A Primer On Interest Rate Caps – Commodities/Derivatives/Stock Exchanges

When the interest rate on a mortgage financing is not fixed, the
amount that a borrower may be required to pay may fluctuate
depending on changes in the underlying index to which the
“margin” or “spread” is tied. While a lender
may be comfortable with its underwriting of a financing and the
ability of its borrower to service its debt at closing, if the
underlying index of a floating rate loan changes over time, the
lender’s comfort and the ability of its borrower to service its
debt will obviously change. To combat against interest rate
volatility, borrowers and lenders usually agree to hedge the
interest rate against the uncertainty in the market for floating
rate loans. The most common form of such hedging is an
“interest rate cap.”

An interest rate cap is a derivative whereby the interest rate
cap provider (the “counterparty”) agrees to pay the
interest which would be payable by the borrower over a strike price
(the “strike”) on the notional amount (the principal
amount) of the loan. Consequently, if the index of the loan rises
above the strike, the counterparty, and not the borrower, is liable
for the excess interest payment obligation. In this way, the
borrower’s liability for payment of interest on the loan in
question is always “capped” at an amount equal to the
strike plus the spread.

As additional collateral for a loan, the borrower will purchase
an interest rate cap and pledge it to the lender. Simply put, the
interest rate cap is an insurance policy on a floating rate loan,
which protects the borrower and the lender if the interest rate
index rises above the strike during a specified period of time (the
“term”). The term of the cap is usually coterminous with
the initial term of the loan. If the loan is extended, extensions
are usually conditioned on the purchase of a new interest rate cap
for the extended period.

Caps are purchased upfront with a single payment at the closing
of a loan. After the premium is paid, the borrower has no further
payment obligations. Most lenders will require borrowers to
purchase the interest rate cap as a condition to closing the loan.
Lenders also require that the cap provider have a minimum credit
rating from Moody’s, S&P, Fitch or another rating agency.
The interest rate cap is usually auctioned to a number of
creditworthy financial institutions to secure the most favorable
terms at the lowest premium price. Lenders will require the
counterparty to maintain a certain rating level during the term. In
the event that the counterparty does not maintain its rating, the
borrower will typically be required to (i) replace the counterparty
with a new counterparty that meets the qualifications and execute a
new interest rate protection agreement, (ii) require the
counterparty to supply a guaranty from a party meeting the ratings
default, or (iii) cause the counterparty to deliver collateral to
secure its exposure to the borrower in an amount acceptable to the
lender and the rating agencies. In most cases, borrowers will
choose either option (i) or (ii).

Since most caps are purchased through an auction process, a bid
package is usually assembled for the bidders, which includes the
agreed-upon terms of the interest rate cap, the timeline for which
the auction must be completed, the assignment of interest rate cap
protection agreement, and the form of confirmation. The
confirmation describes the particulars of the transaction, such as
the loan amount, payment dates, accrual periods and other pertinent
dates, the rates, and other material items necessary to understand
the parameters of the interest rate cap. It is important to review
the confirmation and the bid package to ensure all terms are
correct, and accurately reflect the terms of the transaction. At
closing, the borrower will collaterally assign the interest rate
cap agreement, which is additional collateral for the loan, and
ensures the lender’s right to receive payments under the
agreement.

While interest rate hedging takes many forms, interest rate caps
are the most common derivative in mortgage financing. As we
understand the process, we expect the market and traditional
requirements to make implementation of this aspect of mortgage
financing a smoother and simpler endeavor.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.