The interest rate roulette wheel

Back in June, based on the wager that rates may come back down, we experienced some pullback on early refinances. Ironically, I came across a paper published by a team of psychologists led by Michael J.A. Wohl of Carlton University, in Ottawa, that seemed to explain the phenomenon. The researchers "examined the impact of anticipating poor economic conditions on financial risk taking. In the follow-up to the initial experiment, participants who were reminded of their poor economic prospects bet more money on a spin of a roulette wheel than those in a control condition." On June 19th, chairman Bernanke hinted at "tapering" the Fed's purchase of mortgage backed securities. Since that fateful day, we've witnessed the ten year treasury constant maturity rise significantly, in total, thirty four basis points. Considering the economic outlook for the U.S. is in sync with the study, it is interesting that investors risked more equity in a rising interest rate environment. But there is a more empirical way to assess the opportunity. Because Wall Street offered relatively better value, through more liberal LTV requirements and more aggressive rates, many investors over the past decade used CMBS to lever their real estate investments. CMBS uniquely tied up the collateral with defeasance as standard call protection. When yields on government securities with similar maturity decline, defeasance increasingly becomes more expensive. Borrowers are leery to accept what is notionally an expensive proposition to limit their exposure or gain liquidity. However, if borrowers can keep their visceral reactions to the prospect of spending equity to pay a nominally large defeasance premium, further analysis should open an opportunity to them. An example might be, a borrower who owns an office building in a major CBD, with a first mortgage originated in December of 2005, for $22,000,000 at 5.5%. The principal balance at the projected time of defeasance is approximately $19,140,000 and a defeasance premium of $1,530,000. Although rates have risen, they are still at historic lows and the borrower can afford to refinance at approximately 4.67%. On balance, the defeasance premium would suggest that it does not make economic sense to refinance. However, after factoring in recovery from the interest rate delta and amortization over the remaining loan period, the net percentage cost to the borrower is 3.9%; the ten year TCM would only need to increase another thirty-nine basis points before the refinance would be "in the money." The ten year treasury constant maturity was 2.74% on August 1, 2013, adding back the thirty-nine basis points on top, totals 3.13%. Forward guidance, by twenty-four months also for August 1, is 3.61% ("maximum smoothness method," Adams and Van Deventer: 1996). In this scenario a refinance has an implied "in the money" to the tune of forty-eight basis points today. Since forward methodologies vary and aren't necessarily accurate, many investors may ask themselves, should we spin the interest rate roulette wheel? We continue to believe that there is sufficient evidence beyond fear mongering, to support a refinance now. Daniel Lerer is vice president - finance, GFI Realty Services, Inc.,