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PODCAST: UNDERSTANDING INTEREST RATE SWAPS

Podcasts

  • Transcript

    Podcast Intro:                    Welcome to the Bryn Mawr Trust wealth management podcast, providing commentary on what’s moving the financial markets, financial planning, and other timely business and monetary topics. Please welcome your host, Jennifer Fox, president of BMT wealth management. Hello everyone.

    Jennifer Fox:                      I’m here today with Neil Orechiwsky, the senior vice president, managing director of capital markets at Bryn Mawr Trust. Today we have a very fascinating podcast for everyone focused on swaps. But before we get into the topic of today, I’d like to turn it over to Neil to talk about what capital markets means at Bryn Mawr Trust.

    Neil Orchiewsky:              Hi Jen. Thanks. It’s great to be with you. And um, I’d ever want to, who’s listening out there? So, capital markets is a really broad, concept and can mean a lot of different things to a lot of different people depending on how you’re interacting with the markets. At Bryn Mawr Trust, and at most commercial banks, which Bryn Mawr Trust is, capital markets really deals with interest rate risk and foreign exchange risk management solutions. So we help our customers to manage and mitigate interest rate exposures in their credit portfolio. We help operating companies and individuals who have cross-border payment risk to hedge and to mitigate their, their risk to fluctuating exchange rates. And we do it in the context of delivering traditional banking products and services. So when we talk about interest rate hedging products and risk management, we’re talking about utilizing them in conjunction with typically borrowing facilities that are commercial borrower might have, are high net worth, individual might have with the institution. And we’re talking about foreign exchange risk. We’re usually talking about something as simple as international wires and payments that customers might be sending or receiving to cross border locations. So in a nutshell, that’s what we mean when we say capital markets. And there’s a lot of other things in the capital market. It’s like MNA transactions and investment banking and equity and fixed income. So this is really our niche of delivering what we consider to be higher end risk management services to our wealth and commercial customer base.

    Jennifer Fox:                      So in any, I think that the topic is, is really spot on because I know when we look at and work with our clients regarding their wealth management, we’re having very robust risk management conversations. Most of the time it’s predominantly directed to their investment portfolios in kind of the, the asset side of the balance sheet. Um, we also talk to our clients about insurance as a risk management solution to protect overall wealth for clients in the event of a premature death. But what we’re here today to talk about is really managing the risk on the liability side of a client’s balance sheet and where some opportunities are, especially as we’ve seen the interest rate environment increase a in volatility. We had the, the slight bump up earlier this year with perhaps a, a flattening of the perspective on the part of the FOMC, which we talked about last week on a podcast. So why don’t you give us a little background of what does it mean to take a risk management approach on the liability side of a client’s balance sheet?

    Neil Orchiewsky:              Sure. And those are some great characterizations. And I would, I would think about our sort of product delivery channel if you will, of interest rate hedging products is more akin to the insurance side of the spectrum as opposed to the investment side of the spectrum. So these aren’t products that one would, um, say call up your banker and say, I want to get into an interest rate swap today because I’ve got a view on the interest rate markets. It’s much more so about looking at existing credit facilities that might have exposure to changes in interest rates in one’s portfolio. And for a bank that’s offering a capital market solution, what that really means is aligning the risks and interests that the bank has on its own balance sheet, um, with those that our customers might have on their balance sheets. So generally speaking, I mean the, the context that I would think about this and is as simple as this, if you think about the assets and liabilities of a bank, a banks traditionally have a lot of variable rate liabilities.

    Neil Orchiewsky:              Our funding costs are our deposit base. They fluctuate and they’re very sensitive to interest rates. Most of the assets on a bank’s balance sheet are the loans that it makes to its customers and the majority of them are fixed. So we end up having, from the bank’s perspective is really one way interest rate risk. And if interest rates go up, our liabilities and our funding costs go up with it, but our assets stay where they’re at. And so that can create a really negative interest rate risk profile for, for the bank. Our customers have the same exposures to interest rate markets generally as well. The in their liabilities in their portfolio to the extent that interest rates go up, their borrowing costs go up, their debt service, certain costs go up. And so that can be, you know, obviously detrimental to, you know, to the to the operating, efficiency of their business. So when we talk about interest rate risk management products, it really is more of a behind the scenes structuring that the bank is delivering that enables us to reduce our risk. And in turn, we’re able to pass along those beneficial, funding costs to our customer base. And really at the end of the day, it’s about delivering longer term borrowing solutions at a lower rate. And that’s what our customers most care about. And our interest rate ageing capability enables us to do that.

    Jennifer Fox:                      So Neil, why don’t you share a specific example of what that could look like for a high net worth client who’s looking at their overall kind of credit portfolio from a personal perspective and how would you approach a conversation with that client of who may be contemplating finding a way to protect a that interest rate risk?

