Success in banking is simple. Offer the right product, to the right customers, at the right time. The timing now is perfect to accommodate borrowers who want long-term fixed-rate loans, and the timing is also perfect for banks to convert those fixed-rate loans to a floating rate asset to protect the bank. At CenterState we created a custom built loan product called ARC (Assumable Rate Conversion) program that is currently very popular with our own borrowers, and hundreds of banks across the country are finding it popular with their customers also.
The Right Time
With interest rates still at near historical lows but continuing to rise, many borrowers are looking to lock-in longer loan commitments and lock in their interest rates. That makes plenty of sense since borrowers and banks want to avoid repricing risk that jeopardizes a borrower’s debt service coverage ratios. Below is a graph showing the ten-year cost of money (before credit spread) from 1988 to the present. Borrowers recognize that locking in interest rates at the current point of the interest rate cycle can be very attractive.
While interest rates are low by historical standards, they are expected to rise. The market and the FOMC are projecting substantially higher rates over the next few years. While both the market and the FOMC may be incorrect in their projections, there is a higher probability of rates being higher than anticipated versus lower simply because of reversion to the mean. The graph below shows where the FOMC expects to raise Fed Funds rate over the next few years.
The Right Product
There are four reasons why the ARC program is the right product in this interest rate environment for the right customers.
- Most swap programs are complex and require lawyers, accountants and sales specialists to succeed. ARC is a loan hedging tool that requires no derivative accounting for the bank, no complex derivative documents and no swap settlements for the borrower. What at other banks is a complex product only suited to the very few sophisticated clients, the ARC program democratizes loan swaps for the average commercial borrower. The program is easy for a lender to explain and the borrower to understand.
- Every community bank touts is service as a primary differentiator. Right now many borrowers need the ability to stabilize their P&I payments on real estate collateral. Being able to offer a 10 to 20 year fixed rate product is a tremendous service to these borrowers. ARC allows banks to offer this service but still protect the bank’s balance sheet by converting the fixed rate payment stream to a floating rate. Further, with the lender’s consent, ARC allows borrowers to substitute collateral (assign the loan from property to property) and ARC allows other borrowers to assume the loan. That is a tremendous advantage that can rarely be accomplished through any other means. A borrower can lock a 20-year fixed rate loan and two years later transfer the remaining term to another property – for example through a 1031 exchange or business expansion. This is a level of service that is bound to distinguish a bank.
- Most banks complain about the fierce competition for good credit quality borrowers. One problem that we see in banking is that products are not differentiated. Almost every bank in the country is offering a competitively priced five year fixed rate loan. Creative and successful lenders want to differentiate their product and step away from the herd. ARC allows CenterState Bank and other community banks that use the program to offer novel structures, such as 20-year fixed rate assignable loans, zero cost closing, forward rate locks and construction through perm single close loans. By differentiating the loan structure, we create more pricing power and attract better credit quality customers. Complaining about the competition will not help a bank complete, but considering ARC as a product differentiator can distinguish the bank from its competition.
- There are some, but very few, banks in the country that compete effectively on transaction business. Most community banks that we talk to focus on relationships and to build long-term revenue streams and follow-on business. Unfortunately, loans fixed for up to five years have a short expected life. Most commercial loans are repriced for various reasons such as change in borrower composition, cash out financing, follow-on debt, restructure or other reasons. Every time a loan reprices (and the economy is performing) borrowers take the opportunity to seek multiple offers to gain the lowest price or loosest credit structure. That is a suboptimal relationship-building lending model. The ARC program locks in customers for long periods and eliminates the need to reprice loans for most purposes. The borrower relationship is extended, creating less loan runoff and higher revenue, more profitable customers.
The Right Customer
We reserve our ARC program for our better, larger and more profitable commercial accounts. We always establish product suitability for each customer. We, however, question the appropriateness of extending credit to customers where we would not offer ARC - is a borrower relationship worth establishing if we cannot comfortably approve amortizing credit for 10 to 20 years? If the customer is not ARC worthy, are they bankable?
Swaps and loan level hedging has been made to be a complex and expensive proposition by larger banks, but it does not have to be. The ARC program allows banks to extend fixed rate commitments to 20 years without taking interest rate risk, without complex documentation, without Dodd-Frank reporting or compliance, without any hedge accounting. Right now is the right time to offer the ARC product to the right customers.
Submitted by Chris Nichols on February 05, 2018