Moody's Agrees: Low Rates are Adding Risk to Banks

by Dallas Wells

Last week Chairman Bernanke used the phrase "reaching for yield" in a speech.  To some this might be welcome, as it at least means that the Fed is aware of the building risk in the financial system.  However, bankers are also aware that the Federal Reserve is a regulator, so a focus on who is reaching how far for yield could lead to some uncomfortable exams.

American Banker also has an article up (Low Yields, Loosening Terms Raise Risk for Banks: Moody's) that summarizes Moody's opinion that banks are stretching on both terms and credit standards:

A combination of low yields and loosening terms may be setting banks up for trouble in the event of an economic downturn, one of the nation's top credit ratings agencies said Monday.

Nearly two-thirds of banks with assets of more than $20 billion say they have lowered pricing on loans to large and middle-market businesses in recent months, while nearly half of lenders reported relaxing loan conditions, up from 30% in January, according to the Federal Reserve's latest survey of senior loan officers.

The combination, which comes amid an uptick in commercial and industrial lending, increases risk for banks, says Moody's Investors Service in a report published Monday.

Be careful out there - your choices are generally between paltry yields or too much risk.  Let us know if we can help.

Should community banks get back to consumer lending?

By Dallas Wells

As community banks battle each other to the death on loan pricing, many are actively looking for new products to help grow higher yielding assets.  A couple of years ago that meant more banks jumping into SBA and C&I lending, which has contributed to much of the added price pressure in those markets.  Now many are turning back to consumer lending, hoping they can somehow regain turf that has largely been ceded to the megabanks in recent years.  After all, these loans have high yields, short durations, and great cross sell opportunities.  But is the regulation/compliance problem and competing with the big guys worth the revenue?

I will point you to two articles for more information.  First is a post from Cornerstone Advisors on their Gonzo Banker blog about community and regional banks getting into the credit card business.  The returns they highlight will look very tempting to those out there slugging it out for fixed rate loans that translate to sub 200 spreads over LIBOR.  Banks that do credit cards well have historically been high performers, but make sure you do your homework.  There are lots of ways to tackle this business that can generate revenue and allow you to keep your relationship with your customer - just make sure you match your program with your operational capacity and skill set, or you could be biting off more than you can chew.

Second is an article from Banking Strategies on small dollar loans.  Again, I would suggest caution, as we don't want to get too cute raise the payday lending and overdraft ire of customers and regulators.  However, some of these pilot programs have shown promise, and it is impossible to deny that there is a market to be served.  After all, how many payday loan/check cashing businesses are there in your community?

Community banks are struggling with margin compression, which in the past has caused many of them to make decisions they later regretted.  So, tread lightly, but times like these certainly dictate that we need to keep looking under every rock for potential revenue.  Consumer lending is a business many small banks abandoned as too costly, but with new technology, you just might be able to make it work.

5 Performance Keys

by Dallas Wells

Bank Director posted an article last week (Taking a Cue from World-Class Athletes—Five Keys to Top Performance in 2013) that summarizes the results from a Fiserv study on banks between $1 billion and $10 billion in assets.  While most of this list falls under "easier said than done," there is one item that I found intriguing:

It’s all about the volume.

Top performing banks are simply lending more than their peers. For leading growth banks, total loans as a percentage of average earning assets was nearly 75 percent, compared to an average of 65 percent for all banks studied. But, while top performers lead with higher loan volume, it’s often done with some sacrifice to loan yield. This can be attributed to two factors: aggressive pricing and higher quality of loans.
 

This is a tricky balance, but the banks that are thriving in this zero rate world are those that are doing a better job of choosing their battles.  They are deciding which deals they really want, and aggressively going after them.  On all other deals they are holding the line on disciplined pricing.  As always, loan pricing comes down to a rate/volume trade off.  We suggest that your pay extra attention to variance reports on interest income, and analyze the rate/volume trends.  How much volume do you need to add to cover the inevitable drop in loan yields?

 

The Loan Market as a Nash Equilibrium

by Dallas Wells


There is a common saying in banking that you are only as smart as your dumbest competitor.  Some of you probably hear that and cringe, but unfortunately it seems all too true today, especially in the market for loans.  As a follow up to yesterday's post, why is it that so many bankers are so willing to give in to borrowers right now?

