DealVector Ask An Expert: Joyce Frost on Hedging Warehouse Risk for Issuers

For our first Ask-An-Expert feature, we caught up with Joyce Frost, Partner at Riverside Risk Advisors. Riverside is a leading independent derivatives advisory firm in the structured credit, currency, and interest rate markets. We asked her about interesting recent developments she has been seeing in her client work.

• For many issuers, interest rate risk in structured deals is non-trivial to hedge
• The right structure, dynamic notionals, unwind risk, and doc subtleties all must be considered
• Dodd-Frank uncertainty remains a complicating factor

DV: Joyce, thanks for taking some time today to chat. What is this issue around interest rate risk during the warehouse period that you were telling me about?

JF: Well, it’s interesting. There are some types of structured deals printing now, say, that have fixed rate collateral —

DV: — as opposed to something like CLOs?

JF: Exactly — with CLOs you have generally floating collateral assets that are matched to floating liabilities, with some exceptions like certain mezz tranches. During the warehouse period for those deals the interest rate risk is muted. Credit cards would be another where short duration on both assets and liabilities mitigates the need for an interest rate hedge, both pre and post securitization.

DV: And what would be an example of an issuer that faces rate risk during the warehouse period?

JF: Any issuer that has collateral that bears a long-term fixed rate or collateral that when sold into the SPV is sold at a price based on the then current rate environment is subject to rate risk. In that case, there are more things for an issuer to think about.
DV: Makes sense. But is this a big deal? Wouldn’t you just go out and hedge your cash-flows with a vanilla swap?

JF: That’s a normal first reaction especially when banks are the warehouser and hedging is a requirement.  For starters, if we think back to 2008, one of the big things that hit the banks hard was the fact that they were caught with all of this warehouse risk. The securitization machine was chugging along.  When the music stopped, credit spreads blew out and the banks and issuers found themselves caught with a large number of assets at the wrong price that could not be moved into the SPVs due to market conditions.

DV: Banks found themselves in the storage business rather than the transportation business.

JF: Yes, I guess you can think of it that way.  Those losses were really attributable to changes in credit spread and liquidity risk, Those risks still exist for issuers, but are impossible, difficult or very expensive to hedge, thus the move toward larger haircuts.  In the current environment with so much rate volatility and uncertainty, there are a few things that issuers really need to pay attention to when thinking about the need for hedging. By definition the notional amount is changing in a warehouse ramp-up. So every time you add an asset you need to change the overall hedge amount and account for the impact of the new asset on the portfolio-wide interest rate exposure. The swap shouldn’t just be based on the new incremental amount of assets being warehoused. Addtionally, at times we see cash-flow hedges constructed to hedge the sales price when it really should be a market value hedge.

DV: Good points. The vanilla swap needs some sprinkles.

JF: Yes. Another issue is that long term fixed assets need only be hedged in the warehouse for a short period — let’s say six to nine months. There’s no reason to pay for swap credit risk to your dealer beyond a reasonable expectation on when those assets will be securitized. Additionally, there needs to be an understanding for what it is going to cost to exit that warehouse hedge when the time comes. Certain provisions can be added into the ISDA and agreed upon in advance.  We’ll often work with issuer counsel to help bring a commercial, trading-desk perspective to some of the legalese that benefits issuers for hedging risk during the warehouse period or post securitization.

DV: Example?

JF: Having a trading desk and dealer background definitely clues us in to some of the nuances that sneak into “standard form” ISDAs or credit docs that ultimately benefits the dealers at the expense of the issuers. For example, if there are several swap providers we try avoid pro-rata swap allocations or terminations at all costs. It sets up the issuer for an uncompetitive situation and the issuer could end up paying the worst price offered by any or certainly a disincentive for tight pricing. We’ve seen this on a number of occasions.

DV: Not favorable game-theory dynamics, I guess.

JF: Exactly. It might be hard to see that the legal language results in creating a disadvantage to the issuer but living through it once or twice makes it clear.

JF: Another area to examine is that depending on the pricing received from the dealer, it may or may not make sense to enter into a balance guarantee swap whereby the swap notional amount changes to reflect the actual cash-flows in a deal. Maybe the issuer is better off building hedges out of simpler building blocks themselves or addressing the issue through documentation.

DV: Sort of like the case when the retail investor figures out he can use cash and options to build a principle protected note without all the fees.
Very interesting. Anything else coming down the pike on this issue?

JF: Well, it’s also worth noting there is still a lot of uncertainty related to hedging as a result of Dodd-Frank especially for securitization vehicles that are considered financial entities. There are so many unintended consequences as a result of this overreaching Act, that it would ruin my Friday to start naming them.

DV: So things will stay interesting for you and your clients.

JF: Indeed.

DV: Well, we hope you will be able to come back and keep us posted!

JF: Thanks Dave!

Questions for Joyce? Please feel free to comment below.