emails saying I missed a layup on more tail risk jokes, so I apologize. I must be slipping in my old age. My instinct on fixed rates is a short term lid with all the uncertainty, but as that uncertainty is removed (elections, fiscal cliff, Eurozone crisis), wed expect the yield curve to steepen. This Week Markets closed Monday in observance of Columbus Day. Eco data will take a backseat to lots of Fed-speak and Treasury auctions.

Generally, this material is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument or as an official confirmation of any transaction. Your receipt of this material does not create a client relationship with us and we are not acting as fiduciary or advisory capacity to you by providing the information herein. All market prices, data and other information are not warranted as to completeness or accuracy and are subject to change without notice. This material may contain information that is privileged, confidential, legally privileged, and/or exempt from disclosure under applicable law. Though the information herein may discuss certain legal and tax aspects of financial instruments, Pensford Financial Group, LLC does not provide legal or tax advice. The contents herein are the copyright material of Pensford Financial Group, LLC and shall not be copied, reproduced, or redistributed without the express written permission of Pensford Financial Group, LLC.

ECONOMIC CALENDAR
Economic Data Day Monday Tuesday 7:30AM 10:00AM Wednesday 7:00AM 10:00AM 2:00PM Thursday 8:30AM 8:30AM 8:30AM 8:30AM 8:30AM Friday 8:30AM 8:30AM 8:30AM 8:30AM 9:55AM Time Report Fixed Income Markets Closed for Columbus Day NFIB Small Business Optimism IBD/TIPP Economic Optimism MBA Mortgage Applications Wholesale Inventories Fed releases Beige Book Economic Survey Initial Jobless Claims Continuing Claims Import Price Index (MoM) Import Price Index (YoY) Trade Balance Producer Price Index (MoM) Producer Price Index (YoY) PPI Core (MoM) PPI Core (YoY) U. of Michigan Confidence 370k 3275k 0.8% -1.3% -$43.9B 0.7% 1.8% 0.2% 2.5% 77.5 367k 3281k 0.7% -2.2% -$42.0B 1.7% 2.0% 0.2% 2.5% 78.3 0.4% 93.4 49.5 92.9 51.8 16.6% 0.7% Forecast Previous

Speeches and Events Day 8-9 Wednesday 2:00PM 2:45PM 4:45PM Thursday 12:30PM 8:00PM Friday 12:35PM Time Report Joint ECB and Fed Conference on Bank Funding Fed releases Beige Book Economic Survey Fed's Kocherlakota speaks to Businesses Fed's Fisher speaks at Cato Conference Fed's Plosser speaks on Economy Fed's Bullard speaks on Economy Fed's Lacker speaks on Economy Pennsylvania St. Louis, MO Charlottesville, VA Montana Place Germany

Treasury Auctions Day Tuesday Wednesday Thursday Time 1:00PM 1:00PM 1:00PM 3-year Treasury 10-year Treasury 30-year Treasury Report Size $32B $21B $13B