If you are feeling unlucky every time a loan prepays early then this will help. When banks originate a loan without a prepayment penalty or yield maintenance provision they are giving away economic value to the borrower – on average 7.2% of total loan value to be exact. While banks don’t take a principal hit, the impact is the same because the bank could be as much as 7.2% more profitable if they were to utilize a reasonable prepayment provisions. This may explain why some banks are booking what at inception appear to be highly profitable loans but are consistently producing below a 9% return on equity.
Statistically, that 10-year loan without a penalty has an approximate 92% probability of never making it to maturity. That is a bigger number than most bankers realize and underscores the point that a 10-year loan isn’t really a 10 year loan.
This problem is further compound when you factor in acquisition of gaining the customer that prepaid and the acquisition cost of finding a replacement customer. Worst of all, it is highly likely that the bank is being adversely selected as the loans with the best credit profile are the ones going away. As proof of this, after 2008 on loans originated in 2004 prepayment speeds were about 70% per year. In contrast loans originated in 2008, with much higher loan-to-value, had prepayment speeds of approximately 20% per year. By the end of 2010, loans originated in 2004 had an average LTV of 56%, while loans from 2008, had an LTV of over 81%.
Of course, what banks really want is a “lockout” provision that forces the borrower to pay interest for the whole term of the loan, irrespective of rates, if the borrower prepays early. This places the voluntary prepayment probability at zero and assures (subject to credit) that the loan gives 100% of value to the bank until maturity. Unfortunately, this type of prepayment is not industry standard.
Next to full lockout, the best structure a bank can have is a yield maintenance provision, such as the one found in our ARC hedge program for banks. Here, the optionality hurts the loan’s value by less than 0.10%. From 2007 to the present, these loans have a prepayment rate of approximately 2% per year – that is pretty low compared to other prepayment structures. What is better, is that we have found that of all the prepayment protection structures, selling yield maintenance is the easiest to sell because it uniquely positions the borrower to capture value if rates increase. This is why we are utilizing the structure more and more here at CenterState.
If your bank is looking at different repayment structures and want an easy chart to use in front of the borrower to prevent your lenders from giving away value, the below information will be very helpful (feel free to forward the link to your lending staff). As you can see, not all prepayment penalties are created equal. Before just assuming that a 3%-2%-1% step down prepayment penalty will work, consider a lockout for the first three years. The former decreases a loans value by 5%, while the latter increases a loans value by 4.7%.
Looking at a set of loans, here is a breakdown of different prepayment protection structures:
|Probability of Early Repayment||Value of Loan As Percent of Par|
|Lockout for Life||0%||100.0%|
|Fixed for life at 5%||73.9%||97.1%|
|Fixed for life at 3%||80.3%||96.0%|
|Fixed for life at 1%||87.8%||94.8%|
|Fixed for 5Ys at 5%||85.7%||95.2%|
|Fixed for 5Ys at 3%||88.2%||94.4%|
|Fixed for 5Ys at 1%||89.3%||93.4%|
|Step down: 5%-4%-3%-2-1%||82.8%||95.6%|
|Step down: 3% -2%-1%||88.2%||95.0%|
As can be seen above, any penalty is helpful to building shareholder value compared to no penalty. Having a lockout or yield maintenance structure is the most helpful (which is consistent with options theory) to build value. At a minimum, bankers should price the loan accordingly for the risk of not having a prepayment provision in their loan documents. If you can't get pricing or the prepayment protection you need, that it is your shareholders that end up taking all the risk of optionality - which is unlucky.
If you are a financial institution, here is a link to our Resource Center that will give you further information on how to calculate and sell a yield maintenance provision ( https://services.csbcorrespondent.com/content/working-yield-maintenance ) This will help put the luck of the Irish on your side.
Submitted by Chris Nichols on March 17, 2014