In short, it comes down to the fact that the loan market a a whole is not growing fast enough:

Banks are facing rapidly declining asset yields, and have no more room to reduce funding costs.  Margin compression is a reality for all banks, and the only solution is to outgrow the dropping asset yield.  It is a simple rate vs volume trade off.  The problem is that most banks in any given market are pursuing this same strategy, and the puny overall loan growth can't provide for everyone.  Banks are trying to grow by stealing business from each other, which has created a nasty Nash Equilibrium.

This particular Nash Equilibrium is causing the "right" decision for each bank to be to match low rates.  How so?

Consider a small market that has two banks (Red Bank and Blue Bank) that are competing for the same $2 million worth of loans ($1 million at each bank).  The loans are currently at 5%, but the borrowers want to refinance and feel that it should be a 3% loan in the current environment.  This table summarizes the choices for each bank:

Each bank has the choice to either offer 5% or 3%.  If both banks offer 5%, they can expect to retain their loans.  However, if one offers 3% and the other holds at 5%, the bank with the lower rate ends up with both loans.  Here is the revenue impact of the decision matrix above:

With this table, we can look at the expected outcome.  Red Bank can offer 5%, and they will either earn $50k or they will earn $0.  With a 50/50 probability from Blue Bank, their expected revenue is $50k + $0k = $50k, times the 50% probability = $25k.  In other words, if they offer 5%, they can expect to on average earn $25k.

But, if Red bank offers 3%, they will either earn $60k, or they will earn $30k.  Using the same process, $60k + $30k = $90k, times the 50% probability = $45k.  If they offer 3%, they expect on average to earn $45k.

This is a Nash Equilibrium because both banks face the same decision, and can know how the other will optimally behave.  If both banks were willing to stay at 5%, they would each earn $50k.  Instead, using the basic thought process above, they will actually earn $30k.  Both banks reduce their income out of fear.

So what is the answer?  Unfortunately, there is no easy answer, which is why we are all still facing this conundrum on a daily basis.  The banks that are avoiding this, though, generally fit somewhere on this list:

• They are a niche lender with expertise in a specific market.  This expertise either provides added value for the borrower or limits the competition.
• They have long term borrowers that have been with the bank through multiple rate and economic cycles.  The bank has built trust, and their borrowers know they will treat them fairly.  There is no need to shop every new and old borrowing need.
• They are proactive with their balance sheet structure, and find ways (such as with swaps) to offer terms that other banks will not bid as aggressively.  Every bank in town will chase a short or variable rate loan with a strong credit profile.  Not as many will chase a 10, 15, or 20 year fixed rate.

If you feel like you are stuck in this Nash Equilibrium with no end in sight, where can you fit on this list to end the cycle?  Let us know if we can help.

Negotiating Loan Terms

by Dallas Wells

Most of our recent posts have been about loan pricing and structure, which should come as no surprise to most of you.  This is THE topic for banks right now, from rural community banks to the Wall Street megabanks.  This means it is also the primary topic in our strategy discussions with clients.  Our Flex Loan program is certainly helping clients book longer loans without the interest rate risk, but many are still facing hurdles on prepayment language and prices that translate to spreads under 200 basis points.  I had this on my mind when I saw this post from Seth Godin's blog called "Avoiding the Custom Bully."  Here is an excerpt:

Here's the thing: no matter how much you paid for your ticket, you never bother to even try bullying the conductor or the gate agent to get your train or plane to leave a few minutes later.

It leaves when it leaves, that's the deal.

Part of the challenge of selling custom work is that it sometimes seems that everything is up for grabs. You should stay up all night for a week. You should rearrange the orchids in order of smell, because even though it's not in the spec, hey, that would be good service, and we are paying a lot...
 

Does this sound familiar to any of the lenders out there?  Especially at community banks?  Your borrowers are pushing back because they feel like they can.  This isn't 2006, and they know they have the upper hand.  They can smell the fear.  In working with many of our banks, we have found that just because a borrower asks for something does not make it a deal killer if you don't bend.  While you have to be realistic about the current market pricing, don't bend on every request.  You might lose a few here and there, but the deals you book will be cleaner and better structured.  And your clients might even respect you more for it.

