Leveling the Playing Field

August 26, 2013

_______________________________________________________________________ I wonder if Bernanke skipped Jackson Hole to complete his biography, Why Part Time Workers Should Feel Wealthy When the S&P Sets New Highs? On the interest rate front, rates had a volatile week but basically closed Friday at the same level they opened Monday. Jackson Hole lacked the usual gravitas with Bernanke skipping the event, but there were some interesting takeaways nonetheless. The only voting FOMC member to speak was James Bullard, who reiterated his desire to be patient with tapering. He believes QE has been effective, so this stance is not new. But he did point out that the specifics of tapering have not been debated or laid out, perhaps a nod to a delayed tapering like we have been suggesting. Dennis Lockhart suggested that tapering may begin in September but perhaps at a pace slower than market expectations, which is currently calling for $20B fewer in purchases per month. Oddly, he stressed that the tapering decision will be data dependent but that there isnt enough significant releases between now and mid -September to dramatically alter the current outlook on the economy. SF President John Williams reiterated his support of tapering later this year but that unemployment is still too high and inflation too low. He also conceded that while QE has been beneficial for financial markets, the impact on the real economy is less certain. One notable remark was his desire to first taper Treasurys, not agency MBS, the first public statement from a FOMC member about the specifics of a potential tapering. Fiscal policy is starting to elbow its way back into the conversation. Republicans are starting to push for a short term extension on the government spending resolution to avoid a shutdown on September 30. They will want the extension to coincide with the debt ceiling debate, which will also likely run into a Fed Chair confirmation process. Congress is nothing if not predictable. All of this will likely result in a band-aid until spring 2014.

Case Study - Required Cap Negotiation Two years ago, the Fed took the unprecedented step of providing concrete forward guidance on a timeline until the next FOMC rate hike. Over the next twelve months, it further refined this timeline until it settled on the mid -2015 benchmark before it expects the first hike. During the last two years, short term interest rate caps have been historically inexpensive, making the decision of cap versus swap nearly a no-brainer, particularly for short term financings. The recent spike in rates has pushed swap rates much higher, but has also pushed up cap prices. The surge in cap prices has directly impacted countless loans in progress, unexpectedly requiring significantly more cash than borrowers had budgeted. Many lenders are requiring caps on their loans and this has led to a lot of frustrated borrowers trying to figure out if the project makes sense. In the last week alone we have worked with five different borrowers on negotiating the terms of their required caps. We have spent a lot of time with the lenders showing how they can achieve interest rate protection while also mitigating the upfront cost for their borrowers. Below is one of the analysis we discussed with the lender. Loan amount: $90mm Term: 3 years Required cap: 1.50% on 1 month LIBOR for full term This cap costs approximately $850,000, not an insignificant amount unless youre a derivative salesperson for a bank. But a two year cap at the same strike only costs $176,000. Is the $674,000 for the extra year really worth it? The market currently expects LIBOR to average 1.68% during that third year. On $90mm, that means the market expects the cap to provide savings of about $162,000. And yet the third year costs $674,000 ($850,000 - $176,000). To put this into context, this means LIBOR would have to average 2.25% in the third year for the third year to pay for itself, a full 0.57% above market expectations. How likely is that?

If we take the Fed at its word that LIBOR will remain at current levels until at least mid2015, then the first hike would come (at the earliest) at the start of the third year.

For LIBOR to average 2.25% in the third year, the Fed would basically have to hike Fed Funds 4.00% in one year, putting LIBOR at 4.25% 36 months from today. This is not impossible, but it does seem unlikely. The Fed typically hikes in steady increments to ensure the increase in rates doesnt cripple the economy. The average tightening cycle is 2.00% per year accomplished by hiking 0.25% per meeting. This cap would require hikes of 0.50% per meeting over the course of the third year in order for it to pay for itself. The most the Fed has ever hiked in any twelve month period is 3.00%. Although we are certainly in unchartered waters, we just cant envision a scenario where this plays out. If futures markets have LIBOR at 2.11% 36 months from now, not the implied 4.25% in this cap pricing, then why the huge premium? Uncertainty. Cap prices are driven by expectations (like swap rates) and uncertainty. If you imagine buckshot as it shoots out of a rifle, it spreads across a wider range the farther it moves downrange. Uncertainty, or volatility, moves in a similar fashion. We are recommending to our clients that they purchase a shorter term cap to avoid this premium and then buying the third year at some point over the next twelve to 18 months. The closer we get to the calendar year 2016, the less expensive a cap will become as the future becomes more certain - even if that future includes higher LIBOR. Lenders have been willing to consider this strategy not only because it makes sense from an interest rate standpoint, but because of the additional flexibility it provides over the life of the financing. What if the project is sold or refinanced over the first two years? What if occupancy improves and DSCR would allow for a higher strike? We arent asking lenders to eliminate the third year, just allow us to monitor markets and plans for the asset over the next 12-18 months while LIBOR is likely anchored near 0%. If the financing will be in place in the third year, the borrower has to buy a cap before the first cap matures. We will help our clients monitor the interest rate market and if something changes to warrant the purchase of the cap at that time, then we will be ready to move forward. We prefer an ongoing, dynamic hedging strategy to a snapshot decision at closing.

