At this juncture of the credit cycle, community banks must be judicious in the way they source, structure and book commercial loans. Competition is stiff, and every banker is trying to outsmart and out-compete multiple lenders vying for the same customer. Unfortunately, negotiating terms and pricing on a commercial loan feels a little like entering a bazaar where every purveyor is discounting his carpet and touting why his product is superior to the same carpet across the aisle. Some banks are deploying similar bazar-style strategies in trying to win commercial loan business.
The Trade-off Problem
Instead of differentiating on pile, fiber density and face weight, banks are currently deploying three common features to distinguish their loan products to win business and priced the credit. These three features are the debt-service-coverage ratio (DSCR), loan-to-value (LTV) and fixed rate term which are the most important elements in winning and pricing commercial loans today. However, there has been little analysis as to which of these loan features produce the most success for bankers and which translate to the most profitable loan portfolios. We will look at some industry data from CenterState and Trepp to make recommendations on how community banks should structure their loans to maximize profitability and minimize risk.
We considered current data to analyze the impact of DSCR, LTV, and fixed rate terms on market-driven credit spread. The table below shows the relationship between LTV and credit spreads from hundreds of loans recently booked in the market.
The next table below shows the relationship between DSCR and credit spreads.
Finally, the table below shows the relationship between the fixed rate loan terms and both the fixed rate and credit spread.
- The fixed rate difference for loans between two-years fixed and ten-years fixed is only 18bps. However, of that 18bps difference, 11bps is represented by the shape of the yield curve (the difference in the yield between two and ten years). Therefore, banks are only obtaining 7bps premium to fixed rates to ten years versus two years. It makes little sense for community banks to take this risk with such little compensation.
- Most community banks are only willing to extend fixed-rate loans to five years. The difference in credit spread between two and five-year loans is zero – in fact the data that we observed demonstrates that five-year loans are priced at one basis point discount to two-year loans.
- Given the shape of the yield curve and the lack of premium that borrowers are willing to pay for longer fixed rates, we conclude that banks are not getting properly compensated for extending loan duration.
- We believe that one major reason for the observed lack of fixed-rate loan term premium on commercial loans is the disbelief by borrowers of the benefit of such fixed rate terms. Borrowers understand that fixed rate terms are subject to repricing with any of the multitudes of events, including, cash-out, sales, re-titling, 1031 exchanges or modifications. Therefore, there is little sense for borrowers to pay more for terms that they are likely not to be able to use.
- The credit spread difference between bankable (50% to 80%) LTVs is only 38bps. While bankers can directly influence LTVs through differential pricing and policy, it appears that the premium associated with additional leverage is minimal.
- We observe very few CRE loans with LTVs below 60%. Considering the more realistic span for LTV of perhaps 70% to 80%, the credit spread difference narrows to only 14bps.
- The market is only marginally compensating banks for taking additional leverage. It would appear that community banks would want to take lower LTV for a few bps in yield.
- DSCR drives the biggest difference in yield. The difference between the span of bankable cash flow ratios (between 1X and 2X DSCR) allows banks to recognize 66bps more yield.
- There are a couple of ways of considering this data. Banks that believe that they can better underwrite credit outside of the project DSCR can get paid more significant credit spread premium and comfortably take this risk. Alternatively, banks that believe that late in the credit cycle project specific cash flow is key to safe underwriting must take lower yield today to maximize long-term profitability.
- We are not surprised that cash flow is the biggest determinant of credit spread. However, the magnitude of the difference between the three features we commonly see haggled “in the loan bazar” is stark.
- We believe that the market is currently pricing project cash flow with higher emphasis and DSCR is the largest influencer on credit spreads. This is not surprising especially this late in the credit cycle. On the other hand, there is very little yield difference driven by LTV ratios or fixed rate terms. However, we observed that community banks that offer assignability and assumability of fixed rate terms could garner 25 to 35bps more credit spread premium.
We are often struck by the overall efficiency of the loan market. On the average, banks are not able to obtain pricing premium except when taking additional credit risk. Not surprisingly, the major element of credit risk in today’s commercial loan market is project-level cash flow coverage. We believe that this late in the credit cycle community banks are better advised to forgo yield and choose higher DSCR. However, there is one area where community banks can extract additional yield without additional risk – banks that can deliver fixed rate terms that are portable from collateral to collateral, or from one borrower to another borrower, can extract 25-35bps credit spread premium.
Submitted by Chris Nichols on November 26, 2018