We've all heard that the costs of traditional interest rate hedge products such as caps and swaps have recently become more expensive. How much more expensive? According to this WSJ article, prices on these products have jumped at least 10-fold this month year over year.

For those borrowers who are required to purchase an interest rate hedge (i.e., it is a condition precedent to closing a new financing; the terms of an existing financing require that a hedge be purchased once the applicable floating rate benchmark exceeds a certain threshold; or an investor mandate requires it), some are negotiating with their lenders on creative ways to reduce the present cost of entering into a hedge agreement (with varying degrees of success). Examples include:

• reducing the term of the hedge (with the need for future hedges sometimes based on reevaluating where the benchmark rate is at the time the initial hedge contract is set to expire);
• reducing the notional amount of the hedge (e.g. based on a percentage of the loan amount; or based only on the amount of the loan outstanding, with a condition precedent to future draws that a new hedge be entered into to match the amount of such a future draw);
• increasing the strike rate; and
• avoiding purchasing a hedge contract altogether by posting an escrow or providing a guaranty of the interest expense that would otherwise be covered by a hedge contract.

Despite the increased cost to enter into a hedge contract, some borrowers are voluntarily entering into hedge contracts even though the terms of their financing may not require it. Hedge contract pricing is driven by the forward curve of the applicable benchmark. Some predict that the actual rise in benchmark rates over the next year will outpace the current forward curve projections - leading to an increase in the cost of entering into a hedge contract. By voluntarily entering into a hedge contract now (albeit much more expensive than one year ago), borrowers are able to create underwriting/budget certainty with respect to interest expenses and potentially save on the overall interest expense over the life of the loan.  

Borrowers should work with their counsel and hedge brokers to discuss the pros and cons of these various approaches and to understand what is being seen in the market as this dynamic issue continues to play out over the following months.