Last month, right after lunch, the borrower came into the bank to close his company’s owner-occupied commercial loan for $5mm – it happened to be March 21st. The borrower closed the loan, locked in a 4.50% rate for 10-years, shook hands, smiled and walked out the door. The Chief Lender and the CFO walked over to the business development officer and congratulated him on a job well done. High-fives ensued, and everyone was happy. Should they be? The Bank just lost $238k in one day, and the worst part is, no one knew the difference except the borrower. In this article, we show how this bank was arbitraged by their borrower as we highlight this all-too-common mistake.
Like all tragic situations, it is never one factor that contributes to a bad situation. In this case, other than the lack of knowledge, the biggest mistake here is just bad timing. March 21st was a Federal Reserve Open Market Committee meeting date, and it was that day that the Fed moved the overnight target Fed Funds range up 25 basis points. Banks adjusted Prime as well so that it moved from 4.50% to 4.75%.
Unfortunately, the Bank referenced a ten-year fixed rate to be set to the then published Wall Street Journal Prime rate. The problem is that in addition to Prime being more of a consumer rate, the Wall Street Journal reflects the rate from the day before. By the time the borrower closed the loan, everyone and literally their mother knew Prime was going to 4.75% with 100% certainty. Yet the Bank, because of their language in the note, was out 0.25% for ten years, or roughly $12,500 per year (not counting amortization or prepayment of the loan).
A Bad Index
The 4.50% rate the borrower received was set the previous time the Federal Reserve moved rates which were back on the 14th of December 2017. At that time, the market’s expectations of rising rates were less than it was on March 21st when the Bank closed the loan. Back in December, for example, the 10-year swap rate was 2.32%. Between December and March, rates move steadily up so when the loan closed that 10-year swap rate was at 2.93%. That is the difference of 61 basis points or $238k dollars over ten years (the present value of 61bps for the amortizing loans over a ten year period).
Prime, is an “administered index,” which means it is untethered to market conditions. In a rising rate environment, Prime lags. Prime and Libor are closer together in duration, and since Libor is a more market-driven index, the difference in lag has historically been about 40 basis points. That means that even if the bank were pricing a floating rate loan using Prime, they would still be out an average of 40 basis points if history repeats (and it has so far).
Of course, the biggest tragedy was the Bank didn’t know the basic skills of their craft. They got two-thirds of their self-proclaimed mission statement wrong of “providing value to our shareholders while supporting our employees and serving our community.” This bank basically took money from their shareholders and employees and gave it to their community in the form of a subsidized loan. Great service - but not sustainable.
While the subject bank didn’t know better, readers of this publication understand that the Bank took 61 basis points of interest rate risk on Day 1. That is risk the bank did not have to take. This bank, whose main job is, according to them, is to “make loans” should have known better - you never price a fixed rate loan off a floating rate index, particularly one that is administered and not reflective of even short-term market risk.
If you are making a ten-year fixed rate loan, it is best to agree to a credit spread and then lock the rate in at the time of closing off the ten-year swap rate. While the bank is still taking interest rate risk, at least it is pricing it correctly.
By the same token, if you are pricing an adjustable loan, price your reset to the proper index. For example, pricing a loan in five years off a spread to prime is asking for trouble. In addition to all the risks mentioned above, bankers have no idea what will happen to the Prime rate in five years. It may be more, or less, correlated to an appropriate market rate at that time.
Putting This Into Action
Good banking is the act of doing a lot of little things right. Make sure you get your timing, index and loan structure correct so you can prevent your bank from taking more risk than it needs to. Losing $238,000 on the first day of the loan is easily avoidable if your banking skills are sound.
Submitted by Chris Nichols on April 25, 2018