Using the Right Tool For Fixed Rate Loans

Better Lending Tools

Everyone agrees that using the correct tool for the job is an important rule for successfully completing a project.  Using a sledgehammer on tacks will leave dents, and applying a screwdriver to move boulders will likewise be equally counterproductive.  The same rule applies in banking, and most community bankers are well aware of this.  Community bankers appreciate that their project is very different than the projects at national and regional banks.  Community banks have different business models and different customers compared to the national and regional banks. 

 

We are big advocates of community bankers understanding the services and products adopted by the national banks, and being strategic in their response.  However, we see over and over again how some banks are inadvertently choosing the wrong tool for the job when it comes to loan hedging.  We would like to explain what we see and how to choose the correct tool for the job.

 

The Tool

 

The national and regional banks are eager to offer borrowers long-term fixed rates by using a tool called “back-to-back” swaps (or BTB swaps).  In BTB swaps the borrower signs approximately 60 pages of derivative documentation.  The borrower is then required to make two payments to the bank every month, two payments we note, that vary from month to month. The borrower is required to carry a derivative on the balance sheet and use hedge accounting.  The bank is required to carry not one but two derivatives, sign two derivative documents, perform hedge accounting, allocate capital to both derivatives, pledge collateral for one of the derivatives and report the transaction under the Dodd-Frank Act.  That is a pretty complicated and costly tool.

 

The Job

 

The job is very simple.  The bank wants to lock its margin over its cost of funding while the borrower wants a long-term fixed rate to protect its debt service coverage ratio and stabilize the impact of rising rates on its balance sheet – that is simple.  So the question is this - is the BTB swap program the right tool for the job?

 

Our Assessment

 

At CenterState, we used to use a BTB swap program (as well as just hedge internally) and we see three general areas of concern with a BTB swaps that we summarize as follow:

 

Back to Back swaps

 

 

Marketing Costs – the upfront effort of trying to explain to the borrower why the bank is using the wrong tool for this particular job and the ongoing effort of explaining the process to the customer.

 

Friction Costs – the incidental costs of carrying another product, more accounting, more marketing costs, and more training and support costs.

 

Direct Overhead – the ongoing cost of capital, liquidity, and consulting and processing fees.

 

So let us consider all of these costs in greater detail and discuss if they make sense for community banks.

 

Back to Back Swaps

  

  1. While the borrower simply wants to make a fixed rate payment, by using BTB swaps the bank forces the borrower to review and sign about 60 pages of complex documentation.  The average community bank customer will not be able to understand the documentation, and most will not even read it.  In fact, most lawyers are unlikely to understand the documentation. 
  2. The borrower will then be required to make multiple monthly payments to the bank.  The payments are burdensome and confusing because the borrower needs to make multiple payments: one monthly payment which is the sum of a variable rate and a fixed rate, and a second monthly payment which is the difference between a fixed rate and a variable rate.  The bank will need to generate all of these statements and make payments to two counterparties for each loan.
  3. Because of the complexity of the documentation and processing, lenders need substantial education and training to understand and explain BTB swaps to borrowers.  At national and regional banks, lenders are prohibited from discussing the program with borrowers, and only special swap salespeople are allowed to do so.  Most community bank lenders will struggle to explain the program to the customer.   
  4. A danger of the BTB swaps is that despite the lengthy documentation, there is no language that plainly or directly calculates the borrower’s prepayment costs.  The cost of prepaying is defined as “commercially reasonable.”  It is no wonder that so many borrowers harbor negative experiences with BTB swaps.  The community bank is taking on the liability that the borrower will claim misrepresentation and attempt to renege on its obligation because of contractual ambiguity.
  5. To explain BTB swaps to borrowers, accountants, and regulators, and to handle accounting, trading, reporting, collateral movement and processing, banks are forced to hire consultants.  This may be a great value for banks that plan long-term substantial trading volumes, but this is a questionable strategy for banks that cannot predict their swap business next year, much less the swap volume in 5 or 10 years.  We have witnessed these swap consultants change the terms of their engagement when a bank’s swap volume declines because of a change in the interest rate environment or change in the bank’s appetite for this program.  This makes it difficult for community banks to forecast usage and total hedge cost.
  6. BTB swap programs require that the bank hold two derivatives and each one requires capital, collateral posting, and additional trading lines. This is all costly, but it is proportionally more costly if banks use BTB swaps sparingly (for example only a few deals consummated per month).  Furthermore, because BTB swaps are long-term, these costs will be recurring for the life of that contract (5 to 20 years).  This is an important consideration for banks that will increase their overhead costs for a considerable period regardless of any future benefit or utility of the program.
  7. For all of the reasons above, BTB swaps are not always the right tool for the job.  The biggest issue is that by choosing this tool many community banks find that they cannot properly position or explain the BTB swap program.  When they cannot sell it, they conclude that there is no demand and abandon what could be a worthwhile project.  The problem is that the chosen tool is not correct for the job.

 

Conclusion

 

Before we blindly reach for a tool that might not be right for our project, we as bankers should assess our customers, their needs, our process and procedures and costs, and make a decision that fits our business model.  We went through this same assessment process at CenterState Bank, and we concluded that a BTB swap program was not the right solution for our customers. As a result, we went down a different path and developed our ARC Hedge Program.  We find that our tool works better because we are not Bank of America, and our customers are not Fortune 2,000 corporations.  We welcome any questions about how we made our decision and our process.