    Neil Orchiewsky:              Yeah, that’s a great question. So I think first it starts off with really understanding the characteristics that are in the credit portfolio. And so what we’re, what are we talking about if we’re looking at, say like an operating company or someone they doing to, you know, a commercial or middle market business. Um, it’s understanding what are the debt facilities in the portfolio would, what comprises that letter e lines of credit term debt facilities. Um, what is the composition of the debt portfolio? One single facility, many winter maturities, winter rate resets. All of these things can lend themselves to um, two financial events in the life cycle of a company or borrowing entity. And anytime debt is priced in the market, there’s exposure to interest rates. So where, the short term, borrowing rate was at, you know, four years ago is very different from where it was today.

    Neil Orchiewsky:              So the traditional bank barring facility on, especially if we’re talking about, and really what we’re talking about here are loans or debt facilities generally a million and up in size is, is what we’re, what we’re considering. Um, when banks make loans like that, they typically do them for three or five, maybe at the most seven year terms cause anything longer that is really subjecting the bank to a significant amount interest rate risk. So for anyone that’s entered into a debt facility in the prior five years, they’re either already at or coming up on a appending rate reset and what their interest rate is going to look like today is a lot different than what it looked like five years ago when the Fed had the target rated cro. So now and even in the context of a more volatile rate environment. So once again, after the Fed had to just embarked on a, on a hiking and a tightening regime and hiking the, um, the target rate and now there’s even talk of a potential cut in the short term rate, it’s still significantly higher by a couple hundred basis points than where it was not too long ago.

    Neil Orchiewsky:              So in those contexts, the conversation that we’re having is understanding when those events are occurring and what are some things that, you know, we as you know, a service provider a at the bank can potentially do to help them structure something that can, um, mitigate future exposure with a potentially a longer term borrowing solution. And that’s what a vehicle, like a swap or a cap or a collar people might’ve heard these, you know, these buzzwords before. That’s what these things enable the bank to do in conjunction with a traditional borrowing facility.

    Jennifer Fox:                      As I’m thinking about kind of an impact to, um, our clients or potential opportunity for a client. So, you know, you had mentioned that these work best when it’s a facility that could be $1 million or greater, um, just from an overall mechanics. And that’s great to know of, you know, what type of debt to start looking at from a, you know, from an outstanding perspective. But when I think of a lot of the borrowing that we experience with our clients, so, um, secured lines of credit, which are lines of credit that clients are using for a lot of flexibility and the ability to draw down and invest in whether it’s other real estate or other properties, but utilizing their, um, investment portfolios to do that. I mean, that’s clearly one because of the way that those secured lines are structured, the interest rates are resetting on a pretty frequent basis.

    Jennifer Fox:                      So if I’m sitting with a secured line of credit today, I am going to be exposed to interest rate risk. And depending on which way it goes, but we know we’re at, we’re still at historically low. So when you get historically low, they can only go up. We just don’t know when and how long it’ll take to get there. But if I’m sitting with a secured line of credit and I’m concerned about that, um, interest rate risk or I’m, I’m feeling that rates could go up, is that the type of a structure that’s appropriate for a discussion around whether or not as swap makes sense.

    Neil Orchiewsky:              It certainly can be. And I think that’s a really great example and I where we’d want to start off, especially with a secured lines of credit, is really understanding what is the expectation for balances that are outstanding on those lines of credit. Because the way that an interest rate hedging structure works is really as simple as this. It’s combining and in two components what is ordinarily done in one. So the comparison of drawings between a bank making traditional fixed rate loan in a singular instrument. And instead what we’re looking at, our variable rate loans variable debt facilities that we couple with the interest rate hedging instrument and that’s in say a swamp or a cap or a collar. Um, so what the interest rate hedging instrument is hedging is the fluctuating interest payments on a matching principle balance associated with a, an outstanding debt facilities.

    Neil Orchiewsky:              So for a line of credit, we’d want to understand what the customer’s potential usage of that line is. Is there an amount that is consistently outstanding or is it something that fluctuates from Aha utilization down to, you know, complete payoff and a lot of volatility around that. Some situations like that might not be the most suitable for an interest rate hedging structure. Um, but in that case, I’m, I in looking at that and doing an analysis around that, we might say that the of the exposures that the customer’s facing, given that type of utilization volatility, perhaps they interest rate risk is and their greatest concern. Um, but if someone has a consistently outstanding balance in their credit portfolio, I’d say that absolutely merits taking a little kid of interest rate hedging, structuring possibility. And that’s when we get into the nitty gritty and into the weeds of what’s the appropriate hedging structure. Is it a swap or is there perhaps a cap or a collar or something that might lend itself to have more flexibility than a swap? Um, if that’s some of the issues that they’re concerned about.

