Facing Interest Rate Risk with Confidence
Leverage Financial Risk Management Tools to Tame Interest Rate Risk
By Michael Riddle & Geoffrey Sharp
Making money in private lending requires navigating a minefield of risks every day. From mitigating legal risk with tight procedures or credit risk with careful underwriting, lenders must constantly be vigilant to identify and neutralize threats to their business. Perhaps no major risk they face is more overlooked than the interest rate risk assumed when locking a loan.
The biggest impacts of interest rate risk are hard to miss. Many real estate lenders did not weather the storms caused by the historically-fast increase in rates from 2022 to 2023. With the benefit of hindsight, we can grasp how significantly rates contributed to the reduction in resale value of loans and reduced demand for home purchases and refinancings.
Even though the seismic impacts appear to have subsided, and we seem unlikely to face another 5% rise in rates in a two-year period, we still find ourselves with an inverted yield curve. Lenders who spent years profiting from the “carry trade” of borrowing at low, stable, variable, short-term rates and investing at higher, longer-term rates (especially fixed) find that this math does not work. Those who were fortunate enough to survive the transition to higher interest rates recognize that the gap between the interest rate terms of their funding and investments represents interest rate risk.
Lenders respond to rate risk in three ways, and these responses can mean the difference between profit and loss.
Eris SOFR Swap futures provide lenders one of the best tools to respond confidently.
Response 1
Ignore the risk because “everyone knows rates are going down”
With recent inflation data trending down and the Federal Reserve forecasting multiple rate cuts in 2024, it is tempting to assume the storm of rising rates has subsided and lenders can return to business as usual. But as any long-time lender can attest, the road is littered with the bodies of those who tried to predict the direction and pace of interest rate moves.
Among the primary drivers of interest rate increases are events that cause chaos and uncertainty, such as wars, terrorist attacks, pandemics and large-scale supply-chain disruptions. Unfortunately, these types of events seem to have increased in occurrence and likelihood in recent years. Assuming rates will go down in the coming years and failing to prepare your business for other possibilities amounts to betting against uncertainty and chaos. Is that wise?
Some market watchers may observe that term rates are currently 100-200 basis points lower than daily Secured Overnight Financing Rate (SOFR, the replacement to LIBOR and index underlying most hedging activity) and conclude that “market consensus” or the “wisdom of crowds” points to lower rates. But basing business decisions on forward rates remains inherently speculative, and markets often fail to predict their own futures well. Today’s term rates may represent the most likely path of rates, but without putting in place financial hedges, one cannot assure that outcome.
Even if current market rates are broadly correct and rates end up lower in a year than they are now, who can predict the path they will take to get there? SOFR may end up 100-200 basis points lower overall, but the path may involve weeks or months of increasing rates. A rise of perhaps 10 basis points over a month would seem insignificant over the course of a year, but its impact on a portfolio of loans that have been locked and are awaiting sale or securitization during that period can be significant.
The reality is that predicting interest rates over any appreciable breadth of time is impossible. Private lenders specialize in sourcing funds and deploying them to promising projects, not predicting the direction and pace of macroeconomic factors. It requires humility to recognize that one possesses neither the time nor the expertise to forecast the future, and the frequency with which even so-called economic “experts” miss their predictions should remind us that lenders are at their best when they focus on lending.
Response 2
Constrain lending practices to limit exposure
Perhaps the most common private lender response to interest rate risk is to modify lending behavior to decrease exposure to rates at the expense of competitiveness and commercial upside.
First, a lender who funds at SOFR plus a spread can mitigate risk by lending exclusively on variable rate terms, such as SOFR plus a higher spread. While this is an effective way to avoid spread compression from rising rates, the increasingly-competitive market for deploying funds limits the number of qualified borrowers willing to accept these terms. Lenders are faced with the choice to do fewer deals, loosen their lending standards, or lend at fixed rates and assume the rate risk.
Second, lenders often seek to re-sell their loans as quickly as possible, treating them as “hot potatoes” to be moved at any price in case the market turns quickly. But this approach potentially limits their upside, as they sacrifice the premium available for amassing larger packages of loans for resale or securitization.
Third, many lenders configure their fixed rate loan terms to use rate levels that build in some insurance in the event rates increase. While this approach contains elements of prudent risk management, the challenge is to pick the right rate for every single loan. Picking the wrong rate not only runs the risk of loss from incorrect forecasting (rate rises exceed the buffer levels), it also decreases the competitiveness of the lender’s loan offering. Lenders who build in “extra juice” in the fixed rate as a profit buffer risk pricing themselves out of the market compared both to firms who are more aggressive in taking rate risk, and to those who manage risk through well-calibrated financial hedges like those described below.
Response 3
Market-based loan pricing and simple, cost-effective hedges
Fortunately, financial markets provide lenders the tools to observe dynamically the markets’ consensus for SOFR’s path over time, and to lock in rates and preserve lending spreads on the day of a loan commitment. Using these tools not only ensures that lenders can pick the right rate for each fixed rate loan, but can inoculate them from the spread compression that comes from rate increases.
In this case, “hedging” can mean trading Eris SOFR, a futures contract listed for trading by CME Group, the largest US futures exchange. A lender who commits to a fixed rate loan and then enters into a short position in Eris SOFR has effectively offsetting exposure to the path of interest rates: rising rates will decrease the value of the loan while increasing the value of the Eris SOFR position, and vice versa. There are more details involved, but the net result is that lenders can rest assured that rates will not wreak havoc on their committed loans and can even aggregate a larger pool of loans to sell at the higher prices typically associated with selling in bulk.
Furthermore, the “price discovery” enabled by the transparent, competitive market for trading Eris SOFR can inform lender decisions for setting levels of fixed rate loans. By observing in real-time the precise SOFR rate at which the market allows them to lock in their hedge, lenders can calibrate loans to ensure fixed rates are as competitive as possible.
For example, take the case of a lender seeking to lend for three years at SOFR plus 275 basis points to ensure a spread of at least 150 basis points over their cost of funding (SOFR + 125). The lender observes Eris SOFR markets showing a 3-year SOFR swap rate of 3.55%, prices the fixed rate loan as low as 6.30% (SOFR + 275, which translates to 3.55% + 2.75% = 6.30%), and trades the Eris SOFR contract to lock in their spread.
Interest rate risk tamed
To thrive during the past few years, private lenders have been required to demonstrate entrepreneurial passion and a commitment to problem-solving.
Just as successful lenders have developed the right tools to mitigate the ever-changing landscape of credit, legal and regulatory risks, so, too, can they leverage financial risk management tools to tame interest rate risk.
