Pricing Loans in a Rising Rate Environment with Ed Kofman

[Intro]: Helping community bankers grow themselves, their team, and their profits, this is The Community Bank Podcast.
Caleb Stevens: Well, hey everybody, and welcome back to the Community Bank Podcast. I’m Caleb Stevens. Thanks for joining the conversation today. I’m joined in studio by Mr. Tom Fitzgerald. Tom, how are you?

Tom Fitzgerald: Caleb, I’m doing fine, and hope you are as well.

Caleb Stevens: I am doing great, and we have not had our own Ed Kofman back on the show in a while, and with rising rates with inflation continuing to be in the headlines, a lot of banks out there are trying to think through how are they pricing their loans, how should they compete with, you know, the bank down the street offering a lower rate, but also protect their balance sheet. And so we wanted to bring Ed on to talk about what he’s seeing in the market as far as deposit betas go, as far as loan structures, loan pricing, thoughts on credit. And I thought it was a great discussion. Ed is one of the most brilliant guys around, and so it was good to have him back.

Tom Fitzgerald: It was. And like you said, Ed is just a very intelligent individual and he also has the chance to talk to banks coast to coast. And so he has a unique perspective of what bankers are facing out there, not only in just the neck of the woods where he resides, which is California but again, like I said, from north to south, from east to west, he’s talking to them all. So he’s got a wealth of knowledge from that and some insight into the industry as a whole.
Caleb Stevens: Well, let’s go to that interview right now.

Well, Ed, it’s great to be speaking with you today. Thanks for hopping on the podcast. How are things out your way in San Francisco?
Ed Kofman: Thanks for having me. I appreciate it. It’s beautiful out here. We need more visitors. So anyone who wants to visit San Francisco, go to it.

Caleb Stevens: Well, for folks who are not familiar with you, give us a quick snapshot of your career and talk about what you do here at SouthState to serve community banks.

Ed Kofman: Sure. So I actually started off in corporate law. I originally thought I was going to be a doctor. I don’t have the bedside manners for it, but I did practice law with the JD/MBA, and the law firm I was with, the biggest client we had was a bank. And I interviewed with the bank, thought it was a better fit. And I’ve been with SouthState for nine years, but until I started working with community banks and correspondent division, I didn’t realize there were banks under a hundred billion in assets because all the banks I ever dealt with were the large national international banks. I never understood why community banks avoided hedging while 80% of the banks in the country by asset size, you know, these are the larger national banks or regional banks, they all embraced it. But I’ve always enjoyed problem-solving. And the problem I wanted to solve, and I think did a good job solving it, was to provide a solution that community banks could use to be on par, and in fact, better, differentiate a product than what national banks use to hedge their loans.

Tom Fitzgerald: Let me ask you, Ed, you travel the country, you talk to a lot of different banks. I know I sit next to the guy that runs our AL service for SouthState. So in terms of deposit betas, that seems to be the buzzword that everybody is working through right now, as to how tightly would that deposit beta increase with the Fed raising rates and continuing to raise rates probably into next year. Do you have a handle right now as to what you’re hearing from the banks as to what they’re looking at with that beta as we move into the latter part of this year and into next year?

Ed Kofman: Yeah, that’s an excellent question. And we’ve done quite a bit of research and analysis on how banks’ cost of funding moves with Fed Funds, LIBOR, SOFR. Now, I just want to point out that the betas that everyone talks about can be quite tricky. So for example, let’s say that rates don’t move at all. And we’ve had many quarters, months, years even where Fed Funds hasn’t moved, the LIBOR hasn’t moved very much, but for whatever reason, a bank’s cost of funding could move up or down and you get very unusual results, unexpected results. You could have Fed Funds move zero, but for some reason, the bank’s cost of funding goes up by one basis point. And now you have nonsensical results that the beta is infinite as an example or undefined. But when you look at longer term and you look at hiking cycles, a few important results come to light. And that is, historically there’s been a lag between movements in Fed Funds and a bank’s cost of funding.

