Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
Has anyone out there in creative land used futures contracts to hedge interest rate risk on your ARM? I am wondering what futures to use for commercial loans with floaters past year 5 or so. Selling eurodollar futures to hedge LIBOR floaters may make sense.
Does anyone have experience implementing something like this? Is basis risk the main thing to account for?
Flipper/Rehabber · Louisville, KY · Member since 2008 · 1k+ posts · 1k+ votes
15y
I looked into this a couple of years ago and found it much harder in practice than it seems in theory. (and I am a futures trader by trade!)
This pretty complicated stuff and I never found anyone who had actually done it on an individual basis.
It all looks perfectly straightforward on paper. But then I would do a "paper trade" and use real examples and prices to put the hedge on and then create scenarios and prices in the future to simulate different outcomes. Then tally up how effective the hedge was. I kept coming out on the losing end in these scenarios and finally figured out why.
The problem occurs when you see that the futures market already has priced in certain expected rate increases over the coming years. (look at the Euro$ futures going out a few years).
So let's say you see that 1 yr LIBOR is 1% (just using round numbers for example. Future price would be 99.00) and you want to hedge for an adjustment that will occur in 2 years. You are thinking to yourself "I want to lock in that 1% rate". So to do this you have 2 basic choices. Sell contracts dated 2 years in the future, or sell the nearest contract and keep rolling that nearest contract each expiration (sell a new on every 3 months or so). Most people would sell the 2 year future. The problem is that the 2 year future is not priced at 1%. It is priced at 2% (price of 98.00) because the market is expecting that rate rise over 2 years. (again, example pricing)
So you are not actually locking in a 1% rate, you are locking in a 2% rate. This is fine as long as you understand that.
So then create a scenario to check if your hedge worked.
The easiest scenario is let's say rates stay exactly the same as they are now for the next 2 years. In a "hedge" situation, you would expect to make no gain or loss ignoring commission costs. However, in this case you would lose because that 2 year contract you bought that is now coming to expiration is now priced at the current rate of 1%. So you sold it 2 years ago at 98.00 and now you will have to close the hedge by buying it back at 99.00. You have lost $2500 per contract hedged but your rate on your mortgage is unchanged.
Hope that makes sense.
NOw, in other scenarios the market may have gone your way or it may also go the other way but in all cases you will have that 1% difference between what you thought you were locking in and what you actually locked in. So let's say the market does indeed do as expected and the current rate is 2% in 2 years. You will have no gain or loss on the hedge but your mortgage will adjust up a percent and you will pay more interest costs so you will be a net loser.
If you choose the other strategy of selling the closest month and rolling often, your outcome is a little better but the same scenario happens on a smaller scale each rollover plus you have greater transaction costs. So instead of losing $2500 on 1 contract, you might lose $200 each rollover for 2 years. Still $1600 plus 8 commissions.
The basic idea is that when you hedge you are not locking in "today's rates" as most people think of today's rates. You are locking in today's rate expectations for the future. And the market has already priced in the expectation of a rise. If the market rises MORE than is expected today, then you will benefit by that extra amount. But if the market rises less than the expected amount (as in the scenario where rates stay the same) then you will lose that amount.
If you are happy to lock in that expected rate because you think the expectation is too little and it will be even worse in reality, then go ahead, it works. Just realize exactly what you are locking in.
The moral is to make a timely hedge you must hedge not before the rate move happens, but before the EXPECTATION of the rate move is priced in to the futures. We are in a scenario now where the rate move has not actually happened but enough people think it will happen that an increase is already priced in.
Investor · Cincinnati, OH · Member since 2010 · 1k+ posts · 928 votes
15y
I was glancing at swap rates. A 20 year interest rate swap currently trades at 4.30% (ie. you'd pay 4.30% and receive 3 mth Libor for 20 years). A bank's typical portfolio ARM loan might be 1 Yr Tsy+3.25%.
So using a 20yr swap along with this typical ARM, you could lock in for 20 years at 7.55% (4.30%+3.25%), plus or minus some mismatch betwee 3mth Libor and 1yr tsy (currently they're right on top of each other).
