Working With Borrowers When Rates Rise
Capital markets move quickly, and last week the 10-year Treasury yield did not just increase, but it increased by almost 20 basis points in one day. Many pundits and economists will be writing about the cause and impact of rising rates. They will note how the market is now pricing interest rate hikes by the end of 2022 and how inflation is expected to accelerate on the back of fiscal stimulus. In this article, we want to share how community bank lenders react to their borrowers and how they are positioning their banks in this rapidly rising interest rate environment.
Is this a good time to refinance my commercial loan?
Many borrowers are approaching lenders asking for advice on loan refinancing. Borrowers that have only a few years remaining on their fixed-rate loan or those that have floating rate term loans are anticipating future costs of borrowing to increase. Lenders need to be able to address borrowers’ concerns, have products and services to help their clients and be insightful and professional trusted advisors. Here is an email that one community bank lender sent to his borrower, who was questioning if he should refinance his term loan that is scheduled to reprice in 2023.
Dear Mr. Borrower,
While the federal reserve is managing monetary policy, it has less direct influence over long-term interest rates. The 10-year rate has increased about 100 basis points from July 2020. The long-term rate is a market-driven rate and is influenced by the supply and demand of US Treasuries. Why would the 10-year rate increase? There are many reasons, but the primary reason is that investors believe that the Federal Reserve will increase short-term rates in the near or medium future.
Investors do not believe that the Federal Reserve will keep interest rates at pandemic levels when there is no longer a pandemic to depress the economy. The market is forecasting that business activity (as broadly measured by GDP) will return to “normal” levels in the near future, and the federal reserve will decide to raise short-term interest rates. If you’re an investor in Treasuries, you demand a higher interest rate to compensate for a higher cost of funding in the future and higher inflation.
The interesting question is for you is this: what should you do with your existing $3.7mm term loan that is set to reprice in March of 2023? Below is a graph showing long-term (10-year Treasury) funding costs before credit spread. Right now, interest rates are still abnormally low, driven by a global pandemic. The prospect of the pandemic ending is driving interest rates higher. Currently, borrowers have an opportunity to fund projects or refinance their loans at the lowest rates in 30yrs (outside of the Covid19 pandemic that has lasted for the last 12 months). Lending rates are low in historical context, but we may never see lower rates until the next pandemic or the next severe recession. Let’s meet to discuss what we can do to lock your loan rate past 2023.
My Loan Portfolio is Prepaying Quickly
Commercial loans do not just prepay when rates fall. They also prepay when interest rates are rising. The reason is that some borrowers are in loan structures that are only suited for stable rates (for example, floating rate or short-term fixed-rate term loans). When interest rates are about to rise or are rising, these borrowers will switch to loan structures using longer-term strategies and view. This is where prepayment provisions are all critical. Prepayment provisions protect the lender in both up and down interest rate environments.
While very few banks measure the cost or benefit of appropriate prepayment provision, we believe that a lender obtains between 50 to 105 basis point equivalent spread with a powerful prepayment provision than without one. That means that a bank should be indifferent to a Prime flat loan without a prepayment provision and a Prime minus 105bps loan with a powerful prepayment provision.
Now is not the time for banks to book loans without prepayment provisions and many smart bankers know this very well. Prepayment provisions add value to lenders in the following four ways:
Opportunity Cost: It eliminates the opportunity cost of committing to credit and giving the borrower the unilateral right to prepay when changes in future interest rates or credit spreads make it more beneficial for a borrower to do so. Our analysis shows that this is worth approximately 45 basis points in credit spread on a 10yr loan.
Longer Average Life: It increases the expected life of the loan, and this increases profitability to the bank. This adds approximately 25 basis points in credit spread on a 10yr loan.
Increased Products Per Customer: It converts many loans from single product sales to a relationship. This adds another 20 basis points in credit spread on a 10-year loan.
Limits Adverse Selection: It prevents negative selection bias in a downturn. In economic expansions, both strong and weak borrowers have ample opportunity to refinance their credit needs. However, in a downturn, only the stronger borrowers can secure alternative senior debt financing. In a downturn, the credit quality of a portfolio of loans without prepayment provisions will degrade faster than the same portfolio with prepayment provisions. The lesser quality credits will not see the same financing options available to the higher quality credits. This adds another 15 basis points in credit spread on a 10-year loan.
Banks that value keeping earning assets are making loans today with prepayment protection.
Will Credit Spreads Contract In the Future
Paradoxically now is a good time for banks to book quality credits. While funding costs are at all-time lows for banks, credit spreads are acceptable because many borrowers have been conditioned to expect wider spread because of the uncertainty of the pandemic. Post-pandemic, credit spreads will tighten, as they do with any credit cycle and lenders will be in a weaker position to gain NIM. However, credit spreads very likely cannot contract as fast as funding costs can rise, making it advantageous for lenders to make a loan today and for borrowers to take credit.
Community bank lenders currently have an excellent opportunity to take advantage of volatility in the market, lock quality clients with proper prepayment provisions and recognize good credit spreads.