Now we can only witness a bank’s cost of funding as it’s reported, which happens quarterly. And the line of best fit, when you look at correlation coefficient has been historically six to nine months. Now it’s probably somewhere in there, we just don’t get to see seven and eight-month information. So historically the line of best fit has been six months, nine months, depending on the bank, somewhere in there. Now, if you agree that there is a lag, what we’re witnessing now is just the first hike from March of this year, because we’re now about seven months after that hike. And that hike was 25 base points. When we look at all the banks in the country, the correlation coefficient between Fed Funds, LIBOR, SOFR, those are interrelated short-term rates, the correlation coefficient is 0.95. Now that’s different than beta, but the explanatory factor is very high, and the size of the bank really doesn’t matter. Some of the larger banks actually have slightly smaller correlation, but it’s very close.

A lot of people say this time it’s different. Every time I hear that phrase, I find that dangerous. It might be a little different, but it’s not substantially different. It’s going to be very similar to past hiking cycles, but there are going to be differences. One is the pace. And we have a high pace. In the last six months, we’ve had 3% of movement. That is the fastest rate hiking cycle in over three decades. So that’s important to bear in mind. You’re going to have different quality in nature of cost of funding movement when the Fed moves that quickly. The starting point is important too. People were lulled into believing that rates are going to be zero forever, and then it was just transitory inflation and then it was, whoops, we’ve got an inflation problem and the Fed is moving, but they’re starting at a low rate. The terminal rate is going to be very important. Where are we going to end up? And I look at the forward curve. Well, we expect Fed Funds to be four and a half percent; inflation is much higher than that now. The question is, will the Fed stop at four and a half percent? If they do, they’re never going to achieve a real interest rate that’s positive. Real rates equal nominal minus inflation. So if they stop at four and a half, they’re going to get Fed Funds still to a place where real rates are negative. So that’s a question; banks need to consider that.

The other thing I want to point out, and we talked to a lot of banks about this, everyone is always pointing out to the stupid bank down the street that’s raising rates, not them. Unfortunately, at this point, 10 to 12% of all deposits are controlled by banks that don’t have branches. They’re online banks and their beta is 0.75. They’re highly correlated to Fed Fund movements. So you think about Marcus, Capital One, Discover, all these banks have a very high beta, they control a large portion of deposits, about one-eighth of all the deposits in the country. Each rate hiking cycle is different but I want to point out for those that say that in the 1999 rate hiking cycle, the beta was a little bit over 0.5. In the 2004, it was a little bit over 0.4. And in the 2016, which actually started in 2015, that December rate increase, we only got to about 0.3. All of those cycles were different fundamentally, this one will be different on its own. And I urge bankers not to just extrapolate that each rate hiking cycle will witness a lower beta. It’s going to be a different beta. It’s important to understand the competition, where the Fed has started, where they’re going, how fast they’re moving. I don’t know if that helps.
Tom Fitzgerald: No, it does.
Caleb Stevens: That’s very helpful. And you talk about the emergence of online banks that are taking up deposit market share. That’s a relatively new phenomenon that’s been adopted more and more I would think, over the past five, 10 years. Have you seen that become a drastic player as far as driving up funding costs?

Ed Kofman: There’s absolutely no arguing that the internet and multichannel deposit delivery has shaped the industry. And people say, “Well, did we not have the internet in 2016?” We did, but those online lenders were a much smaller proportion of the deposit base. We didn’t have Marcus. Capital One was a completely different model back then. So we had an emergence of different players, more adoption of technology, and every year customers become a year older. So my mom would never think; she doesn’t know how to use the internet to move funds, but I can very quickly take deposits out of Capital One if their beta is not sufficient to my liking, because I’m a depositor, and go to Schwab, Fidelity, E*TRADE, and right now buy a 1 Year Treasury or agency yielding over 4%. That is higher than a 10 Year Treasury. So I can very quickly move my funds.