    Jennifer Fox:                      But it sounds like what you’re doing is fixing a portion of a variable loan and getting more of a, a term rate or a fixed rate component of that by doing this type of transaction, whether it’s a swap or a color or a cap, you’re basically saying this is the amount of the loan that I’m willing to commit to more of a fixed rate in there has to be some level of certainty around the balances to really make sure that it works.

    Neil Orchiewsky:              Yeah. Because what we want is we want alignment. So the interest rate contract, interest rate hedging instrument is really intended to offset corresponding interest payments on the debt facility. And so if let’s say, let’s talk about an example facility. If we could maybe that might make this even more practical for, you know, for our listeners. So secure line of credit, perhaps that’s, you know, a 3 million, line that’s outstanding of which 2 million is consistently being utilized. There’s perhaps fluctuations in the balance up to the full 3 million but over time and you know, looking at the customer’s usage and thinking ha, asking them to also think about, okay, over the next three to five, to seven to 10 years or whatever their utilization timeframe is, what do they expect to have outstanding? The, we would look to design and to tailor and interest rate hedging contract around those amounts.

    Neil Orchiewsky:              Outstanding and hedge. We can just a portion of that facility. So we might say, well, let’s be more conservative. Let’s avoid having more insurance then risk that we’re actually protecting against. And really that’s one of the things, the biggest thing that we want to avoid is yeah, we wouldn’t want to enter into a $4 million swap on a $2 million balance. Right. Or Cap our collar and in some type of relationship like that. So we’d rather be slightly under hedged than over hedged and that’s going to be more beneficial for the customer. And ultimately allowed them more flexibility. So those are the types of things that we would look at analyzing and determines that determining what was the right hedging strategy for them. And the next part of it is really helping to, you know, our customers to really think through, um, and with our assistance, what is the posture that they want to have in their portfolio for being fixed or floating it. A lot of it depends on what are their assets od exposures as well and looking at their position, their financial position globally. Um, so whether that’s for a corporate or whether that’s for a high net worth individual that’s utilizing, a line of credit, a lot of the same considerations are applicable and these are the things that we would want to take a look at and work through with them.

    Jennifer Fox:                      So it does sound like a good starting place for this conversation is really based on discovery of client’s goals and objectives, um, and making sure that the solutions aligned with what they’re trying to accomplish from a big picture. So from a financial planning perspective looking at that long-term focus and again on managing the risk side of it, making sure we’re, looking at that downside component and keeping it all together. So having that really strong dialogue around discovery and what outcomes you’re looking to accomplish and how does it fit in the bigger, um, plan seems to make a lot of sense.

    Neil Orchiewsky:              Yeah. In one word that you just, you know, utilize. There was the planning, you know, perspective and I think that’s the biggest, you know, facet or one of the bigger advantages of having a capability like this that a lot of other community or regional banks don’t typically have. And instead by having an interest rate hedging vehicle, it enables the bank to offer hedging strategies and debt structuring solutions in a much more proactive manner so clients can look out and not only mitigate and hedge their exposures that they have right now. But one of the ways that we, often work with our client base is taking a look at, like we talked about their entire debt portfolio and identifying not just current market exposure events, but upcoming market exposure events, things that are perhaps six months, a year, two years, three years, even several years further out than that.

    Neil Orchiewsky:              And we have the ability to enter into forward starting hedging solutions that allow our clients to proactively manage their rate risks in ways that really go way beyond the traditional bank borrowing and lending model where you’re really exposed to what the rate is today is what it is. And that’s, this is an entirely different realm of, of nuance. So it requires a little bit more thought and engagement, but I think the end results can be much more tailored to the specific exposures and the outcomes that our customers are targeting.

    Jennifer Fox:                      There’s clearly, um, a number of benefits to a client over the long term for entering into this conversation. And I’ll just start it as conversation as opposed to getting more specific. But what are, what are the risks or the downsides of this type of solution?

    Neil Orchiewsky:              Sure. So the first thing is that certainly understanding the universe of applicability. So we talked with, and we use the kind of around number of generally borrowing facilities, a a million and up is where this is most useful and most applicable. Um, some of that is driven by the fact that, you know, in order to access the efficiencies of the capital markets and, you know, swaps and caps and collars, these instruments are derivatives and the derivatives market walk streamline liquid, it’s most efficiently accessed when you’re transacting in a more meaningful size denominator, like that. The other consideration is certainly, another consideration to think about is from a regulatory perspective. So, um, with the advent of Dodd-Frank, there’s real clarification’s not too dissimilar from the investment market with a qualified investor, consideration in for utilizing derivative products of which swaps and caps and collars are, are, or considered.

