If you’ve held floating Agency debt over the past year, then you’ve no doubt felt the pain of rising replacement cap escrow requirements. However, if the Fed winds up pausing rate hikes this year, the worst of cap escrows could be behind us.
Freddie Mac and Fannie Mae require that borrowers escrow monthly for the cost of a replacement cap. That amount is calculated based on the following:
Recent Shifts in Cap Costs
The last couple recalculations have been especially painful for borrowers, going from a consistent increase to spiking dramatically last quarter. However, recent shifts in cap pricing suggest we may have just peaked. The graph below illustrates how cap pricing has behaved over the past couple years. Notice the trend lower from the end of 2022.
Here’s how the recent dip in cap costs would have impacted the monthly escrows on a generic $25mm Freddie floater with a 3.00% cap strike requirement.
But What if the Dip is Temporary?
Historically, cap costs have fallen dramatically after the last rate hike in a Fed tightening cycle. Whether the downward trend in replacement cap costs continue will be primarily dependent on Fed policy over the next few months.
For example, on average over the past four cycles, cap costs fell 50% within three months of the last hike and 75% within eight months.
Markets are currently expecting the last hike to occur as early as this March. If that actually plays out and cap costs behave anything like the they did during previous cycles, here’s how monthly cap escrows could change over the remainder of 2023.
Need a quick estimate of what your next replacement cap cost calculation could be? Check out our cap pricer. If you need help verifying an amount from a recent calculation from your servicer, don’t hesitate to reach out to the experts at pensfordteam@pensford.com or (704) 887-9880.
