One of the best ways to become a better banker is to pay attention to your competition and analyze their strengths and weaknesses. We pay particular attention to term sheets and commitment letters from other banks to learn what other banks are doing well and where they make mistakes. We intend to capitalize on competitors’ weaknesses and to learn to address and respond to other banks’ strengths. We recently reviewed a term sheet that we thought highlighted some interesting features and market developments that we would like to share and analyze.
A regional bank was responding to a customer request to construct an office building. The borrower would occupy a portion of the building. The loan was $4.05mm and would be capped to 75% LTV. The bank offered a single close construction through permanent (perm) loan consisting of 12-months interest only at Prime, followed by a term takeout. The term takeout options were indexed to either FHLB advances or hedge rates, and the rates would be established at the inception of the construction. The bank offered various options with pricing tied to FHLB fixed-rate advances or hedge rates as outlined below.
While the FHLB Des Moines advances were quoted by the bank as an index, the bank would not use the advances to fund the loan. The regional bank offered the borrower a choice between a fixed rate loan indexed to the FHLB rates and fixed rate loan hedged through the bank’s swap program.
We make the following observations about the various pricing options in the term sheet:
- The FHLB index rates are substantially higher than the hedge rates shown to the customer. FHLB charges a liquidity premium for advancing funds, and that premium is more dear at longer terms.
- The regional bank charged a much higher spread on the FHLB rates than for the hedged rates. The borrower was told that the bank was charging more for the interest rate risk. While the regional bank would prefer a floating rate asset, the bank was indifferent if the borrower was willing to pay a 2.60% spread over three years, and increasing to a spread of 3.20% for seven years.
- The regional bank would not extend maturity beyond seven years on the FHLB quoted option but was willing to go to 10 years for the hedged loan (both options are effective after the 12 month construction period). The difference in rate between the seven and ten-year options is only 6bps.
- The spread for each hedged term was the same because the bank would recognize a variable rate for each of option. The bank was indifferent to the term the borrower chose. The spread of 2.50% for the hedged loan was lower than the spread on the FHLB indexed loan, but that difference in the spread was most substantial for the longer commitment. This makes sense to us given the contrasting risks to the bank between the two loan assets.
- The yield curve is very flat, and this is reflected in the small difference in rate between the three-year and ten-year hedged loans (only 17bps). However, the same flatness is not apparent in the FHLB options as the difference between the three-year, and seven-year fixed rates is 91 bps. This steepness is a function of the FHLB premium on longer advances and the lender’s required compensation to take interest rate risk.
- We calculated that the regional bank priced the hedge index with approximately 1% hedge fee. The bank charged a 50bps loan origination fee (approximately $20k), but with the hedged loan, the lender would also recognize $40k in non-interest income in the first year of the loan. This additional fee income allows the bank to price the loan spread more aggressively.
- Most striking to us was the all-in fixed rate to the borrower between the two sets of options. Each term option in the hedged loan was lower than the FHLB loan. The bank quoted the three-year FHLB loan at a 5.41% fixed rate, compared to a ten-year hedge loan at a 5.24% fixed rate. It was obvious that the regional bank strongly preferred not to take the interest rate risk and have the borrower utilize its hedge program.
The regional bank had one hurdle to overcome – sell the borrower on its hedge program and the benefits of a longer-term, a lower rate, or both. The bank has some hedge expertise and personnel who can explain the hedge program and the pros and cons of various options. The borrower ultimately chose the ten-year fixed rate option through a hedge.
This term sheet shows the importance of offering a borrower different options and the impact of the flat yield curve on borrower behavior. As short-term interest rates and banks’ cost of funding have risen, and long-term rates have recently declined, the importance of accommodating borrower’s desires for longer-term commitments has heightened. Every community bank should review the issues, and competitive pressures outlined in this term sheet and create a strategy to try to capitalize on this competitor’s weaknesses and be able to respond to this bank’s strengths.
Submitted by Chris Nichols on January 10, 2019