Don’t Make These Mistakes When Issuing a Loan Proposal Letter

Last week, we discussed how and why commercial lenders use a bank loan proposal letter (aka commitment letters) to their advantage (HERE).  We argued that a proper strategy and a well-crafted loan proposal letter could help lenders close loans quicker, eliminate more competitors, secure better pricing, and obtain the desired credit structure. In this article, we discuss the top four mistakes that we see in commitment/proposal letters.

Giving Borrowers Free Options in a Loan Proposal Letter

Some banks will quote a ten-year, fixed-rate loan pricing with the first five years fixed and the next five years at the then Federal Home Loan Bank (FHLB) five-year fixed-rate advance plus a credit spread.  The second five-year spread is often higher than the initial rate when adjusted for the current five-year FHLB advance.  The argument is that most customers will negotiate a lower rate at the five-year adjustment period, and the bank can determine its willingness to negotiate that spread at that time.

This is a bad strategy for the following reasons:

• If, in five years, the credit spread is below market because of tight lending conditions, poor borrower performance, or a recession, the borrower will take that credit spread and retain the loan. This is a suboptimal outcome for the bank.
• If, in five years, the credit spread is above market because of ample liquidity, good borrower performance, or a booming economy, the borrower will negotiate a different credit spread and is likely to obtain competing bids, further eroding the bank’s net interest margin (NIM). Again, this is a bad outcome for the bank.
• If, in five years, the credit spread is above market, but the borrower is not motivated to negotiate a better spread, then the bank picks up extra NIM. It is a good outcome for the bank but unlikely for sizeable credits and attractive clients being courted by other banks.

The better strategy is to lock the borrower for as long as possible, with the highest switching costs the bank can negotiate (strong prepayment provisions and cross-selling products with high switching costs).  This strategy eliminates competition for longer, increases return on equity (ROE)/ return on asset (ROA), increases cross-sell opportunities, and eliminates a free option that the borrower can exercise to the bank’s disadvantage.

Adjustable Rate Term Loan Post-Construction

In construction-through-perm financing, banks will quote a takeout term loan priced on a preset spread over an index in the future.  For example, during an 18-month construction period, the borrower’s rate is Prime, and after the construction, the borrower’s five-year term loan rate is 2.50% over the then five-year FHLB rate.  The issue is that the lender is creating a possible credit problem if the rate in 18 months plus the 2.50% credit spread results in a higher rate that causes the debt service coverage ratio (DSCR) to be below underwriting standards.  Using the average cap rate and loan-to-value (LTV), every 100bps increase in a loan rate results in approximately 0.15X reduction in DSCR.  No one can predict where rates may be in 18 months; if rates are lower, the bank will get the negotiated credit spread but a lower all-in rate, but if rates are higher, the bank may have a loan that does not meet its minimum DSCR.

Inappropriate Prepayment Provisions

Some banks will not insist on loan prepayment provisions in their or include diluted provisions that are forgivable on the sale of the property or refinancing in the commercial mortgage-backed securities (CMBS) market.  The real issue is that bankers and borrowers cannot quantify the value of the prepayment provision.  Further, bankers cannot reasonably explain why a prepayment provision is necessary.  Here is an example of a dialogue we heard between a lender and a borrower.

Borrower:  Why do I need to pay you 5% in the first year (declining to 1% in the fifth year) to prepay the loan?

Lender:  I can lower that to 3%-2%-1% instead.

Borrower: But why is there any prepayment provision?

Lender:  The bank has costs to underwrite, book, and fund the loan.  We cannot allow our loans to prepay just because you may find a better deal elsewhere.  We have overhead costs for originating loans that are not captured by the 25bps loan origination fee that the bank charges.

Borrower:  Would there be a prepayment provision if the loan were adjustable rate instead of fixed?

Lender:  No, we do not charge prepayment provisions on adjustable-rate loans.

Borrower:  Doesn’t the bank have the same underwriting, booking, and funding costs for a floating-rate loan?

Lender: [long pause] I’ll see what I can do.

There are four main reasons why prepayment provisions increase value to banks:

• Decrease the value of the option held by the borrower to repay the credit (when rates are lower or the borrower’s credit quality improves).
• Increase the lifetime value of the relationship by increasing the expected life.
• Increase cross-sell and upsell opportunities.
• Reduce negative selection bias in an economic downturn.

Prepayment provisions are easy for borrowers to negotiate away primarily because the declining balance step-down provision is not compelling to either the borrower or the lender.  Banks must develop another compelling provision – such as a symmetrical yield maintenance or make a whole provision.

Mismatch Between Index and Loan Structure

We see some banks set fixed rate pricing on variable or adjustable indexes.  This strategy might effectively set current loan pricing because the bank can quantify the current index level, but this practice hurts the bank for future resets.  For example, setting the fixed rate on a two-year loan post-construction equal to Prime minus 50bps subjects the bank to many mispricing possibilities.  If Prime has plummeted post-construction, the bank is under-compensated for the credit, and if Prime has increased substantially, the bank created an incentive for the borrower to renegotiate the loan, or worse, the bank created a non-cash flowing borrower.  Using a constant maturity treasury rate to set fixed-rate loan pricing also has serious drawbacks.  Treasury rates demonstrate a lower correlation to a bank’s cost of funding than the swap curve or FHLB advances.

Loan Proposal Letter Conclusion

We see at least one of these top four mistakes in approximately 25% of all commitment and proposal letters.  The high-performing banks and astute lenders can easily avoid these pitfalls related to structure and pricing by not making the above outline loan proposal letter mistakes.