You cannot read a financial paper, business feed, or watch financial television without someone mentioning yield curve flattening and inversion. Google searches for “yield curve inversion” are at their highest level ever. What is all the fuss about, and why should bankers care? We will explain an innovative way that bankers are using the current yield curve to protect existing relationships, increase yield and generate non-interest income, and we will use a recent case study to highlight the specifics loan terms and results.
In January 2017, our bank generated a $5mm term loan to purchase a downtown medical park in a major city. The purchase price was $7.54mm, and the project cash flow was close to 2.0X. The borrower wanted a long-term fixed rate, and the bank structured a 25-year amortizing loan, with a five-year fixed rate of 4.75% resetting at the five-year Treasury plus 2.00% every five years with a 4.00% floor. At that time the bank was able to charge a 25bps loan origination fee. The prepayment provision for the loan is 3%, 2%, and 1% of the loan balances for the first three years.
The lender has a good relationship with the borrower, and the borrower has several other credit and deposit products with the bank. The borrower indicated that he sees other banks that are offering lower cost financing on loans similar to his. This is when the lender used the inverted yield curve to the borrower’s and the bank’s advantage and creates substantial value for all parties. The lender proposed refinancing the customer into a structure that allowed the bank to protect the loan from the competition, lower credit risk on the loan, increase the bank’s immediate yield, lower the coupon to the borrower and generate substantial fee income.
The current loan outstanding is $4.6mm, and the loan pricing will next reset in January 2022. The prepayment penalty on the loan is currently 1% of the principal balance. The lender approached the borrower and offered a 25-year amortizing, 10-year fixed rate priced at the 10-year index plus 2.35% and no cash-out except minimal closing costs (documentation and filing fees). The current rate to the borrower was 4.49%.
Here are the advantages of the structure to the borrower:
- Reduce the loan rate from 4.75% to 4.49%
- Increases the certainty of rate from 2.5 years (remaining term to the next reprice) to 10 years,
- Minimal refinancing costs (bank waived the 1% prepayment fee), and,
- Loan closing in 10 business days.
Here are the advantages of the structure to the bank:
Customer Satisfaction: The customer is now in a better position without having to shop for a loan or transition to another bank. More importantly, the current bank was proactive.
Increased revenue: The yield to the bank went up from 4.75% fixed to 4.79% (the manifestation of the yield curve inversion),
Lowered Risk: The loan was converted to an adjustable rate for the bank, thereby decreasing interest rate risk; and,
Increased Fee Income: The bank generated $67k (144bps) in hedge fee income that is recognized immediately.
The yield curve inversion created the following outcomes.
Some bankers will be surprised that the results achieved in this specific case are possible and create a win-win scenario for borrower and lender. However, this is precisely the powerful opportunity presented by the current inverted yield curve. For banks that do not want to lose good credit to competition or those banks that are not seeing ample demand from quality credit borrowers, converting existing 5-year fixed rates into longer structures and converting the loan to an adjustable offers the opportunities highlighted above.
Community banks should be aware of the benefits afforded in today’s interest rate environment. The inverted yield curve allows banks to approach existing strong credits and refinance out of a five-year fixed rate product to lower the rate for the borrower but increase the yield to the bank, reduce interest rate risk, and increase fee income for the bank.
Submitted by Chris Nichols on June 05, 2019