Swap Spreads: Ghost in the Machine

Swaps spreads are a measure of  risk in the credit markets.  The higher the swap spread, the bigger the credit risk as perceived by market players.  To most easily understand how swap spread are a proxy for risk, we can start with a simpler example of how to gauge credit risk in the market.  Credit risk can generally be viewed as the difference between the 90 day T-bill and the 90 day libor.  The t bill is considered to be the risk free rate.  Libor is the average rate at which banks borrow overnight, and has credit risk built into it-  the risk that the bank will not repay the overnight loan to the other bank which lent the money.   If you look at the spread between these rates, it has run around 50 basis points (bps) historically.  Therefore economists argue that 50 basis points is the definition of credit risk.  At times of aberration (stock market crash of 1987, Long Term Capital debacle in 1998, and the subprime crunch of 2007) this spread increased to about 100 bps.

Turning to swaps- swaps are used when market participants want to swap, or exchange positions, with other parties.  The most common use of swaps in commercial real estate is an interest rate swap.  Some people want to borrower fixed rate, and others want to borrow floating rate.  For example, a bank might pay its depositors floating rate and would prefer to lend to its commercial real estate borrowers at floating rate, but the borrower wants fixed rate.  A swap can be utilized to accomplish this.  The swap market is very active, with about $400 trillion of swaps outstanding, dwarfing the U.S. treasury market, which runs around $11 trillion.

When borrowers want to get fixed rate from a floating rate lender that swaps, typically the lender quotes the loan at Libor plus the swap rate.  That swap rate has the swap (i.e credit) spread built into it just at Libor has the credit spread built into Libor.  If we compare, for example, the 10 year treasury (perceived to be the risk free rate for a 10 year duration) to the 10 year swap rate, the difference is the swap spread, or credit risk that the swap counterparty will not live up to its obligations.  Historically this swap spread has run about 55 bps.  At the height of credit crunches it got as high as 125 bps.

However, at end of June the 10 year swap spread was 21 bps, and end of July 13 bps.  This seems odd as many of us perceive more market risk now.  Part of this reduction in swap spread is likely tied to libor reporting issues, as well as banks being flush with cash and not needing to borrow overnight from other banks like they used to.  These low swap spreads offer commercial real estate borrowers great opportunities to lock in long term real estate financing at very low interest rates, and to borrower such long term fixed rate from lenders that are often perceived as short-term, floating rate lenders.  Beware that the ‘prepayment penalty’, or cost to unwind the swap can be hugely expensive, akin to defeasing a CMBS loan.  However, commercial mortgage broker Financial Compound can assist borrower in obtaining fixed rate, swap based loans, with no prepayment penalties at all.  For borrowers experienced with these swap instruments, please don’t fall out of your chair!  We work with certain financial institutions that allow borrowers to enjoy long term fixed rates at much lower rates than the CMBS or life insurance companies offer today (due in part to this perceived imbalance in swap spreads) without burdensome swap agreements or personal guarantees on the swap.  Feel free to call us with your scenarios.  To start learning more about swaps, please use Financial Compound’s Rates App, which can be downloaded with the link at the top right of this newsletter.  Interestingly, there is some steam picking up in the world of economists as a result of these experiences where some economists feel that swaps are no longer the best proxy for credit risk, and they are looking at the spread between 10 year U.S. treasury and 10 year paper sold by Spain and Portugal.

For more information, contact commercial mortgage broker Financial Compound at 310-260-5900 x103