Prior to the credit collapse, many real estate borrowers used Treasury locks (T-locks) in order to fix the base rate of anticipated debt destined for the CMBS (commercial mortgage-backed securities) market. A T-lock fixes the rate of the Treasury note at a future date, corresponding to the closing date of the future CMBS placement of the obligation. This type of hedge is cash-settled, meaning that on the day the T-lock matures (typically the date of the placement), one party pays a lump sum to the other party based on the interim movement of the reference Treasury yield. If the Treasury yield has declined, the real estate client pays a lump sum but receives a lower rate on the CMBS placement to offset that payment over the term. If the Treasury yield has risen, the real estate client receives a lump sum to compensate for the higher rate on the CMBS placement over the life of the transaction. Assuming the settlement and placement occur concurrently, a fixed base rate is secured.
In many cases, this one-time settlement can be a substantial amount of money. For example, the value of a 10-year, $10,000,000 T-lock can change by tens of thousands of dollars with minor intra-day Treasury market movement. If interest rates move by 100 basis points or more between execution and termination of the trade, the cash settlement may reach upwards of $1,000,000 or more.
While remaining a highly successful strategy for fixing future costs, a Treasury lock proves ineffective if permanent markets such as CMBS conduits are for some reason closed, as was the case in the recent financial crisis. In this case, with yields falling precipitously, the borrower may be faced with cash-settling a trade that has a significant negative value to the hedger, while at the same time not being able to place permanent financing. Some of our clients opt for cash-settled swaptions, please give us a call to discuss this structure.
Cardea Partners has assisted numerous borrowers in extricating themselves from these situations by employing a “legging out” strategy. This involves settling portions of the trade over a period of time by closely monitoring for market opportunities. This strategy lessens the effect of timing risk of a full settlement, the liquidity burden of such a settlement, and the likelihood of settling at the mercy of a distressed market. We monitor and negotiate these factors for our clients, and ensure that any settlement amounts are accurate and fair. When permanent financing becomes available, Cardea analyzes the terms and parameters of the debt to provide independent advice for our clients.