Given smokin’ hot production numbers, record low employment and the Fed meeting, many borrowers are concerned about the prospects of rising interest rates and the resulting higher loan costs. Not just that, tax reform has made many loans easily refinanceable. As a result, many borrowers are facing a dilemma – do they keep their existing loan to maturity or refinance now and extend out maturity? In this article, we take a look at one little-known tactic that will set your bank apart from the competition.
One option is for the borrower to refinance today and lose the existing term (perhaps with an attractive rate) but lock in a fixed rate before they climb any further. A second option is to wait until their existing loan matures, but with the risk that financing may be unavailable or more expensive once the existing facility matures.
Most bankers would end the thought process there. However, there is another idea to consider – refinance with a forward commitment. Unfortunately, few banks are willing or capable of offering this option, but in many cases, this could be the best option. In fact, there are a handful of banks that do this with an elegant and profitable methodology.
How Tax Reform Made Lending Easy
Before we get to the methodology, we need to lay the groundwork. First, bankers need to appreciate what is happening in the market on loan pricing. After tax-reform, commercial credit spreads materially compressed in February of 2018 and again in May of 2018. While credit quality did improve in some areas, on the whole, credit quality in 2018 is comparable to 2017. What is different from last year is that tax reform has made all loans more profitable. Let’s take the seven-year loan for example, in 2017, the average credit spread was approximately +2.47%. This produced a 15.6% return for the average bank. In comparison, last month, the average credit spread for the same structure and the same quality borrower decreased to +2.21%. However, because of the reduction of Federal taxes for banks from 35% to 21%, profitability has increased over last year (below).
In other words, that same loan that used to be at a +2.47%, could now be priced at a 2.01% for the same return of 15.6%. The reason why this is critical is it means some 70% of all commercial bank loans are in refinance territory and can now be refinanced at lower rates. Almost any existing floating rate loan can now be refinanced at tighter spreads, and most fixed-rate loans originated from 2010 through late 2011 and from mid-2013 to 3Q 2015 can be refinanced at lower rates and higher returns.
For aggressive relationship managers and lenders, meeting loan production goals has never been easier - Search for loans originated during those time periods above and then show the borrower how you can reduce their rate AND extend their term.
Of course, the first place to start is your balance sheet in order to protect your quality customers. If we have this information on your borrowers, so do other banks. Keep reading to find out how the forward curve can be used to your advantage.
Using The Forward Curve
Bankers should be aware of the emotional and rational drivers motivating borrowers’ decision to refinance. Bankers should also consider their current and anticipated cost of funds and the market’s prediction on future interest rates. A large component of understanding these drivers is appreciating the shape of the forward yield curve. The forward curve for short-term rates (Fed Funds, SOFR or LIBOR) for the next ten years is shown below. This is a proxy for a bank’s cost of funding and borrower’s cost of the loan before any credit spread. The key information in the forward curve is that the market expects rising interest rates over the next couple of years and then a flat line. Of course, the forward curve is just an expectation, and the reality will likely be radically different. However, since we don’t know the future with any certainty, the forward curve is a good starting point.
Many borrowers are confused on how to analyze their best options: 1) refinance now, 2) refinance when the current fixed rate commitment expires, or 3) ask the bank for a forward commitment. If you are a rational borrower and you believe the forward curve, you would be indifferent between options one and two. There cannot be an arbitrage of interest rates available to commercial borrowers, and any higher costs in the future are already built into market rates.
However, the vast majority of borrowers are not completely rational financial players (in fact many borrowers do not have access to, or even understand, the forward curve). Many borrowers also have existing loans that were mispriced at inception and an arbitrage may be available to borrower or lender (depending if the original loan was over, or under, priced).
We have seen many bankers calculate in great detail, using spreadsheets and projections, the cost/benefit analysis for borrowers by calculating the present value of all interest expenses between options One and Two. Unfortunately, in the vast majority of cases, the math, the numerous assumptions, and the conclusions confuse the borrower.
Option Three (a forward commitment to start after the expiration of the existing loan) requires some expertise and knowledge of how to mitigate future liquidity, credit and interest rate risk. For example, not many community banks are in a position to offer a five-year fixed on a two-year forward and manage the myriad of risks associated with that structure.