Margin Compression Goes Mainstream

by Dallas Wells

Well, now the pricing issues mentioned last week are official, as the rate wars for commercial loans have garnered the attention of the New York Times (As Business Lending Rises, Concerns Emerge About Profit):

On the economic scene, it would seem heartening to see a surge in loans that banks are making to corporations of all sizes. The loans help finance business expansion, which may lead to jobs growth. And it shows that banks don’t have to pile back into real estate loans, recently the source of crippling losses, to grow.

But the recent spurt in bank business lending is starting to flash some warning signs.

The concern is that banks are making loans to businesses at rates that are so low that they may end up being unprofitable. A recent survey by the Federal Reserve shows that American banks are charging an average of just 2.83 percent on so-called commercial and industrial loans. That’s down from 3.4 percent a year earlier.

Banks of all sizes are participating in this resurgence, including smaller banks, which managed to avoid many of the excesses of the credit boom of the last decade. In an effort to find alternatives to real estate lending, some smaller banks could be rushing into company loans without due care, says Claude A. Hanley Jr., a partner at the Capital Performance Group, a bank consultancy firm.

As we have mentioned before here (and many times to our clients), bankers should be wary of more than just price.  Huge credit losses and regulator pressure have caused many real estate heavy banks to move away from CRE (commercial real estate loans) and jump into C & I (commercial and industrial) lending with both feet.  However, these types of loans are a very different animal.  Underwriting them takes a different skill set than underwriting real estate loans, and just as important, these are not "set it and forget it" loans.  C & I loans require constant monitoring and far more customer interaction.  If these loans go south, the bank absolutely must be early in noticing the problem and helping the borrower to work through it.  If you are late, your secondary source of repayment will very likely be gone.

Yes, these loans are short duration, and even at an average of 2.83%, offer great spreads over other alternatives at this same spot in the yield curve.  But if you have grown these loans in excess of 10% per year (and the industry as a whole has) you may want to ask yourself if you are underpricing them.  Are you taking market share from established C & I shops?  What do they know that you don't about the overhead and credit risks?  Are you sure you are paying for all of the infrastructure that these loans require?

Properly Pricing Loan Credit Risk

by Dallas Wells

Managing net interest margins in banks has changed dramatically since 2008.  In almost all community banks, management teams took assets as they came.  What I mean by that is that the booking of loans was determined by loan demand, as banks simply responded to what borrowers were requesting.  The types of loans, and even the structures were driven by the local economy and by what the bank down the street was willing to offer.  The bond portfolio came about much the same way, as structure and yield were driven by market factors.  Banks booked those assets, and then used the funding side of the balance sheet to manage the risk and maximize spreads.  If asset yields declined, or durations got longer, we simply adjusted funding accordingly.  This was always easy to do, as community banks generally have rock solid core deposit bases, and wholesale funding is flexible and cheap.

Now, though, we can no longer back to the well on the funding side.  How much more can you realistically squeeze out of your cost of funds?  And in our recent experience, no matter how much of a premium you pay, it is next to impossible to get retail deposits further out on the yield curve.

Because of this, how we book assets is now driving the overall profit levels of the entire bank.  And I can promise you that the bank will not be setting any earnings records in the bond portfolio.  How sophisticated is your loan pricing?  Are you getting paid enough?

With rates this low, bankers are between the proverbial rock and a hard place.  Your borrowers are coming in asking for lower rates (usually with 3 or 4 handles).  Do you bend and watch your yields drop?  Or do you let the deal walk and pile even more of your assets into the bond portfolio?  Most banks are looking at the nominal yields, and feeling that since the 4.25% on a fixed rate commercial real estate loan is way higher than the 1.00% on the bond, they have no choice but to match the rate. 

Obviously 4.25% is better than 1.00%, right?  On a risk adjusted basis, maybe not.  One way to do a quick sanity check is to separate the components of that rate.  Within that 4.25%, you have to cover your overhead, pay for the capital allocation, pay for your interest rate risk, and pay for your credit risk.  If there is anything left, that is your profit.

