In the movie Forrest Gump, Bubba talks about 21 kinds of shrimp preparations, but only lists a couple (our preference is the shrimp gumbo). In the 1975 Paul Simon hit, the singer claims that there are 50 ways to leave your lover, but only list five. While presumably a sequel is in the works to explain the other 45 ways to leave a lover, our point is that to make the best decision it is helpful to know all the options. Just is the case when it comes to loan structuring as there are many ideas that bankers don’t consider. This limits the competitiveness of banks and hurts return in many cases.
When it comes to bank balance sheet, bankers that are able to book different loan structures will have the best chance of success. Fixed-rate loans provide the bank many advantages, as they stabilize cash flow and reduce prepayment speeds for the bank while adding certainty to the borrower’s future. However, interest income declines if a bank’s cost of funding increases. This has become a real concern for bankers in today’s interest rate environment and the expectation of future rates. Especially because the unusual current interest rate environment creates such a lopsided forward term structure for rates and we now have a clearer picture of when the Fed will start to move.
Floating rate loans allow the bank to increase yield as interest rates rise. The trade off, of course, is that the bank exposes itself to higher credit risk, a less sticky relationship (as there are likely to prepayment provisions) and refinance risk.
One alternative, that many community banks have started using, are hedge tools to allow the borrower to pay a fixed rate but the bank to receive a variable rate of interest. The downside here is that the current period’s interest rates are low so interest income is reduced relative to making a fixed rate loan.
Here is where simple loan structuring comes into play to create a very viable option for all parties. Rather than hedge the entire term of the loan, bankers are hedging only the back-end term. In the front end, the borrower pays fixed and the bank receives fixed, on the back-end the borrower pays fixed and the bank receives floating – the bank receives the floating rate to coincide with the anticipated increase of those rates interest rates (typical periods are one or two years out). The borrower doesn’t know the difference as they always have a fixed rate loan, while the bank could get the best of all worlds.
The Case Study
Here is a case study: Let’s take a $1mm loan, amortize it over 20 years and fix the rate to the borrower at 5.00%. We see this structure frequently in today’s market. If the bank holds the loan fixed on its balance sheet, it will earn $421,258 of interest over the 10-year period. If the bank hedges the loan, the bank will convert the yield to LIBOR + 2.47%. What will be the lifetime interest earned for the bank? Since the hedge is the market’s expected future course of interest rates, the bank is expected to earn the same yield. In fact, a model will show that the bank’s expected interest yield is exactly $421,258 over the 10 years. However, the interest income is lower at the beginning of the loan and increases through the term (rising with the expectation of increasing short term rates in the market). The interest rate starts at approximately 2.63% (LIBOR + 2.47%) and ends at 6.21% at the end of the loan (still using the same LIBOR + 2.47% spread).
However, not every bank currently wants the hedged loan structure in its bank portfolio. There is another way to hedge a loan, allowing the borrower to pay fixed for the life of the credit but the bank to recognize the fixed rate upfront and only hedge the back side. By allowing the bank to maintain the 5.00% fixed rate for the first year, and hedge the last nine years of the loan, the bank creates higher interest income in the first year, at the expense of lower interest earned in later years. However, the total interest expected to be earned over the 10-year period is, no surprise, $421,258. But when that interest is received is important in today’s low, but possibly rising interest rate environment. The bank will receive 5.00% for the first year and LIBOR + 2.15% for the last 9 years. The downside in receiving the lower LIBOR spread is offset by the higher interest received in the first year. More importantly, the LIBOR interest period kicks in when floating rates are expected to increase – creating a natural earning hedge for the bank.
Similarly, the same loan can be structured as two years of fixed payments followed by eight years of floating rates. The floating rate spread is LIBOR + 1.80%. Again the expected interest yield is $421,258 over the 10 years, but the bank may be better able to match its income stream to its balance sheet. The bank will recognize higher income in the first two years, when interest rates are lower, followed by eight years at a lower margin over a floating rate, but when those floating rates are expected to be higher.
If we can help run various options, cash flows and profitability modeling, please do not hesitate to ask as we want to make sure you have the same tools that our lenders successfully utilize. We have always been curious about all the ways to cook shrimp and all the ways to leave a lover (just kidding honey), but hopefully this article might give you another option to achieve your bank’s objectives.
Submitted by Chris Nichols on October 09, 2014