In a previous blog, we described what factors community bank managers might want to consider in analyzing a loan hedging program for their specific needs. In that blog, we listed the pros and cons of using a hedge to control risk and increase profitability. We then wrote a follow-on article that analyzed the various instruments and strategies common in the bank hedging market to include swaps and other interest rate derivative instruments. We provided an in-depth analysis of various programs, the advantages, and disadvantages of each hedging strategy and best use scenarios. In this article, we will describe some specific application of loan hedging and how community banks are using interest risk hedges to win more business and increase profitability. Each example listed below represents a loan and hedge combination used by community banks within the last 12 months. The borrowers and financing described below are typical community bank scenarios and the examples we list are intended to represent a general cross section of loan hedges used by community banks.
Many community banks start using loan hedging products defensively. At inception, many community banks are hesitant to lead their sales efforts with hedging products. In this example, a bank’s existing customer was seeking to extend its existing term loan financing on an industrial building (owner-occupied commercial real estate collateral). The borrower was looking to extend its existing fixed rate in anticipation of rising rates. With only 26 months left on its fixed-rate term loan, the borrower approached the banker on a number of occasions seeking at least a ten year fixed rate offer. This bank in the Southeast was hesitant to offer a fixed term beyond 5-years. However, at the risk of losing this important customer, $1.7mm in loan balances, and hundreds of thousands of dollars in checking balances, the bank decided to offer the borrower 10, 15 and 20-year fixed rate options. The borrower chose a 15-year fully amortizing structure at just under 5% fixed rate. The bank retained an important customer and the borrower committed to a long-term relationship with the bank. On a risk-adjusted basis, the relationship is a strong return on equity (ROE for the bank, and the jeopardy of losing the customer to another bank was averted.
Less Competition is Better
Competition for loans is intense, and a bank that can limit competition will increase margin and profitability. One easier way to limit competition is to offer a single close construction through permanent financing where the borrower’s term interest rate is locked before construction starts. This one-time loan closing eliminates competition for the take-out financing on the backend. In this example, a bank in the Northwest was concerned that they would offer their customers construction financing while the insurance companies and national banks would take the term loan after the construction was complete (after the majority of the risk in the project was eliminated). The bank started offering single-close 12 to 18-month construction through permanent financing on 10 or 15-year fixed rates. In the last $5.4mm project to construct an office building, the bank was able to earn Prime flat during construction and LIBOR + 2.75% for the term loan, which was fixed to the borrower for ten years at 4.54%. Now the community bank is very unlikely to lose this specific term loan to Wells Fargo, US Bank or Umpqua because the borrower has prepayment provision making it difficult to refinance the loan at the completion of construction.
Cash Flow Is King
Smart bankers preach the virtues of lending on cash flow. How does a bank maintain strong underwriting efforts with a mismatch in cash flow payments between the loan and the asset? Banks that finance CRE collateral with long-term leases through shorter-term facilities are undermining their own credit efforts. In this example, a bank in the Midwest was adamant that the borrower takes at least a 10-year fixed rate loan to match long-term leases on restaurant properties. The borrower chose a 15-year, fully-amortizing, fixed rate that matches the duration of the leases at 4.45% fixed rate and loan cash flowed at over 1.5X DSC. The bank has what they call a “bullet proof” loan. The interest rate hedge greatly improved the credit quality – a good outcome for both bank and borrower.
The Next Step in Marketing
At first community, banks deploy hedging products apprehensively and defensively. But after understanding the product, the sales process, and benefits, bankers soon begin to lead with the hedged loan. A bank that we work with in the South shows every borrower the option of fixing their term loan from 5 to 20 years using a hedge. The bank is also comfortable, depending on the borrower and credit parameters, if the borrower chooses a variable rate loan or a shorter term fixed rate loan. However, when the borrower sees the small incremental cost of fixing the loan out to 20-years, the appeal of low rates is compelling. In this example, the bank has a sophisticated borrower who finances retail malls with 20-year fixed rates. The borrower knows that at any point in the life of the loan he can transfer the unused portion of the loan/hedge combination to any of his multiple malls (as long as the bank can underwrite the collateral).
The loan hedge product is not only a risk mitigation tool, but it can also be used to generate substantial fee income. This helps community banks stay profitable, allow lenders to be more competitive on loan pricing spread and creates the ability to offer novel structures and closing techniques. In this example, a bank on the West Coast offers its borrower’s zero cost closing. The bank uses the hedge product to generate a fee that offsets any cost of the closing. On a recent $3mm 10-year term loan, the bank generated over $41k in non-interest income from the hedge fee. This was used to pay for the appraisal, documentation, title and escrow. The bank retained the remaining $32k in fees to boost ROA on that loan by 100bps in the first year.
Community banks are starting to use loan hedging products under various circumstances and for a variety of business reasons. We utilize our ARC Program and work with community banks as small as $100mm in assets that have discovered that they can use loan hedging to mitigate interest rate and credit risk, generate substantial fee income and respond to competition. All this can occur without a derivative on the bank’s balance sheet. In the upcoming interest rate normalization cycle, community banks will discover that a properly designed hedging program can be an important tool in keeping the bank safe and a big boost to income.
Submitted by Chris Nichols on December 13, 2016