The best solution that we have seen is relatively simple, takes advantage of the borrower’s propensity to retain what they feel is a below market rate, and allows the bank to decrease the risk of losing the customer, decreases credit risk and retains a good relationship for a longer period thereby increasing profitability.
The structure 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 (creating a hybrid structure).
Here is an example of a recent deal that a bank structured: This high-value relationship borrower had 14 months left on an original five-year fixed rate at 4.00%. The borrower considered various options described above, but the banker suggested a better alternative. The bank refinanced the loan into a hybrid structure. It retained the loan for 14 months at 4.00% - the economics were already locked in for the bank. The bank offered the borrower another seven years after the 14 months at a variable rate which the borrower chose to fix, resulting in a fixed rate of 5.15% for seven years (after the initial 14 months) and the bank earns LIBOR + 2.25% after the initial 14 month period.
Here are the benefits of structure:
Low Initial Rate: The borrower does not feel like they lost the bargain of the original loan term and rate. The bank also receives exactly the economics it had when it originated the loan four years ago. The borrower feels that they eliminated the fear of rising interest rate risk in 14 months when the loan had to be refinanced.
Profitability & Retention: The Bank now has the certainty of retaining a valuable customer for an additional seven years. Since the bank already had the loan for 14 months, it has a huge competitive advantage. The bank used this advantage and leveraged the extra time to negotiate a loan extension instead of waiting until maturity where there might have been more competition. Many banks, including ourselves, monitor UCC filings so we often know when a loan is coming up for refinancing. We often start discussions 13 months in advance of maturity in an attempt to pull a loan away from a competing bank. We are not alone on this tactic (since we publically talk about it) and many banks employ the same tactics. This is why locking in your customer for a longer period should occur no later than month 14.
It is also worth noting that the borrower signed up for a symmetrical prepayment provision to solidify the relationship with the bank. The longer commitment increases the lifetime value of the loan, boosting the return on equity to over 20% (below).
Non-interest Income: The icing on the cake was that the bank was able to generate a 1.50% lock fee that is recognized immediately in income, increasing the initial yield on the loan from 4.0% to 5.50%. This is an important point – the bank took an existing unprofitable loan and made it profitable (above). The Bank made the original loan not taking interest rate risk into account. That 4%, 14-month loan is now underpriced at a 1.10% credit spread (4% - the 2.90% 14-month swap rate). By capturing the fee, the bank now has saved the economics of the remaining term of the loan with a respectable, and profitable, +2.60% spread (5.50%-1.10%). Not bad.
Lower Interest Rate Risk: Short-term rates are expected to climb, but the real benefit of higher rates for the Bank will be felt in about a year, just when the floating asset commences (14 months out). The 4.00% fixed rate for the next 14 months is a meaningful risk; however, as can be seen from the forward curve, the bank has a benefit in a floating rate asset after 14 months when interest rates are expected to be about 1.00% higher.
Lower Credit Risk: The bank decreased the credit risk associated with a loan that will reprice in 14 months. Now the borrower’s debt service coverage ratio (DSCR) will be stabilized for a little over eight years. This should be an important consideration for many banks.
Simplicity: The borrower and banker did not have to solve for an average loan rate for the remaining 14-month term and the seven-year extension. The simplicity of the structure allowed the borrower to keep the original rate and term. The bank created a new note that mirrored the original loan features and added the additional seven-year commitment. The borrower felt like they retained a great rate, but the bank obtained an above average fixed rate for 14 months and a floating rate when interest rates are expected to be substantially higher.
Given that credit quality is at or near record highs and the economy is humming along, now is the time to protect those borrowers that you want to protect and go after the customers at other banks that you want. Improving credit quality, tax reform and the threat of rising rates has created an ideal time to catch borrower’s attention.
While there are a number of different methodologies to refinance your current customers, the hybrid-structure works well because the current forward curve has steepness in the first year and is flat after that. The added yield from fee income can make the hybrid structure a very profitable option for community banks. If we can further help explain or structure how to use this forward loan commitment, be sure to contact us as we would be happy to walk you through the same tactics that we use here at CenterState.
Submitted by Chris Nichols on August 01, 2018