How To Use The Hybrid Loan Structure To Win More Profitable Clients

Profitable Loan Structures - Man staring

It sometimes pays to be opportunistic in marketing your community bank’s products. There is currently an exceptional market opportunity for community banks to win profitable business from larger competitors. The recent decrease in interest rates presents an opening for smart bankers to poach good quality clients and lock them in as customers for a decade. Our bank recently did just that, and in this article, we would like to share this strategy through a case study.

 

Interest Rates Dip

 

The graph below shows 10-year Treasury yields for the last 30 years. In the last six months, long-term interest rates decreased by almost 90 basis points. This decrease in rates creates a potent occasion for community banks to offer an opportunistic product to select prospects. The prevailing low-interest rates allow community banks to provide competitive long-term financing and win new business customers. This lending strategy creates an opportunity for community banks to differentiate, create substantial value-add, and win larger and better credit quality customers.

 

History of the 10-Year Treasury Yield showing we are back down to record lows

 

Case Study

This strategy appeals to a borrower’s greed of wanting to take advantage of the recent dip in interest rates.  Lenders should approach their prospects who are currently at other banks and demonstrate why today is an excellent opportunity to obtain financing at rates that have been this low only once in the last 60 years.  Lenders may need to overcome resistance if a prospect has an attractive rate remaining at the incumbent bank, and this is where our bank offered a loan with an initial period to match the prospect’s existing rate, followed by an extension of credit. 

Our community bank started calling on two owners of an investment company that is banked by a larger regional bank.  The prospect has a few real estate properties and a large operating account with this regional bank.  The community banker established a good rapport with the two owners and asked for their banking business.  The two owners were ready to move their bank relationship but had 18 months remaining on one of their loans (with a balance of $1.3mm) at an attractive rate of 3.95%. 

 

The banker explained the three options that the community bank could offer.  The first option is for the borrower to refinance today and lose the existing fixed term.  But borrowers may be reluctant to give up their existing favorable economics.  The second option is to wait until the existing loan matures, but the risks are that rates are higher and the borrower will not want to move.  The additional downside is that the banker does not obtain the customer.  A third option is to offer the borrower the remaining existing rate and term at the community bank, but extend the commitment to the borrower’s desired commitment term. 

 

The third option is what the banker structured to win the loan and deposit business.  The structure that the lender offered involves an immediate refinancing of the existing loan that retains the term and pricing for the original period and an extension of the loan at market prevailing rates (we call this a hybrid loan structure).  The bank offered a 10-year loan, fixed at 3.95% for the initial 18 months (same economics that the borrower had at the incumbent bank).  The bank offered the borrower another 8.5 years after the 18 months which the borrower chose to fix, resulting in a fixed rate of 4.45% for the last 8.5 years. 

 

Here are the benefits of structure:

 

  1. The borrower does not feel like they lost the bargain of the original loan term and rate. 
  2. The borrower feels that they eliminated the interest rate risk in 18 months when the loan had to be refinanced.
  3. The bank was able to win a new profitable customer for ten years. 
  4. The bank was able to convert the last 8.5 years of the loan to a variable rate on its balance sheet, thereby, eliminating interest rate risk for the bank end.  However, during the first 18 months, the bank has a fixed rate and thus, protection if rates fall further. 
  5. The bank decreased the credit risk associated with this loan and has stabilized the borrower’s DSC ratio for ten years.
  6. The bank obtained a symmetrical prepayment provision to solidify the relationship with the bank.  The longer commitment increases the lifetime value of the loan, boosting ROE, which was calculated to be 21 percent with the deposit relationship.
  7. The community bank offered the loan without charging a loan origination fee but was able to generate 1.70% hedge fee that is recognized immediately in income, increasing the initial yield for the loan in the first year from 3.95% to from 5.65%.

 

Conclusion

Many bankers are now struggling to attract new business in a very competitive market.  Right now, the interest rate market is offering an excellent opportunity for community banks to win business with some novel structuring and some hard work.  Our bank is offering this hybrid structure to select borrowers who meet our relationship criteria.