Commercial banks grew loan balances by 2.11% in the second quarter of this year compared to the first. This growth belies that some banks increased their commercial loan portfolios more than the industry average and other banks experienced shrinking loan volumes. While the industry is experiencing much needed total growth, that growth is not evenly distributed among banks. The reason that loan growth is not evenly distributed is primarily because some banks are better than other banks at poaching existing borrowers. Total business activity is moderate, and new funding is relatively tepid, therefore, to succeed in growing loan portfolios community banks need to pursue customers at other banks. It is estimated that over 90% of commercial loans can be refinanced based on today’s prevailing interest rates and terms versus the rates and terms of the existing commercial credits.
Big banks are increasing their push in refinancing borrowers from other institutions amid this low-interest rate environment. Below is an ad from Wells Fargo that is directly targeting borrowers with loans at other institutions.
We have seen similar ads and campaigns from other banks, including JP Morgan, US Bank, Fifth Third, Regions Bank and others. The aim of these campaigns is to target existing loans at other institutions that are ripe for refinancing. These large banks are targeting high credit quality investor commercial real estate (CRE) and owner-occupied CRE opportunities.
These ads will sometime state terms and conditions. Some national and super regional banks are offering no closing costs, 15-year terms, ability to assign the loan (and the rate) if the borrower refinances with the bank in the future, and low-interest rates (we have seen a few banks advertise high to mid-3% for 15 years, and a couple of banks have stated sub-4% for 20-year terms).
Banks that are coveting refinance opportunities are looking for the following loan characteristics: higher than market loan rates, no prepayment protection on the credit, short term to maturity or loan structures that were originally not desired by the borrower.
The strategy by these poaching banks is to entice the borrower with very low existing index rates and explain that this refinancing opportunity may not last long.
Another strategy is to show that the flatness of the yield curve makes refinancing existing loans that much more desirable. The graph below shows the underlying index rate (or swap rate) for a 25-year amortizing loan with maturities from three years out to 20 years. The argument to the borrower is that if you want to refinance your existing loan not only are interest rates low but in today’s environment you can fix your rate for ten years for only a 0.38% premium over the five-year rate. Further, the premium to fix the rate out to 20 years is only 0.27% above the ten-year rate. The message to the borrower is that rates have never been lower, and you should lock in your rate now before rates move higher. Further, once the borrower locks the new, lower priced and longer term loan with the lender, a future poaching opportunity is almost completely eliminated for two reasons: 1) it is hard to imagine an interest rate environment over the next decade that would entice the borrower to entertain a refinancing again, and 2) a correctly structured prepayment provision will make it prohibitive. The poaching bank ends up booking a highly stable loan with profitable margin (while the index is low, by historical standards the margins on today’s commercial loans are often above average due to record low projected credit risk).
We recently worked with a bank that had $4.5mm loan to an owner-occupied commercial real estate customer in the business of distributing and retailing car tires. The loan was originally structured as a 20-year amortizing loan, ten-year fixed with a rate adjustment every five years. The current interest rate was 4.75% fixed with three years remaining on the first five-year period of the loan. Wells Fargo offered the borrower a 20-year amortizing loan fixed for ten years at 2.75% over LIBOR, translating into a fixed rate of 4.37% for ten years. The borrower had asked the bank on numerous occasions to amend the loan to a ten-year fixed rate to eliminate the refinance risk in 2019. We priced the loan as offered by Wells Fargo (adjusting for term, credit quality, ancillary business, and the community bank’s cost of funding). Our calculation showed that the bank lost a 20.71% risk-adjusted return on capital relationship. Replacing $4.5mm of earning assets, and matching the high ROE will not be easy in this market.
Community banks must go on the offense to take advantage of the unique interest rate environment and refinance business from other banks. Equally important, community banks must also defend top relationships from competition by locking in the customer with meaningful prepayment provisions. Today’s interest rate environment allows quality borrowers to obtain fixed rate loans all the way out to 20 years at rates well below 5.00%, while still earning the average community bank a risk-adjusted return well above its cost of capital.
Submitted by Chris Nichols on August 16, 2016