    Neil Orchiewsky:              Um, there is a regulatory standard known as ECP, or eligible contract participant, that really defines, essentially two different metrics for who is eligible to enter into a hedging structure. Um, there is the quantitative measure of net worth or total assets. And there’s also the qualitative consideration of having an actual risk to manage. So this isn’t something that someone would call up to our trading desk and say, I’d like to take a view in the market and enter into initial trade, swap contract without having an actual underlying debt facility with the bank that they’d be seeking to manage the risk on. Um, so one of the other considerations is, is from when thinking about potential prepayment of a facility that has been hedged with an interest rate contract, one of the benefits that we’re able to convey with a swapped debt facility as opposed to a conventional bank facility is that we’re separating out the interest rate component from the debt component.

    Neil Orchiewsky:              And that’s how we have two contracts, a variable rate debt facility coupled with a hedging instrument. And the combination of those two instruments works to mitigate, the customers interest rate risk exposure. But in doing so, the interest rate contract itself is a market based instrument and one of its benefits is that it can take on positive market value in a rising rate environment that customers can benefit from. Should they be paid their debt facility early and need to terminate or mature early that interest rate swap. The downside can be that if interest rates haven’t risen or they haven’t risen as much as what was forecast then that contract not unlike another financial instrument like a stock or bond, it can also have a loss associated with it if it were to be exited early. So one of the things that we spend a lot of time on as we work with our customers and tailoring a specific hedging, structure with them is really to help them to understand what is the risk profile of that instrument.

    Neil Orchiewsky:              And so an example of how we do that is we would shock that instrument in, in a variety of interest rate environments throughout the life of the contract. And we have a robust discussion around what does that exposure profile look like and how much is a consideration of that for you. One of the ways that we try to mitigate that risk for our customers is again, kind of a topic that I talked about earlier, which is not over hedging. So we don’t want to enter into a 10 year interest rate contract if we think we have three to five years of of debt exposure. And we’d want to tailor the instrument to really conform to that. And really so we want to stay underneath, you know, what the customer’s risk profile is and ensure that the contract that was intended to mitigate risk isn’t creating more risk and other areas that aren’t necessary that, that we certainly would want to avoid that.

    Neil Orchiewsky:              There are, and sometimes some perceived complexities around swap. So when get you say that word, eyes, eyebrows go up, or they shut a win when discussing it at cocktail parties or, or elsewhere. But there, the accounting for interest rate contracts is slightly different. Um, and so, you know, we would refer our customers to work with their accounting professionals to determine if it’s suitable for them. But the biggest is, is really understanding the, the potential, early termination profile associated with the contract. Again, because it is a market based instrument.

    Jennifer Fox:                      What I’ve heard from today first is that there’s a, there’s a tremendous amount of potential to protect the liability portion of your portfolio from the interest rate risk environment and we will likely continue to see volatility in the interest rate environment. Um, while the longterm trajectory can still be uncertain. We know there’s a little bit of volatility, but it sounds like that having that robust conversation, um, with your advisors understanding kind of total balance sheet and where some of those risks and potential opportunities might be as a great place to start the discussion. Um, like many solutions, not all solutions, but many solutions, they might start out, um, as challenging and become really appealing or they may start out as really appealing and find out that they’re too challenging, but we’ll never know what that a discussion with with the advisors. So, um, with that, Neil, I think the best way to engage in that conversation is for, for all the clients that are listening is to reach out to their Brenmar Trust, a wealth management advisor who then can connect the client with you and your team to really explore whether or not that this could make sense and is appropriate for those clients.

    Neil Orchiewsky:              Yeah, absolutely. So if you have debt exposures that meet some of the parameters that we’ve talked about here today, then I would absolutely advocate, reach out to your wealth advisor, reach out to your, to your banking representative and they’ll look to see if we can facilitate a discussion and those how we want to add value to our customer base going forward.

    Neil Orchiewsky:              Fantastic. Neil, this was incredibly helpful and a lot of really good information, especially when, yeah, we look to work with our clients to protect their overall wealth. So thank you very much.

    Neil Orchiewsky:              My pleasure. Thanks for having me, Jen.

    Podcast Close:                   This has been a production of Bryn Mawr trust. Copyright 2019 visit us online at bmt.com/wealth. The views expressed herein are those Bryn Mawr Trust as of the day recorded and are subject to change without notice. Guest opinions are their own and may differ from those of Bryn Mawr Trust and its affiliates and subsidiaries. This podcast is for informational purposes only and should not be construed as a recommendation. Any product or service. BMT wealth management provides products and services through Bryn Mawr Bank Corporation and its various affiliates and subsidiaries, which do not provide legal, tax or accounting advice. Please consult your legal tax or accounting advisors to determine how this information may apply to your own situation. Investments and insurance products or not bank deposits are not FDIC insured, are not backed by any bank or government guarantee and may lose value. Past performance is no guarantee of future results. Insurance products not available in all states.

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