An Introduction to Interest Rate Ceilings | Cadwalader, Wickersham & Taft LLP
Where the interest rate on mortgage financing is not fixed, the amount a borrower may be required to pay may fluctuate with changes in the underlying index at which the “spread” or “spread ” is linked. Although a lender may be comfortable with its funding security and its borrower’s ability to service its debt at closing, if the underlying index of a floating rate loan changes Over time, the comfort of the lender and the ability of its borrower to service its debt will obviously change. To combat interest rate volatility, borrowers and lenders typically agree to hedge the interest rate against the uncertainty of the variable rate loan market. The most common form of such coverage is an “interest rate cap”.
An interest rate cap is a derivative whereby the interest rate cap provider (the “counterparty”) agrees to pay interest that would be payable by the borrower on a strike price (the ‘exercise’) on the notional amount (the principal amount) of the loan. Therefore, if the loan index exceeds the strike price, the counterparty, not the borrower, is liable for the obligation to pay the excess interest. Thus, the borrower’s liability for the payment of interest on the loan in question is always “capped” at an amount equal to the strike price plus the spread.
As additional security for a loan, the borrower will purchase an interest rate cap and pledge it to the lender. In simple terms, the interest rate cap is an insurance policy on a variable rate loan, which protects the borrower and the lender if the interest rate index rises above the strike price for a period of time specified (the “Duration”). The term of the cap generally coincides with the original term of the loan. If the loan is extended, extensions are usually conditional on the purchase of a new interest rate cap for the extended period.
Caps are pre-purchased with a one-time payment at loan closing. Once the premium has been paid, the borrower no longer has any payment obligation. Most lenders will require borrowers to purchase the interest rate cap as a loan closing condition. Lenders also require the capitalization provider to have a minimum credit rating from Moody’s, S&P, Fitch, or another rating agency. The interest rate cap is usually auctioned off to a number of creditworthy financial institutions to secure the most favorable terms at the lowest price. Lenders will require the counterparty to maintain a certain level of credit rating over the term. In the event that the counterparty does not maintain its rating, the borrower will generally be required to (i) replace the counterparty with a new counterparty that meets the conditions and sign a new interest rate protection agreement, (ii) require the counterparty to post collateral from a party responding to the rating failure, or (iii) cause the counterparty to post collateral to secure its exposure to the borrower in an amount acceptable to the lender and rating agencies. In most cases, borrowers will choose option (i) or (ii).
Since most caps are purchased through an auction process, a bid package is typically assembled for bidders, which includes the agreed terms of the interest rate cap, the time frame for which the ‘auction must be completed, the award of the interest rate cap protection the agreement and the confirmation form. The confirmation describes the details of the transaction, such as the loan amount, payment dates, accumulation periods and other relevant dates, rates and other material elements necessary to understand the parameters of the rate cap. interest. It is important to review the Confirmation and Bid Record to ensure that all terms are correct and accurately reflect the terms of the transaction. At closing, the borrower will pledge the interest rate capping agreement, which provides additional security for the loan and secures 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 implementing this aspect of mortgage financing a smoother and easier undertaking.