Activity in a type of hedging program that allows banks to offer commercial borrowers fixed-rate payments while simultaneously laying off the interest rate risk could accelerate this year after a dip in 2021, according to Chatham Financial.
With "back-to-back" swaps, banks write floating rate loans but offer borrowers fixed rates by entering into concurrent swaps with the customers. Offsetting swaps with dealer banks keep the payment flows to the lender floating. According to Chatham, which helps banks set up and run such programs, the structure helps small and midsize banks meet borrower demand for fixed rates and compete with larger banks while managing interest rate risk.
Volume fell across asset-size categories in 2021 from a "high-water mark" in 2020, according to Chatham's annual statistical report on the swaps, as headwinds like soft loan demand and uncertainty over replacement rates for Libor prevailed. The programs can also be attractive to banks because they generate fees for originating and servicing the swaps, and average fees fell slightly across most asset-size categories in 2021.
Now, "a lot of those headwinds are largely gone," said Ben Lewis, a managing director at Chatham. Regarding the questions over reference rates, the "market has really coalesced around" the secured overnight financing rate, or Sofr.
Another big factor has been the shift in the interest rate environment, with policymakers' projections suggesting that substantial rate hikes were years away being quickly replaced by forecasts for a rapid string of increases in 2021.
Some banks may have been less interested in hedging fixed rates in 2021 "given how flush they were with deposits, given the expectation for the Fed to not really be raising rates at all," Lewis said.
Back-to-back swaps can serve as a complement to other derivative strategies banks employ to manage interest rate risk. Regional banks like Citizens Financial Group Inc. and Regions Financial Corp. have described changes in their hedge portfolios in recent periods as their rate expectations evolve. In a note on March 17, analysts at Jefferies said they expect asset-sensitive banks to add swaps as rates rise to moderate their positioning and boost net interest income, while other banks terminate existing hedges ahead of further rate increases.
The crosscurrents and a high degree of uncertainty about the rate outlook — with markets implying that the Fed will have to back off its hiking campaign in the near term — defy a tidy story.
But Chatham expects back-to-back swap volume to continue a long-term growth trajectory as familiarity with the structure among banks and borrowers increases.
"For owner-occupied commercial real estate and for some investor types of real estate, [borrowers are] just interested in rate certainty," Lewis said. "They just want to know what the rate is going to be for the next five to 10 years. And that is something just that has always been steady, regardless of the current rate environment."
