The saying 'When Hell freezes over" to describe a low probability event is apt. These days, low probability events happen as often as snow in Las Vegas (like yesterday). In such odd times, bankers that can adapt will prosper.
In the last two days we have written about the challenges that the low Fed Funds rate will pose for community banks. With a 3.25% Prime rate, most community banks cannot generate positive net interest margin on floating rate loans, much less a positive ROA (after subtracting overhead). The efficiency ratio for floating rate loans is higher than fixed rate loans, translating into an even lower ROA for floating rate portfolios. Setting floors in a very low rate environment creates its own challenges - it shortens loan durations as rates rise, may come with commensurate caps that subtract ROE and detract from the marketability of the loan (since in most cases the collared rate loan is a weak substitute for a fixed rate loan).
However, with the 5Y Treasury yield below 1.50% and the 10Y Treasury yield at barely above 2.00%, this is the wrong time to originate fixed rate loans - especially, with the threat of inflation in 2010. While the average loan margin for a quality "relationship loan" is between 2.50% and 3.25% above the swap rate, most banks cannot efficiently match-fund long-term assets. Once the Federal Reserve communicates its cessation of quantitative easing (or simply states that Bernanke's comments about targeting the purchase of long-term Treasuries was taken out of context) the yield curve may rise significantly.
We are not advocating that banks stop lending. In fact, with average loan spreads above their recent 10Y trend, now is the time to replace lower spread loans with higher spreads.
One way to do this is to originate hybrid loan structures. At BIG and PCBB, we have been helping banks structure 5Y and 10Y loans with prepayment protection that yield the bank a fixed rate for the first six months of the loan (a rate that has ranged recently from 5.00% to 6.50%) and then convert for the remainder of the loan to a floating rate of an average of 2.50% to 3.25% above LIBOR. The structure provides banks with a higher yield in the immediate 6-month term when net interest margin is particularly precious, followed by interest rate protection after the initial 6-month period when rates are anticipated to rise.
The structure is particularly effective in today's rate environment when the yield curve is flat and the term premium is low (the cost to obtain yield further out on the curve is low). If you are like most people and prefer to see specific and real numbers, here is a typical structure that we have seen replicated on a number of occasions: 10Y owner-occupied or high DSC CRE loans, 6.00% fixed rate to the borrower, 5.90% fixed rate to the community bank for the first six months, followed by 9.5Y floating rate return to the bank of 3-month LIBOR + 3.30%. While 3-month LIBOR is 1.85% for loans funding today, the floating option does not start for another 6 months (when LIBOR is expected to rise). For reference, in the previous 2Ys, 3-month LIBOR has averaged 4.17%.
We expect that the next year in community banking will be as challenging as the last year. However, by stacking the odds in favor of the house, banks can continue to differentiate their products and win profitable relationships - no matter how snowy things get.