JUGGLING CRE LOAN PREPAYMENT PENALTIES

Yesterday's commentary on the value of prepayment penalties touched a nerve, as we were flooded with questions and comments. In light of these comments, one area that needs better clarification is the fact that the value of a prepayment penalty is constantly changing depending on rates, volatility and credit. If you think of not having prepay protection as being short an option (the option to refinance and take advantage of the market), then instituting a prepay penalty has the opposite (and positive value) affect. To put it in perspective, a prepayment penalty that is worth 40bp one day, may be worth 150bp another (say, if rates drop). As some respondents implied, then it goes to follow that loan officers can be active managers of prepay penalties in order to derive additional value for their bank. This works two ways. One, in periods where the rate view is expected to decrease, bankers can offer lower rates to existing borrowers in exchange for prepayment penalties. Given the market's expectation of future rates, now may be the time to take a look at existing loans and see which borrowers might be open to trading a lower rate for a period of prepayment protection. Those borrowers that do not have intention to refinance and/or do not fully appreciate the expected change in rates, may take a bank up on the offer. By doing so, the bank protects its quality credits by effectively extending a loans average life. The converse of this also works. For loans that already have prepayment penalties, an offer can be made to remove them either for free or for a fee. A perfect example is in cases where you have a prepayment penalty with deteriorating credit. For certain sectors, loan types or geographies, a bank may be better off to waive prepay penalties in order to entice the borrower to refinance with a different lender. In these cases, the increase in projected credit risk is greater than the value of the prepay penalty. Bankers should review their loan portfolio for opportunities and rerun credits through a pricing/credit model in order to determine which loans might qualify. In the current market, we have identified several areas of lending where the probability of default is expected to sharply rise. Loans on class B office space in areas where increased lease space is becoming available either through new construction or subprime related vacancies is one such example. We have a group of loans in our database, where the cash flow is already thin (less than 1.2x) and the coming shock will further deteriorate credit. Having a prepay penalty on these loans is actually a detractor of value, so if a bank can motivate the borrower to refinance with another institution, then it may have just saved itself a problem loan in the future. In similar fashion, loans with higher LTVs or with lower than market fixed rates, may not need prepayment protection (as the loan itself has low optionality) and the bank may wish to trade the removal of prepay protection in exchange for a one time fee. Working with prepayment structures and penalties is part of active portfolio management and can add an estimated 40bp to 250bp in total return versus those managers that do not actively manage credit and structure. If you would like to learn more about active loan management techniques and pricing, come to our next High Performance Bank Workshop in June (details included).