With a low and flat yield curve, generating profits through investments has become more challenging. There are some very poignant lessons that CFOs are learning about investment strategies that apply directly to commercial lenders. In this article, we look at several basic capital market precepts that the average investment officer lives with every day but lenders may not notice.
One of the biggest current challenges in investing is how to manage increasing prepayments in mortgage-backed securities and how to minimize that risk. As the 10-year Treasury yield dropped 120bps in 2020, prepayment speeds have increased on residential mortgages. Almost the same challenges are faced in commercial lending. This challenging environment for investment professionals and the tools they are using to mitigate these challenges are directly applicable to commercial loans.
Prepayments of investment assets decrease profitability in the following ways:
- Earning assets need to be replaced because of the yield on cash is almost zero,
- Increased resources are needed to identify new investment opportunities (decreasing profitability),
- In a declining interest-rate environment, the replaced earning assets have a lower yield,
- Long-term lower-yielding assets are booked at the bottom of an interest rate cycle when cost-of-funding is expected to increase during the hold period, creating interest rate risk, and
- Most importantly, almost all assets are booked at a premium – that applies to investments and commercial loans. When assets booked at premiums prepay, the bank recognizes the premium as negative income. Because banks need to source, underwrite, approve, document, fund, onboard, and maintain a commercial loan, the premium on the average commercial loan is somewhere between 1% and 3%. The smaller the commercial loan and the less efficient the bank, the higher the premium.
Solutions - Call Protection
CFOs and investment professionals look for call protection on their investments. Looking for ways to protect premium bonds from excessive prepayments is a tough job because you can only buy what the market offers. However, in commercial lending, banks have some latitude in structuring call protection because the bank is structuring the earning asset. For commercial loans, prepayment speeds decrease with longer commitments, fixed-rate coupons (but banks need to manage that interest rate risk), higher cross-sells of sticky products, and, most importantly, prepayment provisions. Empirical evidence suggests that prepayment provisions can lower commercial loan prepayment speeds from 30% per year to under 5% per year, and increasing the average loan profitability from 6% to 14% ROE.
Size matters for prepayment speeds. For commercial loans, larger loans come with lower average premiums. Consider that it takes almost the same amount of resources to book a $100,000 loan as a $1,000,000 loan, but the revenue generated is substantially higher on the larger credit. Therefore, smaller loans lead to higher premiums and lower profitability when those loans prepay.
Absolute Interest Rates
In a lower interest rate environment, prepayments are even more unprofitable for banks. Not only do borrowers prepay loans when interest rates fall, as they have through 2020, but when loan yields are lower, it takes longer for banks to generate enough revenue to offset the cost of booking that loan (the premium associated with obtaining that earning asset). Therefore, in today’s lower interest rate environment, loan prepayments are even more unprofitable for the average bank.
Selecting Your Customer
CFOs spend substantial effort swapping into specified pools that prepay at lower speeds (for example, different loan size pools, or different coupons). Finding assets that exhibit a lower likelihood of prepayment is easier for commercial loans than investments because banks can better understand and select their borrower. Identifying the client that will retain the credit for longer is a simple way to increase loan profitability. For example, one main reason that owner-occupied CRE loans are preferred by lenders is because of the longer hold periods for the underlying asset that serves as the collateral for the loan. Longer hold periods by borrowers for the collateral helps banks retain loans for longer. Borrowers that invest in CRE for long-term (as opposed to flipping investments from lower to higher CAP rates) exhibit very similar economic characteristics for lenders – more profitable loans as a result of lower prepayment speed. In the course of underwriting new borrowers or understanding existing clients, it is simple to assess which borrower will hold the loan for longer periods and which borrower will cycle through their loans looking for better terms, pricing, or prepay the loan because their business model is flipping CRE investments.
Retaining earning assets for longer is one of the easiest ways for community banks to increase profitability in this very challenging credit and interest rate environment.
Submitted by Chris Nichols on June 29, 2020