We recently compared and contrasted various prepayment provisions for commercial term loans (HERE). The symmetrical breakeven prepayment provision garnered more attention and inquiries from bankers and we want to further expand our discussion of that provision. That provision offers a number of advantages for banks: first, it reduces customer attrition; second, it aligns the borrower’s view of interest rates with current interest rate environment making it a powerful sales tool; third, it enhances the credit quality of the relationship; and fourth, it allows the bank to engage on a relationship versus a transaction level.
Symmetrical Breakeven - Defined
The symmetrical breakeven prepayment provision calculates a cost/benefit for a prepayment of a loan based on interest rate movements. If rates fall from the time the loan is originated, the borrower must pay a cost to prepay the loan and this cost is calculated as the savings the borrower will enjoy by refinancing into a new loan at those lower prevailing rates. Conversely, if rates rise from the time the loan is originated, the borrower receives a fee upon a prepayment of the loan and that fee completely offsets the higher cost of a new loan at those higher prevailing rates.
Much has been written about the costs of customer attrition and lifetime value of customers in banking. The basic precept is that it costs significantly more money to acquire new customers than retain existing ones. Further, it costs far more to re-acquire defected customers than to acquire new customers. Therefore, a longer relationship with a customer is more profitable for a bank.
The symmetrical breakeven provision eliminates the number one reason for loan prepayments: refinancing with lower rates. Over the last eight years, borrowers have systematically pitted one bank against another to obtain the lowest spread possible, only to refinance the loan at still another institution when rates dropped. That behavior is eliminated with the symmetrical breakeven provision because the borrower becomes indifferent to refinancing as rates fall or rise.
Alignment of Rate View
A powerful aspect of this prepayment provision is the marketing – and especially in today’s interest rate environment. Borrowers who believe that interest rates are heading higher, will more likely choose fixed rates over floating rates. Once that choice is made, then the symmetrical prepayment provision allows the borrower to reap a fee upon a loan prepayment if rates do increase as the borrower expects. If the borrower hesitates on this prepayment symmetry, then the borrower is tacitly expressing a view that rates are not heading higher. That makes the borrower a perfect candidate for a floating rate loan, or perhaps short term fixed loan. Either way, the lender can learn the borrower’s view and offer the right product for the right circumstance. In a very competitive lending environment, this fact finding can be a powerful tool in closing more loans.
Enhancing Credit Quality
The ability to offer longer term fixed rate loans in today’s low interest rate environment is a positive for credit risk. In today’s market, three principles are conspiring to create credit risk for lenders: 1) interest rates are exceedingly low, 2) advance rates are heading higher, and 3) cap rates on most properties are at historical lows. This all makes the impact of refinance risk troublesome. Credit officers can well imagine a scenario where upon loan maturity, interest rates are higher and cap rates are lower, and where the advance on the original loan was 75, 80 or even 85% LTV. By offering medium term fixed rate loans with little principal amortization to the maturity date, lenders are creating situations where borrowers may not cash flow even though their EBITDA or NOI has not decreased. The ability to offer long-term fixed rate loans through FHLB advances, hedges, or other matched products can save a bank’s capital. A symmetrical breakeven prepayment provision permits banks to structure long-term fixed rate loans and not take that interest rate risk on their own balance sheet, or conversely force the borrower into a medium term fixed rate loan and transfer the interest rate risk to the borrower. Banks must factor how interest rate and credit risk interplay.
Relationship versus Transaction
The emphasis for most banks has rightly shifted from transaction to relationship business. Relationship banking involves cross-selling multiple products, long-term engagements and deeper connection with the customer’s entire hierarchal structure. Consider that the average loan made today must be repaid and the economics renegotiated when the borrower changes underlying collateral or there is a change in the borrower’s structure. The average loan does not go to term and each sequential refinancing is available for all lenders to poach. Worse still, most borrowers take every refinancing opportunity to extract better pricing from the bank. The symmetrical breakeven provision alleviates this issue and creates long-term relationship lending opportunities. Because the provision preserves the borrower’s and lender’s economics regardless of interest rate changes, the loan does not need to be repaid when the collateral, borrower entity or even dollar amount and term change. Instead, the rate first established on the loan can be transferred from one collateral to another, one borrower or another and the dollar amounts and terms can be changed to accommodate new needs – all this without changing the original economics of the loan. Historically, this was a very powerful feature, but in today’s extremely low interest rate environment, this feature can be even more compelling to a borrower. Imagine being able to offer a 20-year fixed rate loan to a developer or business owner at today’s current low rates, and have the borrower move the loan from property to property without any out-of-pocket costs. The only requirement is that the bank re-underwrite the new collateral or obligor.
The biggest risk to the borrower is that interest rates decline and the borrower does not need the loan (no opportunity to assign the loan to new collateral or have another borrower assume the balances), thereby, exposing the borrower to a prepayment cost. While banks often tout this downside risk as unacceptable to the borrower, the bank can always choose to pay the cost of this prepayment itself. The fact that virtually no bank ever pays this potential cost on behalf of the borrower is very telling. It means that this cost is unacceptable risk for the bank to take. Yet many banks will consistently take this risk by making fixed rate loans without the symmetrical breakeven provision – after all the provision protects the bank’s yield from falling interest rates, as it protects the borrower’s loan from rising interest rates, therefore, by not utilizing this provision banks are economically paying the cost of prepayment on a fixed rate loan when rates fall if the proper prepayment provision is not used.
Community banks would be well advised to consider embedding the symmetrical breakeven prepayment provision in some of their term loans. The provision can protect both the borrower’s and lender’s interest rate and credit risk. It can also be a powerful marketing tool that creates stickier borrowers and more profitable relationships. And in today’s low interest rate environment, it can actually be an easy sell.
Submitted by Chris Nichols on March 17, 2016