2012 Windy city summit INTEREST RATE SWAPS PRESENTATION

1. 2012 Windy city summitINTEREST RATE SWAPSPRESENTATION

2. Interest Rate Swaps Table of Contents • Derivatives Overview • Derivatives and Interest Rate Risk • The Interest Rate Swap • What is it? • Purpose and Functionality • Swaps and Me… • Why should today’s borrower consider it? • Other Types of Protection • Caps and Collars • Where’s the Crystal Ball? • Historical and expected rates • Q & A

3. Derivatives Overview

4. Interest Rate Swaps Derivatives—What are They? • Derivatives are financial instruments whose value is derived from another "underlying" financial security. • An interest rate derivative gains or loses value based on the movements of a specific interest rate index (U.S. Dollar Prime, LIBOR, Fed Funds, Treasury yields, etc.). • There are two broad categories of derivative products: • Exchange-traded products • Often used by traders & speculators (and dealers looking to balance their books) • Standardized contract sizes & terms • Not typically used for customized hedging solutions • Over-the-counter (OTC) products • Developed to meet hedging demand by companies & investors • Customized contracts between 2 counterparties

5. Interest Rate Swaps Derivatives—Growth in the OTC Market Source: BIS

6. Interest Rate Swaps Derivatives—Why? One word—RISK! • Example of interest rate exposure on a $100 million, 10-year financing. The present value of every basis point change in interest rates prior to locking the rate is worth about $82,000! Increase of $10.4mm in interest cost in six weeks (127bps * $82k) Decrease of $12.1mm in interest cost in four months (148bps * $82k) Source: Chatham Financial 10-Year UST

7. Interest Rate Swaps Interest Rate Markets Term Structure of Interest Rates: • When you hear “interest rates moved lower today” – which rates are being discussed?? • Short-term deposit rates? • Intermediate maturity rates? • Long-term mortgage rates? • Interest rates differ across the maturity spectrum due to: • Liquidity • Market expectations • Concept known as the “Yield Curve”

8. Interest Rate Swaps Source: Wintrust Financial

9. The InterestRate Swap

10. Fixed Rate Party B Party A LIBOR Interest Rate Swaps What is an OTC Interest Rate Swap? • An agreement between two parties in which one party agrees to pay a fixed rate of interest and the other agrees to pay a floating rate of interest on an agreed upon notional amount • No principal changes hands, simply an exchange (“swap”) of interest payments for a set period of time • Swap rate is derived from market expectations • The FIXED rate is the Present Value of Expected Future FLOATING rates • LIBOR is the foundation of the swap market

11. Interest Rate Swaps How Does an Interest Rate Swap Work? • Overview: Interest rate swaps allow borrowers to effectively lock-in an interest rate on an existing or future variable rate financing • Method: Separate contract from the loan that effectively fixes the rate by creating a stream of cash flows that perfectly offsets any rise in rates • Cost: There are no incremental fees associated with the interest rate swap Fixed Rate Borrower Bank Floating Rate Floating Rate Loan

12. Interest Rate Swaps How are Swap Rates Determined? • How does the market demand what the proper fixed rate is for an interest rate swap? • A swap is simply an exchange of cash flows: therefore, the party paying a fixed rate should demand a rate that is, on a present value basis, the average of the market’s expected floating rate settings over the term of a particular swap contract. • One mechanism for predicting the future path of rates is by observing the interest rate futures market. • In general, 3-month LIBOR serves as a baseline rate for calculating an interest rate swap’s fixed rate.

13. Interest Rate Swaps LIBOR is the Foundation of the Swap Market London Inter-Bank Offered Rate: • Rate at which banks lend to one another for various terms • Resets each day at 11:00 a.m. (London time) based on average of 16 contributor banks • 3-Month LIBOR = Fed Funds + 0.25%* (historical avg.) • Prime = 3-Month LIBOR + 2.75%* (historical avg.) • Any variations in OTC structures (1-month LIBOR, Prime, etc.) are taken into account by calculating a specific spread, or “basis”, to the 3-month LIBOR futures market

14. Interest Rate Swaps • How is the Fixed Swap Rate Determined? • Fixed rates are derived from the present value average of the market’s expectation of future floating rates over a given term • If the market’s prediction of rates is CORRECT, there is no difference between paying fixed or paying floating on the same notional • If the market’s prediction of rates is NOT CORRECT, the swap will gain or lose value

15. Interest Rate Swaps • Valuation of an Interest Rate Swap • At inception, the swap has no value because the swap rate represents the average of what the market believes variable rates will be over the life of the swap • As rates change, the swap will begin to take on or lose value • If the swap holder needs to break the contract before maturity, it may be subject to breakage provisions: • Rates Rise: Replacement Swap Rate > Actual Swap Rate, swap is an asset to the swap holder. The swap holder will receive payment from the Counterparty for the value of the swap. • Rates Fall: Replacement Swap Rate < Actual Swap Rate, swap is a liability to swap holder. The swap holder will make a payment to the Counterparty for the value of the swap.

16. Swaps and Me…

17. Interest Rate Swaps • What are the Benefits of an Interest Rate Swap? • Flexibility: • All or a portion of the term • All or a portion of the notional • Duration: • Longer term financing available • Certainty: • Known debt service costs • Bi-lateral Prepayment: • Retain benefit if rates rise • Prepayment often less than traditional yield maintenance if rates fall • Core-Competency: • Swaps allow borrowers to focus on their “line of business” and not fluctuations in the interest rate markets • Current Rate Environment: • Swaps allow borrowers to take advantage of below-market rates when compared to traditional fixed loan rates

18. Interest Rate Swaps • What Types of Debt can be Hedged? • Over-the-counter Interest Rate hedging products are customized contracts • Provide great flexibility to borrower • Loan amortization characteristics can be matched in a derivative hedge contract: • Construction loans • Forward Starting • Irregular/ uncertain draw schedule • Permanent financing • Monthly, quarterly, or semi-annual payments • Mortgage, Hybrid, Straight-line, I/O, Custom amortization

19. Other Types of Protection

20. Interest Rate Swaps • Other Types of Hedging Products • An interest rate CAP will: • Guarantee the borrower a maximum fixed rate, yet allow the borrower to retain the properties of a floating rate loan under a specific strike rate • Cost the borrower a premium to purchase, paid upfront • Be most cost-effective for terms under 5 years and/or when providing “worst case” disaster protection at a high cap strike rate • An interest rate COLLAR will: • Guarantee the borrower a maximum fixed rate, yet also require the borrower to pay a certain minimum rate (even if market rates fall below this pre-determined floor strike rate) • Help or fully offset the cost of a cap by borrower selling a floor to Bank

21. Interest Rate Swaps • What is an Interest Rate Cap? • Example of a $5MM Cap struck at 1.25%

22. Where’s the Crystal Ball?

23. Interest Rate Swaps Source: WSJ Historical Average (since 1989) = 3.9219%

24. Interest Rate Swaps Source: Wintrust Financial

25. Interest Rate Swaps Source: FRB Historical Average (since 2000) = 3.8737%

26. Questions?