With a flat and low yield curve, borrowers’ demand for long-term fixed-rate loans is high. Furthermore, based on the forward market and most analysts’ predictions, the yield curve is expected to stay low and flat in 2020. The difference between five and ten-year loan rates is currently only nine basis points, and the difference between five and 20-year loan rates is 21 basis points. Banks are pressured by borrowers to extend loan portfolio duration (increase the term of fixed-rate loans) at the exact wrong time in the interest rate cycle – when the possibility for rising interest rates is much higher than the possibility for decreasing rates, given the current low level of Fed Funds rate. One possible lender solution is to use derivatives to allow the bank to book an adjustable rate of accrual while the borrower pays a long-term fixed-rate.
However, community banks are not embracing derivatives for several very sound reasons.
The use of swaps (the primary tool that banks use to hedge interest rate risk on loans) has increased substantially in one year from 2018, but the majority of that increase is at banks that are larger than $25B in assets. The number of banks using swaps under $25B in assets has decreased from 402 banks (as of December 2018) to 380 banks (as of September 2019) mainly as the result of mergers. It appears that community banks are not widely utilizing derivatives as a viable commercial tool. The reason for this lack of adoption by smaller banks is no surprise to us.
There are several reasons why community banks are not adopting derivatives. Some of those reasons are as follows:
- The standard derivative documentation is lengthy (45 to 60 pages), cumbersome (multiple agreements, written in dense legalese) and the integration of loan and swap documents requires substantial legal expertise,
- The regulatory compliance and reporting are complex and confusing,
- The accounting for both lender and borrower is complex and typically requires outside consultants,
- The overhead costs are high for banks that use derivatives only sparingly (less than a few deals per month), and
- The marketing of the product is challenged – lenders cannot easily explain the documentation, the mechanics, or the risks of the product, which means that borrowers choose alternative structures.
At CenterState Bank, we believe that the average banker, regardless of education, background, and experience, would prefer to sell a used car than a swap to a borrower. This is why we use a program called ARC (Assumable Rate Conversion) program that has the following advantages to the lender and borrower:
- Only a short (4-page) and simple addendum to the promissory note as additional documentation,
- No additional reporting or regulatory compliance for the lender or the borrower,
- No derivative accounting for the lender or the borrower,
- Virtually no ongoing or upfront costs, and
- CenterState provides lenders with education and marketing support to sell the ARC program.
Bankers often ask us about the form of the ARC documentation. Our short sample addendum can be downloaded HERE in case you are curious as to how we do it. The only documentation change for the community bank’s promissory note to accommodate the ARC program is as follows:
The Index: The promissory note must reference an adjustable or variable index. The acceptable indices are Prime, LIBOR, Fed Funds, or (in the near future) SOFR.
Index Matching: The index must change at least as often as the payment date. The most straightforward index for banks to use is 1-month LIBOR that resets monthly, with monthly borrower payment dates.
Day Count Convention: Most community banks use ACT/360 accrual method. However, some banks prefer ACT/365 or 30/360. The ACT/360 accrual method adds approximately 6bps additional yield to the loan (not an insignificant amount).
Caps and Floors: Stand-alone caps or floors are not permitted in the note. If a floor is present, it must be offset in the hedging instrument. This is a concept of interest for bankers in today’s market. Some bankers insist on obtaining floors on commercial loans. When hedging an adjustable-rate loan, the borrower pays a fixed rate, while the lender accrues on the adjustable rate. By inserting a stand-alone floor, the result is that if the adjustable-rate falls below the floor rate, the borrower's fixed rate would increase to make the floor economics work. Most borrowers would not agree to a fixed-rate loan, where the loan rate would inexplicably rise if interest rates fall. A way to accommodate the lender’s desire for the floor is to trade the floor into the hedge. However, embedding the floor into the hedge also increase the cost of hedging. Once that increased cost is determined, virtually every lender has chosen to avoid purchasing such a floor.
Prepayment Provision: Prepayment language in the hedged loan is typically governed by the hedge and not the loan documents. The symmetrical prepayment provision of the hedge serves to extend the lifetime value of the loan, it makes the borrower indifferent to prepay, and it also allows the borrower to transfer the economic value of the loan to another property (a portability feature that lenders use to their marketing advantage). This prepayment feature enhances retention, increases ROE and provides a unique marketability feature for the loan.
If your bank is facing borrower demand for long-term fixed-rate term loans, there are several possible responses. Some community banks turn those borrower requests away – letting the competition handle that demand. Other community banks have a marketing program aimed at convincing borrowers that they do not need long-term fixed-rate loans. A small number of community banks have dabbled in interest rate derivatives. CenterState Bank and a few hundred community banks that have joined the ARC program utilize a tailored made solution for community banks that delivers many of the benefits of loan hedging without the encumbrance of the accounting, compliance and documentation hassles.
Submitted by Chris Nichols on January 13, 2020