If banking had an Olympics, creating loan value would be an event. While many lenders and business development officers are good at gathering new business, they are often reactionary when it comes to structure not taking the time to find the best structure for the client. They may provide what the client wants, but not what the client needs. To make it into the finals, bankers must not only understand how to work with structural components but how to position them for the most efficient application of the creation of value. In this post, we focus on prepayment provisions and look at how a past gold medal winner does it.
Prepayment Provisions Not Penalties
In a competitive market for commercial loans, every feature that can preserve credit quality or maintain pricing can be very valuable to the lender. One element that many commercial banks are attempting to differentiate with borrowers is the prepayment provision (or sometimes the lack of one). Many community banks will market their fixed rate loans based on the simplicity of the prepayment provision and this starts by understanding the value that each provision creates. This can be summed up by the table below that looks at the probability of repayment and the net value of a ten-year commercial loan over up, down and flat interest rate cycles:
As you can see, some prepay structures create more value than others. A lockout for the life of the loan is a provision where the borrower has no ability to repay without satisfying all the interest is at one side of the spectrum, while a loan with no repayment provisions is on the other. No prepayment provision gives the borrower a free option and almost guarantees (92.1% probability) that the borrower will repay early.
Of all the options, the declining balance prepayment provision is the most commonly used. Here,we will focus on the structure where the borrower’s prepayment charge will equal 5,4,3,2 or 1 percent of the loan balance for years 1 through 5 of the loan. This is by far the most common provision. To better learn how to position against it, we asked one of the top performing lenders from Wells Fargo Bank how they sell against the declining balance prepayment provision. We would like to share their strategy so that community banks can manage their marketing more effectively.
Step 1: There is No Prepayment Penalty on the Loan
First, when positioning a loan to a potential borrower, the Wells Fargo Bank representative tells us that they always start out with a loan with no prepayment penalty. The representative describes the loan as prepayable at any time without a cost or a fee. However, the representative also indicates that the loan will be a floating rate only structure and that the loan will come with slightly higher fees/interest rate because the borrower has complete freedom to refinance. The banker explains that the borrower could take the loan out and then, fearing rates could be heading higher, could refinance into a fixed rate at another bank, leaving Wells without a relationship.
In like manner, the banker also explains that if the borrower wants to fix the rate, then the interest rate risk management department can fix that rate through a swap with a separate contract and separate prepayment provision. Therefore, the borrower is presented with a loan that can be “tailored” (a word used a number of times in the presentation) to the customer’s specific needs. The loan can be fixed up to the commitment term of the credit based on the borrower’s cash flow requirements and interest rate views.
Step 2: Align Interest Rate View
Wells Fargo sales rep goes on to explain that the prepayment for the financing is called a symmetrical prepayment or yield maintenance. It requires the borrower to pay a fee at the time of prepayment if rates are lower, however, the borrower will receive a fee at the time of prepayment if rates are higher. We believe that the strategy by the sales rep is to create two emotions: first, fear that if rates are lower there will be a prepayment penalty, and, second, greed that if rates are higher there will be a prepayment fee paid to the borrower. In addition, the Wells Fargo banker explains that the symmetrical nature of yield maintenance is “fair” as it can benefit the borrower if rates move up just the same way if rates move down. This sense of equality is a powerful psychological trigger and helps the borrower understand the loan from the bank’s position.
The Wells Fargo rep then quickly asks the question: “Where do you think interest rates may be in the future?” Any borrower who expects rates to be higher is a good candidate for Wells Fargo’s fixed rate product, and any borrower who expects rates to be lower or the same is a candidate for the bank’s floating rate loan. With either view, Wells Fargo has a product to sell.
Step 3: Transferring the Economics in The Future
The most impressive part of the sales pitch was how the rep explained to the borrower that he should lock-in rates for as long as possible given today’s low-interest rate environment and use that financing for any future borrowing needs. The explanation stated that not only can the borrower enjoy the low rate for the existing loan, but the low rate can be transferred from one loan to another if the loan stays with the bank. For example, if the borrower wants to finance another property, or amend the loan to include additional loan commitments, the existing low rate can be preserved without prepayment consequences for any future use as long as the bank can underwrite and approve the credit in the future. Wells Fargo points out to the borrower that the loan can be transferred among any of the borrower’s properties and the rate stays unchanged.
Step 4: Comparing Provisions
Finally, the rep compared the standard 5,4,3,2,1 declining balance prepayment economics with the symmetrical prepayment provision and pointed out how far rates would have to fall for the borrower to be indifferent to each outcome. The table below explains the economics to the borrower.
The table shows a $1mm loan, 25-year amortization, 5-year fixed rate, priced at 4.20%. The second to last left column demonstrates that rates would have to fall 105 bps for the borrower to prefer the 5,4,3,2,1 prepayment provision over the symmetrical prepayment provision. The right side of the table shows the borrower’s fee (payment to the borrower) if the loan is prepaid in a higher interest rate environment.
The rep then concluded that for borrowers that believe interest rates are generally heading higher, the symmetrical prepayment provision offers safer and more advantageous prepayment economics for the borrower. In fact, interest rates would have to fall almost to zero across the entire interest rate curve for the borrower to experience a higher prepayment cost with symmetrical prepayment than the standard 5,4,3,2,1 declining balance.
Community bank commercial lenders need to know what they are selling against and position their product effectively. While the above example was the sales technique from Wells Fargo, we have seen similar sales pitches from BB&T, Fifth Third, Regions Bank, PNC, US Bank, SunTrust and other national and regional banks.
We believe that to succeed against national banks, in some circumstances, community banks must present an alternative to the declining balance prepayment provision. In an anticipated rising interest rate environment, the simplicity of a declining balance prepayment provision does not offset the downside risk to the borrower and an alternative prepayment provision may make more sense.
Increasing lender training around the area of loan structuring helps lenders better compete in today’s competitive marketplace. Having a thorough understanding of prepayment provisions is the cornerstone to being able to create value for both the bank and borrower. If lenders are able to do that, they will find that they will also create value for their career as the ability will help position the lender as a clear trusted advisor. Lenders that are able to do position themselves as such, may find themselves in medal contention, should there ever be a banking Olympics.
Submitted by Chris Nichols on August 23, 2016