Your floating rate loan portfolio may be ready to hurt you, and your bank might not be aware. Unlike fixed rate loans, floating rate loans tend not to have prepayment provisions. This part is well understood. What is far less understood is the fact that ANY material rate movement ends up hurting performance. While we have written about how interest rate risk and credit are interrelated, today we focus how rate movement causes unaware community banks to be adversely selected, thereby hurting performance.
Let’s take a select portfolio of 16 loans and see what has occurred in both an up and down rate cycle. This is the environment that we faced in 2013 and one that we are likely to see again over the next two years. In our Basecase example in Figure 1, we have an evenly distributed floating rate (Prime and Libor) credit portfolio containing under performing loans in red, average performing loans in yellow and top performing loans in green. In order to simplify comparison, we use risk-adjusted return to take into account loan size, risk (interest rate, credit, operations and liquidity) and administrative/acquisition cost.
Our Basecase portfolio has a risk-adjusted return of 9.04%, which is about average for community banks over the past year. When rates fall, several factors come into play. The most obvious factor is that the overall return is lower, as the floating rates reset down. Falling rates usually mean a weaker economy, so credit risk is increasing. However, since debt service cost is also falling, these two factors offset each other sometimes increasing net risk and sometimes decreasing net risk. As a rule of thumb, credits that are closely tied to the economy such as real estate development, hospitality and alike are usually hurt, while consumer, commercial real estate with credit tenants and longer leases and counter-cyclical industries are usually helped.
Unfortunately, credit, interest rate, liquidity and operations risk are not the only risks that are impacted by a change in rates. Optionality is also in play. In this case, as can be seen in Figure 2, not only does the return change, but also those borrowers that can refinance to lock in a lower fixed rate do. Unfortunately, this adverse selection leaves the bank with the lower yielding, risker credits. Here, the portfolio starts to negatively skew as to credit evidenced by the risk-adjusted return that goes from 9.04% to 6.16%, a 32% rate of change.
In a rising rate environment, like the one we are currently facing, the opposite happens. Here the economy is getting stronger, but as rates go up, so does debt service. This also has a mixed net effect as some borrowers are helped and some are hurt. Unlike fixed rate loans, rising rates also shorten the expected life of most credits. As can be seen in Figure 3, those borrowers that are strong enough to refinance and fear continued rising rates, seek a longer term fixed rate structure in order to protect against interest rate risk. This also takes the stronger borrowers out of the pool. In Figure 3, the risk-adjusted return goes from 9.04%, to 6.77%, a 25% rate of change.
To prevent this optionality from impacting the loan portfolio, here are four steps to manage this risk:
Credit monitoring is a must - Loan officers must have a clear view on how their credits rank in order to take steps to prevent premature runoff and monitor those loans that are at risk for prepayment.
Yield Maintenance or Prepayment Penalties – Even in floating rate loans, banks must be conversant in how to work with the pricing prepayment penalty trade off. Lenders must be incented to get prepayment protection where possible and understand how to sell, market and position the feature.
Hedging – Actively using a hedging program will help with one and two above, while giving the loan an optimal structure. Our ARC Program, back-to-back swaps or other tactics are all suitable alternatives.
Covenants – Structuring the loan with variable pricing tied to covenant performance can dramatically reduce optionality. This is the most underutilized tactic in banking and presents a significant opportunity for banks to enhance loan portfolio performance.
For your bank, make sure your lenders and managers understand the cost of optionality and how to work with the various tactics that can mitigate much of the risk. Floating rate loans have many positive characteristics and do well in stable or slowly changing rate environments. Being able to identify and manage the risk of optionality can bring earnings right to the bottom line.
Submitted by Chris Nichols on February 18, 2014