How To Deal With Current Loan Pricing Pressure

Current Bank Loan Pricing Pressure

Context is defined as the circumstances that form the setting for an event, statement, or idea, and in terms of which it can be fully understood and assessed.  Some numbers are difficult to understand without proper context. For example, we read the other day that Hurricane Harvey dumped approximately 19 trillion gallons of rainfall on the State of Texas.  We know that is a lot of water, but it is hard to put that number in context.  Similarly, in lending, some of the drivers of loan structure, borrower demand, and prepayment behavior are difficult to understand without context.  We will outline some very important contextual information that is currently driving loan pricing and borrower demand and where that pricing and demand may be heading in the near future. 

Loan Context

A very important way of creating a context to understand the current loan pricing environment and borrower demand is to look at the three points on the yield curve in a butterfly analysis.  The three points on the curve are as follows:

  1. The floating rate of interest which is a proxy for commercial bank’s cost of funding and we will use one-month LIBOR for that rate (although Prime would work as well);
  2. The five-year point on the yield curve (or five-year swap rate) which is where most banks are comfortable setting term loan repricing; and
  3. The ten-year point on the yield curve (or ten-year swap rate) which represents a common hedge alternative to conventional loans and is currently in strong demand by many borrowers.

 

The first graph below shows the historical relationship between five-year and floating rates and the second graph shows the differential between these two rates – this is the left side of the butterfly.

Flat Yield Curve

 

Yield Curve Shape for Loan Pricing

The key observation from the left side of the butterfly is that the differential between five-year interest rates and floating interest rates is low and decreasing.  Outside of recessions in the early 1990s, 2001, and 2007, the differential between these two rates is close to the lowest it has been in history.  Another way to put this in context is that the Federal Reserve would need to raise interest rates just two more times (for example, once at the end of 2017 and once at the beginning of 2018 – as many market participants expect) and a bank would earn the same loan yield on a floating rate loan as on a five-year fixed rate loan.  A borrower would likewise pay the same P&I payment on a floating rate as on a five-year fixed rate.

Now, let us consider the right side of the butterfly. The first graph below shows the historical relationship between ten-year and five-year rates while the second graph shows the differential between these two rates.

Loan Pricing  

Working with the Yield curve

The key observation from the right side of the butterfly analysis is that the difference between 5 and ten-year interest rates is also at historical lows.  Outside of past recessions, the difference between these two rates has never been lower. To put this in context, the difference between these two rates is just 25bps or one incremental move by the Federal Reserve.  The interest rate market is demanding almost no term premium for borrowers to lock rates for ten years versus five years.

The butterfly analysis explains why borrowers are demanding longer-term fixed rates and why the term premium for longer commitments has disappeared.  However, bankers are well served to interpret this information in context and extrapolate borrower behavior and pricing pressure as the Federal Reserve continues to increase short-term rates – as they are expected to do – over the short and medium term.  Lenders will need to consider how they can react to borrower demand for longer fixed rate loan commitments and the continuing drop in premiums for longer commitments.  How, will banks react to borrower’s demand for ten, 15 or 20-year fixed rate commitments to when the premium between a floating rate and a 20-year fixed rate evaporates when the federal reserve raises rates two more times?   

Conclusion

An analysis of the one-month, five-year, and ten-year interest rate portion of the curve shows that the yield curve is flattening in a way that is making the five-year fixed rate term loans less competitive in today’s market.  Bankers should consider the possibility that we are only two rate hikes from earning the same yield on floating rate loan as on five-year fixed rate loan.  Furthermore, borrowers are paying virtually the same for five, ten, 15 and 20-year fixed rate loans.  What borrowers and lenders need to consider is the context of the current shape of the yield curve.  If bankers believe that the Federal Reserve will increase interest rates once or twice in the near term, then many banks will need to consider repositioning their loan and securities portfolios.