Heres a sample of the language weve negotiated with some lenders: Lender shall require that Borrower purchase, at Borrowers cost, an interest rate cap agreement for the Initial Term acceptable to Lender in its sole discretion for the Loan Amount from (LENDER) or a counterparty with a long term debt rating from Moodys of A1 or better or S&P of A+ or better. In lieu of providing an interest rate cap agreement for the entirety of the Initial Term, Borrower may at its option elect to provide one or more renewable interest rate cap agreements each of a term not less than one year provided that, in the event Borrower so elects, failure by Borrower to provide a renewal or a substitute interest rate cap agreement upon the expiration of a then existing interest rate cap agreement shall constitute an Event of Default under the Loan Agreement. The borrower is still required to have a cap in place at all times or it constitutes a default, it just mitigates the upfront cost associated with the third year.

Other Thoughts - For projects with anticipated cash flow improvements, some lenders have agreed to a step up cap. In the first year while occupancy is lower, the cap strike is lower. As occupancy improves, the DSCR improves and the strike can be moved higher. For example, year 1 is at 1.00%. Year 2 is at 1.50%. Year 3 is at 2.00%. And it still provides a blended average cap of 1.50% over the life of the financing. - With the Fed committed to keeping LIBOR low for the next two years, more lenders have agreed to hedge requirements on 50% - 80% of the loan amount rather than 1.00%. Each situation is unique and this may not make sense for everyone, but we at least wanted to put it on your radar as you look at financing alternatives. Please call us to discuss your financing.

LIBOR As discussed above, we believe the Fed will change its forward guidance on FF (and therefore LIBOR) by lowering the UR threshold from 6.5% to 5.5%. This will help offset the financial tightening from the gradual withdrawal of QE. Inflation is at a 50 year low, so the Fed has no reason to begin hiking short term floating rates anytime soon.

Fixed Rates In June we featured a newsletter with TBTIHEK, or The Best Trader I Have Ever Know. It was one of the most read newsletters weve ever produced - apparently our readers like to hear from someone that actually knows what he is talking about. In that newsletter, Jon Farrin of Sandpiper Asset Management cautioned against a spike in long term rates and even said the 10 year Treasury could hit 3.00%. Within two weeks, the 10T was hitting 2.84%. A lot of clients have been asking us if the 10T is poised for another run up, potentially as high as 3.50%. In last weeks newsletter, we laid out the reasons why we do not think that is the case. But more importantly, I wanted to know what Jon thought. Farrin: In the very near term, I see the selloff being constrained by the 2.95% - 3.05% area. I wouldnt worry at all about 3.50% in the next month as were oversold. Longer term, the normalization has begun. But in the near term I wouldnt be surprised if we trade in a 2.65% - 3.05% range for the next 30-60 days. Next week we will be sitting down with Jon again to help provide insight about the recent jump in yields and what to expect over the second half of the year, so be sure to stay tuned.

This Week Quite a bit of data releases this week following last weeks slow calendar. Consume r confidence is likely to take a hit due to the increase in interest rates and the impact that has had on mortgage rates. GDP in the second half of the week may come in a bit stronger than expected, but this is a lagging indicator and unfortunately wont account for much of the hit from the sequester and increase in rates over the last few months.

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 Time 8:30AM 8:30AM 10:30AM Tuesday 9:00AM 10:00AM 10:00AM Wednesday 7:00AM 10:00AM 10:00AM Thursday 8:30AM 8:30AM 8:30AM 8:30AM 8:30AM 8:30AM Friday 8:30AM 8:30AM 8:30AM 8:30AM 9:45AM 9:55AM Report Durable Goods Orders Durables ex Transportation Dallas Fed Manufacturing Activity Case-Shiller 20-city Index Richmond Fed Manufacturing Index Consumer Confidence Index MBA Mortgage Applications Pending Home Sales (MoM) Pending Home Sales (YoY) Initial Jobless Claims Continuing Claims GDP (QoQ) Personal Consumption GDP Price Index Core PCE (QoQ) Personal Income Personal Spending PCE Core (MoM) PCE Core (YoY) Chicago Purchasing Manager University of Michigan Confidence 330k 2990k 2.2% 1.8% 0.7% 0.8% 0.2% 0.3% 0.2% 1.2% 53.0 80.5 0.0% Forecast -4.0% 0.5% 3.9 12.10% 0 79.0 Previous 4.2% 0.0% 4.4 12.17% -11 80.3 -4.6% -0.4% 9.1% 336k 2999k 1.7% 1.8% 0.7% 0.8% 0.3% 0.5% 0.2% 1.2% 52.3 80.0

Speeches and Events Day Tuesday Thursday Time 6:50AM 8:50AM 2:00PM Friday 9:00AM Report Fed's Williams speaks on Monetary Policy Fed's Bullard speaks at Leadership Memphis Fed's Lacker speaks Fed's Bullard speaks on US Economy Place Sweden Memphis, TN Newport News, VA Memphis, TN

Treasury Auctions Day Tuesday Wednesday Thursday Time 1:00PM 1:00PM 1:00PM 2-year Treasury 5-year Treasury 7-year Treasury Report Size $34B $35B $29B