The last quarter in the year is typically a suboptimal time to generate commercial loans. Most bankers have met their annual goals factoring the existing pipeline of credits. Furthermore, banks that have not met their goals for the year are likely to price and structure more aggressively, thereby depressing profitable opportunities for more disciplined lenders. However, there are several different cycle variables at this time that community banks must take into account. We see an unusual amount of activity from community banks that are refinancing their existing commercial loans into more profitable structures, and this barrage of business can be explained by a few unusual market conditions.
The Unusual Market Challenges
It has not been easy for community banks to find and retain quality commercial real estate and C&I loans. The graph below shows that commercial banks under $5Bn in assets have experienced decreases in total loans since Q’3 2017. Next year will be even more challenging for several reasons.
There are three main reasons for banks to be cautious about loan demand next year.
First, as the graph below shows that the current economic expansion is the longest in US history at 123 months. We cannot predict when the next economic slowdown may occur, but we recognize that we are much close to the end of this expansion than the beginning. Depending on the severity of the next downturn, banks will be challenged to find sufficient loan demand with acceptable credit parameters to replace runoff and prepayments.
Second, many of the fast-growing community banks have been heavily involved in the financing of purchase and sale of real estate assets. That business accelerates as cap rates decrease but decelerates when cap rates increase. The graph below shows national average cap rates on all categories of real estate. The current average cap rate of 6.5% is near the all-time historical low. The number of commercial properties that real estate investors will be motivated to flip is likely to decrease in the next few years.
Third, the cost of financing credit is at historic lows. The graph below shows the 10-year swap rate from 1988 to the present. Borrowers tend to prepay and refinance their loans when interest rates drop. However, based on historical ranges and the concept of reversion to the mean, it is unlikely (not impossible) that rates are at their cyclical lows. That means that borrowers that lock in their financing costs today will not be candidates to refinance their credits for the foreseeable future.
All of the above leads us to conclude that quality loan demand will be weaker for the next few years than it has been in the last few years. However, we see some smart community banks take advantage of these challenging times.
The Opportunity for Community Banks
Other bankers have taken note of the above and have seen the “writing on the wall”. These bankers have developed smart ways of protecting their existing loans from being poached by the competition. We work with banks across the country that have developed products to proactively approach existing borrowers and refinance those customers into long-term credit facilities with compelling prepayment protection.
Rather than wait for an existing customer to be marketed by competitors, these community banks are actively engaging their customers to refinance existing loans into a structure and pricing that is more advantageous to both lender and borrower. We have worked on hundreds of transactions in the last few months where banks are changing terms of existing credit facilities that have one to 3 years to maturity. These banks are locking in their best customers for 5 to 20 years. This strategy only makes sense under the following conditions:
- Banks must identify top credit quality customers – above 9 or 10% debt yield, strong repayment history, and stable business models. The longer commitment terms also serve to enhance the credit quality of the account by mitigating refinance risk, and the current low-interest rates help boost borrower’s free cash flow and repayment capacity.
- The borrower must be a relationship account. It makes little sense to target transactions accounts for such a long commitment period.
- Banks must be capable of eliminating interest rate risk on their balance sheet. It makes little sense to add duration with rates near historic lows. Combine that that often in a recession the Fed lowers short-term rates, but long-term rates increase with the expectation of future economic turnaround and expected expansion.
- The credit facility must be sold with meaningful prepayment protection for the lender. It makes little sense for banks to offer long-term commitments at historically low rates and create a credit that may be poached if rates dip again in the future.
The next few years may be much more challenging for creating loan demand and preventing runoff. But we are seeing many community banks that are creating winning strategies by locking in existing quality relationship accounts and reducing the risk that competitors poach their best customers.
Submitted by Chris Nichols on October 02, 2019