And you’re talking about younger kids who never grew up going into a branch. I feel that if I have to go into a branch or even use an ATM, the bank has failed me. And you can think that as the average banking consumer is getting younger and more tech-savvy, that beta is going to change. So I think, on a retail side, that’s a phenomena. On the commercial side, it all depends on the kind of business that you do and how important for that treasurer sweep account is. Are they willing to keep funds overnight paying zero or can they sweep it into a money market account? So all those things are important.

Caleb Stevens: Well, I think that’s a good segue. We’ve talked about the liabilities side of the balance sheet with deposits. Let’s move to assets and to the loan portfolio. In this environment, what should community banks be thinking about in terms of how they’re pricing their loans, how they’re structuring them? Obviously the number one goal is always to meet the need of your borrower, of your customer, but from an AL profile, as you see banks trying to navigate this rate environment, do you see the need for more floating rate assets? Do you still see banks putting more fixed-rate loans on the books? Any thoughts there and any advice?

Ed Kofman: So every bank is different, but historically, bankers have subscribed to fund transfer pricing building blocks. And for community bankers that haven’t come across that term, they should do some research on fund transfer pricing. National banks, when I worked at B of A, Wells Fargo, I know that the larger regional banks, they all subscribe to fund transfer pricing where they match assets and liabilities, they deconstruct them. And so on the deposits side, liabilities, which would price relatively quickly. Bankers forget the concepts because rates haven’t moved for a long time. We’ve been sitting at near zero since the pandemic started. And even before that, during the great recession, we were bumping along at zero for a long time. But it’s important to understand that you take your duration. If you’re going to take duration, you should take it on the investment securities side, not on the loans side. So your loan duration should match your deposit duration. That has been banking 101 for a long time.

This specific environment we’re in right now, the business environment, is fundamentally different than what we’ve seen for the last 40 years. We saw this 40 years ago when we had inflation and interest rates went up. We haven’t seen it since. The differences are going to manifest themselves in the following way. Number one, bankers need to be able to protect the primary source of repayment from borrowers, which is cash flow. So as rates go up, loan payments increase, debt service coverage ratio is pressured, the ability to service the loan is now compromised. So it’s a banker’s job to protect that primary source of repayment, the cash flow. The secondary source of repayment, which is collateral value, is likewise pressured because as rates go up with inflation, cap rates go up. Invariably the value of collateral decreases. So bankers have said, “Well, I’ve got first source of repayment second,” the two are highly correlated. When rates go up, debt service coverage ratio comes down, values come down as well. So again, bankers are in a position where they must defend the secondary source of repayment, which is the value of the collateral. So that’s the fixed-rate loan.

And finally, by putting on fixed-rate loans, banks now have a problem using those building blocks of fund transfer pricing (FTP). You need to be able to manage your balance sheet as a banker. And so fixed-rate loans are putting pressure, and they will put pressure on net interest margin for banks. So the issue that I see is that borrowers need the certainty of fixed-rate payment for as long as possible to stabilize debt service coverage ratio and to be able to amortize the loan that credit facility to get below that vulnerable LTV levels. But lenders need floating rate assets to be able to manage net interest margin. So every bank needs to find their own solution, but we are in an environment that we haven’t seen since the late seventies.

Tom Fitzgerald: Well, let me ask you, Ed, we’ve talked a little bit about the funding side. We’ve talked about your asset pricing side. And with the economic uncertainty that we have and likely to continue to have, and it sounds like you think the Fed also is going to probably have to go beyond that four-and-a-half, four and three-quarter level that they’ve sort of marked out as the terminal rate. What do you look for just in general speaking about credit, into next year? You know, credit quality. It looks like the Fed is really going to have to crush the demand side of the economy. And of course, that has implications with all sorts of loans that are on the books, I think. Do you feel bankers need to get a little bit more aware of what could be the potential there in 2023?