Does this sound correct? I assume a futures position would accomplish roughly the same thing. These trades will require cash to be posted to the counterparty if rates actually decline from here, so you need cash reserves or an LOC to supply the liquidity.
If your holding period is just 5 years, the 5yr swap is at 2.50%, so you can lock a fixed rate of 5.75%. This is pretty close, no coincidence, to where banks will loan you money on a 5/1 ARM.
Multifamily Investor · Toledo, OH · Member since 2008 · 296 posts · 308 votes
15y
@David- are swaps pegged to a notional value like eurodollars are? If so, then I will explore your idea too. One reason I chose eurodollar futures is the $1mm notional value.
@Deuce- you are correct. A monthly or quarterly eurodollar trade will not cover prior period rate increases. The way I see it, there are two ways to deal with that. First, I could go out farther on the curve. But then I would lose out more on the expectations that are already built into the market. Sept 2016 is already at 5.02%.
Second, I could increase my position as time goes on. But that means significantly more leverage, significantly more risk and significantly more collateral. Scary.
I just started doing some business with a local commercial bank. I am going to take your suggestion and see if they will create a swap for me. You never know...
Real Estate Investor · Alpharetta, GA · Member since 2010 · 415 posts · 484 votes
15y
Love to hear what the bank says. If they are locally-based, my guess is that they won't be able to help you. You probably need a bank with a real swap desk. I've pinged an ex-colleague to see if the bank would entertain this.
Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
15y
Another good thread to kill time on the fringe of reality, LOL.
OK you market gurus, what loan amount does that ARM need to be to justify the trading expenses, time and capital reserves to hedge that interest rate risk?
Why not use the brain damage, time and money to make more in real estate endevors and write off your interest rate expenses. Don't you think one more good property will usually net you more than the spread on your ARM?
Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
15y
If you have a very large loan where your time, money and brain damage breaks even, that would be ok, how big would that loan need to be? And chances are, if you have a loan that big, you obviously qualified to get it, which means you must be busy making money in other areas which makes the cost of your hedging project go up.
You really come up with some wild ideas as brain teasers for, mostly, individual RE investors. LOL, I know you don't like large banks Bryan, but I really think you would be happier in the asset management department at Chase where you could explore ideas and your quest for the ultimate risk management tools.
One of my duties as a Finance Officer in the Army was cash control and I was required to see to it that our balances were constantly invested and maturing to meet cash obligations or operations for the post, hundreds of millions, that's why I'm finding it humorous. If you had this problem, you won't have a problem as you should have other investments maximizing profits.
Multifamily Investor · Toledo, OH · Member since 2008 · 296 posts · 308 votes
15y
The brain damage is definitely worth it to me. If rates go up 4% that's $40,000 a year on $1 million. If I can find a way to save $40,000 a year, I consider that time well spent. Also, I personally find it fun and interesting to think about things outside of my normal real estate world. That's part of the beauty of the freedom of this business.
@David- I have an appointment with Glamour Shots in the mall to get a better picture.
@Deuce- my local commercial bank said no dice with them and he warned me against doing such a transaction with big banks. He very eloquently said that a big bank would rake me over the coals in such a transaction.
Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
15y
So Ryan, how many million dollar ARMS do you have? I would consider getting a good broker and sluff that job off and do what I do best. But, I understand the fun of discussing the fantasy.
Investor · Cincinnati, OH · Member since 2010 · 1k+ posts · 928 votes
15y
Financexaminer -- I know you've run most of the companies in the Fortune 500 at one time or another and the breadth of your experience is beyond comprehension to most of us, and we're undoubtedly a source of never-ending chuckles, but really...
your commentary adds nothing to the discussion other than permitting you to preen before us.
Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
15y
David, how did you find that out? I have tried my best to keep that a secret. I didn't mean to pop your fantasy, maybe you could do a little break even analysis on the subject and come up with that single loan amount, I thought that was a valid question. Now that would be something to read! I'll go back to the RE subjects now, I won't butt in anymore......later.
Multifamily Investor · Toledo, OH · Member since 2008 · 296 posts · 308 votes
15y
Finance- I have many small ARM's, about $40k each, totalling $1 million. I am taking extra cash flow from flipping and paying them off. In the meantime I would like to cushion the blow of any future rate increases.
