In our previous blog (HERE), we discussed the three primary criteria that banks should consider in choosing an appropriate index to price commercial loans. We concluded that, for the time being, LIBOR (surprisingly) was a superior index for community banks to use because of its high correlation to community banks’ cost of funding (better than Prime or US Treasury). We also discussed why LIBOR is a more flexible loan index for community banks because that index can accommodate amortizing, floating, fixed, forward-starting loans, that pay monthly, quarterly, semi-annually or annually. No other index can match this robustness.
In this blog, we explain the process we use at CenterState Bank for quoting borrowers fixed and floating-rate loans using a publicly available LIBOR index. We also describe how our method allows us to quote any commercial structure, and how it allows the borrower to track rates in the market until we close the loan.
What Is A Basis Adjustment?
The most important concept in our quoting and pricing method is basis adjustment. Basis adjustment involves taking a published and common index and adding or subtracting from it to arriving at a commercially quoted and executable rate. For example, two, five, seven and ten-year LIBOR or Treasury rates can be broadly found on the internet and in various newspapers. However, commercial loans do not fit common index structures for the following reasons: the accrual methods on commercial loans are loan specific, most commercial loans amortize, and payment conventions are diverse - this is where banks use basis adjustment.
Below is a table that our lenders receive by email every morning, and is also available online. Any community banker in the country can sign up to receive this information from CenterState without any cost or obligation. The table represents LIBOR fixed rates with the amortization term on the left side and the fixed rate terms across the top. This table shows mortgage style amortization rates, starting today. We can produce this table for any amortization style, accrual convention, and forward starting period. But to keep it simple, let’s just use the table below which uses the following convention: mortgage style amortization, ACT/360 accrual, monthly pay, and starting today. You will note in the table below that the rate for a 25-year amortizing, 10-year fixed rate is 2.91%.
The above table is published daily (but updated live in our modeling throughout the day).
Now, how does the lender provide this information to the borrower, who, presumably, does not receive these daily rates? Our lenders refer the borrower to one of many public sources of LIBOR rates. Below is information from Barchart.com that shows LIBOR rates from 1-year out to 30-years. There are other public and free sources of rates, but Barchart is one of our favorites for its ease of use and information.
Let’s assume that our borrower is interested in a loan structured as a 10-year fixed rate based on a 25-year amortization period. The rate we publish at CenterState Bank is 2.91%, but the public rate is 2.78% on Barchart. Therefore, our basis adjustment is 13 basis points, and we inform the borrower that the loan rate will be the Barchart rate for 10-year fixed, plus our basis adjustment (13bps) plus our agreed upon credit spread or margin (a discussion for another blog). We explain to the borrower that the 13 bps basis adjustment converts the benchmark 10-year rate (with specific conventions, such as quarterly pay and 30/360 accrual) to a commercial loan, based on monthly pay, mortgage style amortization, ACT/360 accrual and specific starting date from today.
Using the above method, the borrower can quickly and easily track rates until the loan closes. Most importantly, this methodology limits business development officers from quoting loan rates and instead focuses on quoting spreads. This dramatically limits interest rate risk for the bank and gives the borrower a greater sense of ownership.
This quoting technique also creates transparency in pricing (which should be a goal for all banks) that engenders trust and openness. We can use the same basis adjustment to quote various structures including forward-staring loans, floating and fixed rate loans, various indexes (Prime, LIBOR or Treasuries), and different amortization conventions.
One complaint we hear from borrowers is lack of transparency in pricing across bank product lines. The customer experience is impacted when lenders are not clear on the bank’s loan pricing indexes and credit spreads. The basis adjustment technique we use at CenterState is a way to solve both of these problems. The technique allows lenders to easily obtain and communicate rates to their customers, and it allows borrowers to verify and track loan rates until the loan closes all without the bank taking interest rate risk. We believe that banks should strive to create as transparent and straightforward a pricing method for customers as possible and this is one of the best methodologies we have found to accomplish this.
Submitted by Chris Nichols on April 09, 2018