In the last few months, more than a dozen bankers have reached out to us about the merits of a fixed-rate loan program. Up until a few months ago, we didn’t know that the industry had started coining the term “fixed-rate loan program.” We always assumed that banks made loans that borrowers needed, whether fixed-rate, adjustable-rate, or some form of hybrid. Now, this seems to be a thing and we, not surprisingly, have an opinion on the matter.
Why Fixed-Rate Loans Pose Challenges for Community Banks
Historically, community banks offered fixed-rate loan terms for up to 3 to 7 years. Beyond that term, most banks were uncomfortable with interest rate risk and optionality risk (if rates decreased, the borrower would refinance at a lower rate). However, in today’s interest rate environment, many banks are facing stiff competition from larger banks, insurance companies, and credit unions that do offer longer-term fixed-rates. Given that the yield curve is so low and flat, it is even more challenging for community banks to offer fixed rate terms beyond five years.
The question is this - should community banks innovate their product offering to create long-term fixed-rate financing options for their better customers? We believe that community banks should proactively develop a formal fixed-rate loan program, and we see five reasons for that.
Why A Fixed-Rate Loan Program is Essential for Community Banks
Manage Borrower’s Balance Sheets: The majority of community bank’s assets are loans, and the majority of community bank’s loans are used to finance real state. The graph below shows loan mix for banks under $1Bn in assets, $1-$3Bn in assets, and $3-$5Bn in assets. Real estate loans represent 74% to 81% of all loans for this group of banks. We were taught in our first-year finance course that duration of assets and liabilities should be relatively matched so that cash flows can be better predicted, and change in asset and liability values move in tandem. Real estate is one of the longest assets that a lender can finance; therefore, real estate is better suited for long-term fixed-rate loans.
There are some bankers that claim that their banks do not offer the product and that borrowers are free to manage their cash flows outside of the bank’s products. There are two flaws with this argument; First, the bank is in a better position as a financial institution to create the product than the borrower who, most likely, has the less financial acumen and product access. Second, if one bank will not offer the solution a borrower needs, another bank will. Your bank should have an off-the-shelf solution that meets your better borrowers’ needs.
Manage Borrower’s Credit Risk: Part of managing the borrower’s balance sheet is mitigating credit risk. One reason that real estate has a long duration is because the cash flow generated by that real estate tends to be stable. That is a positive in a declining economy because cash flows are sustained. However, that can be negative if the economy is doing well, and interest rates increase, but cash flows are still stable. This poses a challenge for lenders because, for a standard 1.22X DSCR, 77% LTV, 6% cap rate loan, rates only have to increase 199bps for the 1.22X DSCR to fall below 1.00X. None of us can predict rates for the next 12 months, much less the next few years. However, offering fixed-rate loans is a much safer credit strategy than offering floating rate loans. This is especially true when rates are near all-time lows, and the tradeoff between higher and lower rates is not symmetrical for the lender’s credit exposure.
Locking Customers: Long-term fixed-rate loans offer community banks an added advantage; they allow banks to extend the duration of the relationship by embedding prepayment penalties and increasing switching costs. That has several attractive results: first, it extends the lifetime value of that customer, second, it increases cross-sell opportunities for the bank, third, it makes poaching by competition more difficult, and, fourth, customers value long-term commitments on fixed rates thereby decreasing principal reductions and increasing loan outstandings. There are other ways of achieving similar results in banking, but in real estate lending, creating stable long-term assets (fixed-rate loans) is the easiest way to increase loan profitability.
Address the Yield Curve: The yield curve is presently flat, and borrowers can lock fixed rates out to 20 years for the same loan coupon as a floating rate. Some bankers point out to us that in their market borrowers pay a premium to lock longer rates – while this may be true, a borrower that approaches any of the biggest 100 to 200 banks, which are using funds transfer pricing and the yield curve to rationally price loans, would get a 20-year fixed rate loan priced a few basis points less than the same loan priced off a floating index whether that index is Prime, LIBOR, SOFR or fed funds. This creates a very strong incentive for borrowers to lock their rate to eliminate cash flow variability.
Banks that cannot address this strong customer motivation will need to make other concessions to attract customers. Such concessions may be lower credit spreads or looser credit structures – both are inferior options for banks. There are always borrowers that naturally gravitate to the stability created for their business by financing with long term fixed-rate loans. That appeal becomes that much greater when borrowers do not have to pay a premium to get that stability.
Don’t Compete by Happenstance: Banks that want to offer longer-term fixed-rate loans should design a program and pricing that fits their customer base and the bank’s product strategy. However, we believe that banks should not compete in this area only defensively or make ad hoc decisions to try to salvage a customer. If your bank decides to not offer long-term fixed-rate loans, then stick to that decision and decline every customer request for such a solution. If your bank decides to offer such a product, then design the offering, pricing, and other credit and structural features from inception.
By reacting to specific circumstance instead of creating an off-the-shelf product, banks make inferior decisions on pricing or structure. For example, we see banks that do not have a formal longer-term fixed-rate program in place compete for customers on 7 and 10-year fixed rates by charging a premium to offer such a loan. The problem is that customers who are willing to pay such a premium (when one does not exist based on the shape of the yield curve) are accepting the premium because either they have no alternative option from more rational lenders (because of credit or profitability issues) or because competition does not exist in that specific market. Neither scenario is a sustainable and winning long-term business strategy for any bank.
We are not proponents of swap programs the way that they are offered at national and regional banks. However, we have a view that every community bank should consider a long-term fixed-rate loan program in some manner. Every community bank will create a different program and manage its risks differently. There are many reasons why community banks should have such a program in place, but the flat interest rate environment is ratching pressure on banks to create a solution for current customer demand.
Submitted by Chris Nichols on July 31, 2019