Ed Kofman: Yeah. So I don’t feel that the Fed is crushing the economy, because what’s driving the economy is real rates, not nominal rates. So for example, is charging 20% on a loan, is that a lot? Well, if you’re in Venezuela, you’re missing out on 1000% of additional inflation. So the way to look at interest rates is real rates, not nominal rates. So it’s nominal minus inflation. And so right now the Fed isn’t there yet. They haven’t created real rates above zero. Real rates are still negative. And so that’s a tailwind for every investor and every business owner. Credit will deteriorate, but I want to point out that recessions are actually positive for the banking industry. Good banks outperform in a recession but perform at industry average when rates are highly stimulative. So again, every bank can do okay when real rates are negative and there’s no recession, it’s the good banks that distinguish themselves when there’s a credit downturn and interest rates, real rates are positive.

So I believe recessions, now, not the great recession, not a depression and not a pandemic, but regular run-of-the-mill recessions are good for banks. They reset expectations and they call poor business models for both lenders and borrowers. So I believe that a recession would be welcome after so many years of zero rates, and most banks will do just fine. There will be some banks that will struggle and certainly some business models that won’t survive when real rates at least reach zero. And as you correctly pointed out, the Fed is not there yet and they’re not even there in their projections.

Caleb Stevens: I think that’s a helpful perspective. Well, Ed, as we wrap up, tell us about how you and your team are specifically serving community banks. Tell us about the ARC program and tell us why it may be a great fit for a lot of community banks out there who have never considered any kind of hedging solution before.

Ed Kofman: Yeah. So as I pointed out, we haven’t seen this type of scenario played out since the late 1970s with inflation rising and the Fed intent on raising rates to tame inflation. Credit will be more challenging, there’s no question about that. And cost of borrowing will go up, but the opposite, which is higher inflation is a much more pernicious force. So what we have right now, what we will continue to witness, based on market’s projections, is an inverted yield curve where the short end of the curve will be higher than the longer end. Now we already have that between twos and thirties, but we’re going to see that as the Fed continues to do its job and lift rates, we’re going to see that with short-term rates. That’s where the ARC program can help community banks.

And what we’re doing with the ARC program is we are helping the borrower achieve their goal. So we’re trying to protect the borrower, but we’re not jeopardizing the bank’s balance sheet. We’re allowing borrowers to lock in rates, fixed rates for up to 20 years, and in fact, they can obtain a lower coupon that if they floated or if they had a two-year rate because of this inverted yield curve. But the ARC program allows the community bank making the loan to recognize a floating rate asset. So that protects the bank’s balance sheet by keeping the net interest margin steady. So it eliminates that interest rate risk for the bank, protects the balance sheet, yet protects the borrower’s debt service coverage ratio and allows the borrower to pay the loan down over a longer period. Where at a reset or balloon juncture, the LTV is much slower than it would’ve been if it was a shorter loan.

The ARC program also allows the bank to develop a longer-term relationship. So longer loans. The ARC program allows for the loan to be portable from one underlying piece of collateral to another. That leads to more cross-sell opportunities for the bank in the form of deposits and fee income that banks can generate. So it develops a longer, more meaningful relationship for community banks. That cross-sell could be a huge win for the bank because our banks that use the ARC program are able to generate one or 2% of the loan amount. So in a million-dollar credit, that could be 10,000 up to 20,000. And banks recognize that upfront. They don’t need to amortize that over the life of the loan.

And finally, the ARC program creates a higher level of service that’s differentiated from the competition. So it’s not for every borrower, but a borrower that needs a long-term fixed rate, all of a sudden the bank can say, “Well, unlike the competition across the street that’s only offering a five-year fixed, Mr. or Ms. Borrower, I’m able to offer a 20-year fixed and you can use it from collateral to collateral.” That’s to higher level of service. You can differentiate and that can lead to higher spreads for the bank.

Caleb Stevens: Well, it’s a great product and it’s helping a lot of community banks out there. We’ll link to some resources in the show notes if folks want to check it out and learn more. Ed, if folks are listening to this and they want to connect with you, get more of your thoughts on the industry, maybe hear more about the ARC program, how can they get in touch with you and your team?
Ed Kofman: So the easiest way is ARC, A-R-C, arc@southstatebank.com. That comes to our team and we’ll respond pretty quickly.

Caleb Stevens: We appreciate your time. You’re always a wealth of knowledge and we look forward to having you back soon.