Real Estate Investor · Alpharetta, GA · Member since 2010 · 415 posts · 484 votes
15y
Originally posted by Ryan Pyle:
@Deuce- my local commercial bank said no dice with them and he warned me against doing such a transaction with big banks. He very eloquently said that a big bank would rake me over the coals in such a transaction.
Well, of course he said that. (Are you even sure he knows what an interest rate swap is, though?) It's the local guys' job to slam the big banks, and it's the big banks' job to slam the little banks. That's the way the world works.
In the event that a big evil bank could do a credit swap for you, though, they wouldn't rake you over the coals. (That's just little-bank-speak to remind you exactly how evil the big evil bank is.) Would they make money off you? Yes, of course. Isn't that what any bank does?
In any event, it's not going to happen, so let's move on to something else.
How about shorting enough Treasury notes so that if rates go up, your gains are enough to curtail your principal so that your net interest expense stays the same? Have you ever modeled that out? I guess you'd have to structure this in such a way that if the short position moves against you, you're still breaking even net-net.
With respect to Bill's comment, I see where he's coming from, although I don't think there's any harm in trying to figure out how to create synthetic fixed-rate debt from floating. And the fact is, if someone figured out how to do that for investors having, say, $500K or more in debt, that person would probably make a pile of money -- or go broke!
It's these kinds of "what if" discussions that keep the brain in shape, not to mention you never know what solutions might be uncovered.
Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
15y
What a tactful post Paul! Well done sir!
Maybe $40k in annual savings is small potatoes to you Bill. For we mere mortals it is certainly worth kicking it around on a message board for a bit. This thread has had responses from a number of folks so it seems there is more interest than you think.
I have seen far more commentary devoted to rubbish on this board so I don't think the "fantasy" discussed herein is going to hurt much.
Flipper/Rehabber · Louisville, KY · Member since 2008 · 1k+ posts · 1k+ votes
15y
Ryan,
I tried in earlier posts to explain why this hedge would not accomplish what you hope. It is so much more complicated than you describe. The fact that you have 25 mortgages makes it geometrically more complicated.
Each potential rate adjustment is a separate event that needs to be hedged. When your rate adjusts, you need to remove the hedge to complete it but your adjustment amounts are too small.
For example, if your rate adjusts higher one year, it will cost you more in interest the next year. If you are hedged, then you would have to take your profits on the hedge to offset your losses on the mortgage. You would not be able to remove the hedge on a $40K mortgage. Why does this matter? Let's say you don't remove the hedge and you just pay the higher rate for the year. Then rates go back down to the same as they were previously. What is the end result? You have paid more interest on your mortgage for the year but you did not take profits on the hedge and you no longer have any profits on the hedge. So your hedge did nothing to protect you when your interest costs went up.
In addition, when you roll each quarter you are not rolling at a Zero spread. In other words, it will gradually cost you basis every time you roll.
Also, if you are tied to treasury's you would be using Tbill futures. Euro$ should be used if your rate is tied to LIBOR.
I suggest you dig up some historical futures prices and do a simulation for the past couple of years of your strategy. YOu must look at each rollover and count transaction costs and look at what action you would have taken when your ARm's adjusted. I think you will see what I mean.
Multifamily Investor · Toledo, OH · Member since 2008 · 296 posts · 308 votes
15y
Well, given the Fed's statements yesterday and the continued rally of short term treasuries, I don't think we have to worry about this topic for a while...at least until the next big crisis.
Smithtown, NY · Member since 2011 · 1 post · 0 votes
15y
Hi everyone. I stumbled across this post while researching how to create interest rate swaps for myself using futures contracts. In browsing the CME website I noticed that they offer interest rate swap electronic futures contracts.
Real Estate Investor · West Des Moines, IA · Member since 2011 · 1 post · 0 votes
15y
I'm not sure but it seems farmers are talking about using ED futures for hedging a line of credit out 3-7 years. http://accordent.powerstream.net/008/00102/videoplatform/kv/101209DTNkv.html. Why not just buy puts on the ED futures?