One thing that is underappreciated in our industry is the difference between loan structure risk versus credit risk. While these are intertwined, the two risks are different as we will explore. Not only do lenders have to pay attention to their exposure at default, their probability of default and their loss given default, but also their structure risk. One major aspect of structure risk comes up when you try to answer the question, “What loan structure is better for the bank: a balloon or fully amortized loan?”

**Inserting Liquidity Risk **

To best answer the question, let’s look at a real-life example. We will analyze two loan structures on the same medical office building credit. One loan is a ten-year fully-amortizing loan and one is a five-year balloon with ten-year amortization. Do you price them the same? Is there a risk difference?

The answer is that you don’t price them the same and there is a risk difference. Unfortunately, that difference is largely lost unless you can capture structure risk. To understand the details, let’s look at the risk profile below.

On the left is the annual probabilities of default and cumulative probabilities of default for the ten-year fully-amortizing loan, while the loan on the right is the balloon structure. As can be seen in the top left graph, the risk structure of the fully amortizing loan quickly ramps up, peaks in year three and then trails down to year five, where it then starts to dramatically drop due to seasoning, appreciation, increased cash flow and amortization.

This contrasts with the balloon structure that ramps, plateaus and then peaks because of the refinancing event. If all goes well, then no problem, the loan gets refinanced without a hitch. However, the balloon structure causes an event that greatly exacerbates risk. Should greater vacancies occur, the building develops structural problems or the loan market turns illiquid, as it did in 2009, then the odds of default materialize.

**Longer Cash Flows Equal Greater Marginal Profitability**

The downside to the fully-amortizing loan is that each year adds an additional chance that the loan could default. For example, if the market took a downturn in year six, the balloon loan would have already been refinanced, whereas the fully amortizing loan would suffer impairment. That said, each additional year also adds an additional year of cash flow which increases profitability. Further, it is worth noting that, as can be seen by the historic data on defaults above on the bottom left, each year after year three comes with lower risk and a better risk-adjusted return rate.

Note that both loans have about the same cumulative probability of default at around 3.4%. However, it should be noted that because the balloon feature causes more than a doubling of the probability of default, the profiles are different. The fully amortizing loan has a more stable profile, with less volatility and an average annual probability of default of around 34 basis points. Compared to the balloon, the spike in risk as a result of the balloon increases the volatility of earnings and results in an annual probability of default of 69 basis points, or twice as much.

**The Optionality of Profitability**

In addition, the fully amortizing ten-year loan has a longer net cash flow stream, thus the profitability is greater as the customer’s terminal value is greater. If you insert a five-year balloon maturity, then there is a chance (more than 30%) that the borrower will refinance away from you or at least entertain other term sheets.

Increased competition at the five-year refinance mark likely results in decreased margins, or worse, the loss of the loan. This contrasts with the ten-year, fully-amortizing loan where the bank is likely over the greatest credit risk and can now enjoy relatively greater risk-adjusted margins.

The answer to the question is that assuming you used our ARC Program or other methods to hedge the interest rate risk, you would much rather have the ten-year, fully-amortizing loan. In this manner, you can reduce the interest rate risk, provide the borrower payment certainty, be able to convert the ten-year loan to Libor + 2.25%, and have a longer set of cash flows at greater profitability.

The other way to look at this is to ask the question, what should the pricing difference be to become indifferent? The answer is - loan officers should price the balloon about 32 basis points higher to equate to the same risk-adjusted return.

**Conclusion **

The above is a clear example of how structure plays into pricing. Covenants, interest-only features, tenant composition, lease composition, prepayment penalties and other aspects of a loan’s composition all play into a bank’s overall risk. The next time you are pricing a loan, consider the structure risk of the loan and how a balloon may actually result in more risk, rather than less.

Submitted by Chris Nichols on January 30, 2019