How to Make A 15% ROE Making Loans at A 2% Spread (Or How To Get Out Of A Sinkhole)

Bank Lending

Listen, some bankers fear making loans below a 4% margin like I fear Florida sinkholes. To put that in context, I wear an avalanche transceiver whenever I am in the State. This makes bank meetings a little awkward, but gives me a fighting chance to be found when I get swallowed up. By the State’s own website, they refer to sinkholes as a “fact of life” which is why Florida is the only state where banks have to consult the “Sinkhole Clearinghouse” database before making a loan.  I used to joke about this until I realized that our branch map and the State’s high risk sinkhole area map looks almost identical. There is a reason why Florida has more missing people than almost every state – all 62,000 of them are likely in sinkholes. Florida is clearly dangerous, so I can relate when the “net interest margin anxiety” (NIMA) washes over a banker’s face whenever they see a sub-3% credit spread.


However, let’s face our fears head on. Despite the 7,000 new sinkholes in Florida last year, the odds are against people falling into one just like the odds are against hurting profitability when making a loan at Libor + 2.00%. This is a net rate to the borrower of 2.17%. 2.17? Ok – now you have the NIMA.


To get rid of your NIMA, let’s walk through some math. Let’s assume this is a successful, local manufacturing company with a track record that wants a loan to purchase a warehouse for $2.5mm at 75% LTV, 1.75x debt service coverage and a growing business. We will assume average bank expenses and customer acquisition costs plus an 8.5% capital charge combined with a 14bp expected loss. We make the loan either at Libor + 2.00% or take that spread, use our ARC fixed-to-floating rate conversion program and convert the loan on our balance sheet to 4.75% fixed. Either way, the return is about the same. 


Now given the above, this produces about $16,424 per year after expenses, taxes, capital and risk for a 9.2% risk-adjusted ROE. While 9.2% isn’t great, it is still better than what half the banks in the US are producing and better than most banks that are below $10B in total asset size. What many banks miss is that they only take into account the loan and not the entire relationship. It happens that the more successful companies, while tighter on loan spread, are more profitable in terms of total relationship. These higher quality companies tend to have greater cash flow, better risk profiles, greater deposits, greater use of cash management products, longer lifespans and both greater and higher quality referrals.  If you start adding fees, deposits, personal accounts and other services, as can be seen below, that 9.2% account can easily be built into a 16.8% risk-adjusted ROE account. 


Loan Profitability



Banks that focus on net interest margin tend to be adversely selective as largely the riskier accounts gravitate towards the option. If banks just look at the profitability of a loan without regard to risk or other products, banks might make suboptimal decisions.  The above matrix demonstrates the incremental value of each product so that lenders can “build” profitability and turn an average loan into a profitable one.


Like sinkholes, 2% margin loans tend to strike more fear than need be. If handled right and quantitatively approached, the data shows that banks can be successful with a high quality loan strategy. Plus, we would add, having a portfolio of higher quality credits will make you sleep better at night – which is more than I can say for me as my avalanche beacon usually keeps me awake. 

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