If you want to win more loan business here is a tactic that experienced bankers know that many loan officers don’t. This should be part of every loan officers training (we work it in) and is handy to have in your back pocket for those rate-focused borrowers.
Here is the setup: A borrower wants to purchase their own industrial space and needs a 75% LTV loan with 1.56x coverage for $2mm. The borrower has an offer from Suntrust for 3.80% for a 5-year maturity with 25 years of amortization, no fees and a yield maintenance provision. You run the risk-adjusted spread and the loan comes out to a 14.79%, or just under your target 15% hurdle rate. You go back with a 3.85% (a 15.04% risk-adjusted ROE) and see if you can talk the borrower into it. The borrower says he would like to go with you, but he can’t give you the business at a higher rate. Sometimes the best service in the world can’t overcome rate. So what do you do?
It turns out that borrowers are more rate sensitive than maturity sensitive. As such, by adjusting to a five-month shorter maturity, 55 months instead of 60, the shape of the funding curve is such that it turns out to be a 15.74% rate, or better than even the return on the 3.85% rate that you are willing to do. Since the borrower, like most borrowers, doesn’t really care too much about 5 months, you match the rate and win the business. You pat yourself on the back as you were almost ready to go to the Chief Lending Officer and ask for an exception to the pricing guidelines, but now you are thankful that your superior loan structuring skills saved the day for all parties.
Make no mistake. This isn’t about gaming the relationship profitability model (but it does open up a philosophical discussion over key rate duration, funds transfer pricing and the shape of the forward credit curve), as utilizing the implied duration of the loan to find the implied duration of the funding curve is a very common way to calculate profitability and one that most loan models and loan pricing methodologies utilize. This is potential legitimate profit that can go to your bottom line.
Now if it was a longer maturity, shortening the duration wouldn’t have mattered and might have actually hurt profitability. Because the yield and funding curve steepens in the three to seven-year range, shortening maturity, even my five months, makes a difference. By comparison, had you shifted amortization to 20-years instead of 25 that would have resulted in a 14.79% return, or still below your target. Shifting amortization has much less impact on the duration and hence pricing than shifting maturity. In fact, to underscore this point, you would have had to shorten amortization from 25-years to almost 10.5-years to equate to the same performance as shortening the five months of maturity.
While we have lots more loan structuring tricks to come, make sure your lenders know about this article and have them stay tuned. In the near future, we will be discussing the profitability and marketability of a “flex rate option” loan.
Submitted by Chris Nichols on January 29, 2015