TRAVELING AT THE SPEED OF LIGHT

The yield spread between the 2Y Treasury and the 10Y is only 4bp. The overall yield on the 10Y Treasury is 5.10%. This environment is perfect for the small business customer seeking longer term fixed rate financing – particularly when you consider that 10Y fixed rate loans can now be had for an average of around 7.25%. After all, just because one operates a drycleaner, doesn't mean they don't know the difference between uncertain monthly loan payments at 8.25% and certain ones locked in for 10Y at 7.25%. When one considers the average $3mm loan saves the client roughly $30k per year AND locks in their payment for the next 10 years, it isn't hard to see why so many banks are getting pressure from clients to make long-term fixed rate loans. From an interest rate risk and liquidity perspective, however, this environment is far from ideal for most independent banks. Since most independent banks fund themselves with short-term deposits, this pressure to lend long is definitely straining net interest margins. While many banks continue to try and convince clients to accept a loan with a 3Y to 5Y maturity, they sacrifice pricing or structure (i.e. waiving prepayment penalties), thereby hurting profitability. It is far better to give the client what they want, gain a longer term asset and hedge the risk accordingly. Readers needn't take our word for the increasing popularity of interest rate swaps, however. As the most recent regulatory data shows (as of the end of March), the total notional value of interest rate swaps held by financial institutions has reached $111.2T. If you do the math, you will find that light travels at about 6T miles per year, so comparatively speaking; the swaps business has been moving at the speed of light for a long time. As the data shows, 1 in every 8.9 institutions are now using hedging instruments, a whopping 22% increase over 2005! Things are moving so fast that about 1 new institution per working day has begun using swaps in 2006 to help manage risk. In so doing, these banks found out they could give their customers what they wanted (i.e. to lock in 10 or 15 year fixed rate loans), improve credit quality (i.e. rising interest rates do not strain customers, they can budget more effectively and NOI improves) and offset risk by transforming fixed rate loan coupons into shorter floating rates through a swap. In so doing, these banks have found a simple way to fund shorter (where money is naturally available to independent banks), maintain profitability and improve borrower creditworthiness. Perhaps even more interesting, as one sifts even deeper through the data, are the statistics by bank asset groupings. While it is not surprising that most swaps are still done at the larger banks, what many may find shocking is how many independent banks have quietly been getting on board. After excluding institutions with assets below $100mm and those with assets above $10B, we find more than one in 6 banks is now using swaps. Look, we know people can find their way in the dark by feeling around. However, with the yield curve expected to remain flat for the next 5 years, flipping on the light switch is sure an easier way to go. Call us and we'll show you how to begin traveling at the speed of light.