So, let's say the borrower is requesting a 20 year loan (with a 20 year amortization) at 4.25%.  We can simplify the question by using swap rates to turn this into a floating rate loan (removing the interest rate risk).  Using an amortizing LIBOR swap, today we could convert that 4.25% into one month LIBOR + 1.90%.  Since we should be able to match fund it near LIBOR, that 190 basis points represents your actual spread.  Does 1.90% cover your overhead AND your credit risk?  And still leave enough for an acceptable ROE on a 100% risk weighted asset?

We see a lot of loans getting booked at these levels, and banks are justifying it in part by combining their duration and credit spreads.  When you separate them to see what you are actually being paid for the credit risk, you may decide to let a few more of these deals walk.

One solution is to use a pricing model to make sure that you are at least being consistent and making informed pricing decisions.  We have looked at a lot of these, and most of them either use faulty logic or are impossible for lenders to use in real time.  We have found one, though that is excellent in both regards: PrecisionLender.  We very rarely recommend specific vendors or products, but this is one exception.  In fact, we now use it in our own bank.  Check out their website here for more information.
   

The Shrinking Branch Network

by Dallas Wells


Community banks are facing a very difficult dilemma.  Most of these banks were built to operate on a net interest margin of 4%, and to thrive when times are good by earning a 4.5% net interest margin.  At those levels, banks didn't have to sweat fee income too much, and as long as costs didn't get too far out of control, even mediocre management teams could crank out 1.50% ROAs.  Now, though, all components of that formula are changing.  Fee income has been shrinking for years, and the regulatory changes to overdraft programs and interchange revenue is only exacerbating the issue.  Costs have risen with the growing complexity of technology and compliance, and now net interest margins are compressing.

The Fed is getting exactly their desired outcome, as the various QE programs have increased liquidity and driven banks to aggressively court each other's best borrowers.  The result, of course, is dropping asset yields.  Most of the 12 and 24 month projections of margins we see are now looking very ugly.  We are telling our clients that unless rates change soon, cost cutting is inevitable.  If it helps, you are not alone.  This article was in today's wall Street Journal (After Years of Growth, Banks Are Pruning Their Branches):

Following years of nearly unchecked expansion, financial institutions across the U.S. are closing thousands of outposts, as pressures mount to cut costs and more customers embrace online and mobile banking.

U.S. banks and thrifts shut 2,267 branches in 2012, according to SNL Financial, a Charlottesville, Va., research firm. That put the U.S. bank-branch count at 93,000, according to AlixPartners, a New York consulting firm—the lowest tally since 2007. The firm expects the figure to drop to 80,000 over the next decade, putting the total closer in line with 2000 levels. 
 

and:

Banks say they are closing branches because they are becoming too expensive to operate. Associated Bank, ASBC -1.42%which is the largest bank based in Wisconsin, estimates that each branch shutdown saves the company $300,000. A unit of Associated Banc-Corp, it closed 21 branches last year and is in the process of shutting another dozen.

Many industry executives and analysts expect the trend to gain steam in coming years, in a shift that promises to hit smaller communities such as Athens especially hard.
 

Have you analyzed your branch network lately?  Are all of the locations still pulling their weight?  Because if they aren't, you probably can't afford to keep them now that net interest margins are in the low 3s and falling...

The Margin Squeeze is On

by Dallas Wells


Most small banks have been feeling margin compression for the last several quarters.  It won't help earnings, but it may help you feel better to know that you are definitely not alone.  The down side to that is that many bankers are feeling comfort in adding risk because "everyone is doing it."

Edward Harrison at Credit Writedowns has a post up this morning (Us small and medium-sized banks hit by interest rates) that gives some of the gory details:

According to an analysis by Reuters, small and medium-sized banks in the US have started to take on risk as the squeeze in net interest margins is beginning to hurt profitability. The goal is to boost returns despite the low-interest rate environment by increasing risk and/or leverage. The analysis is confirmation that the Federal Reserve’s accommodative monetary policy is causing investors to reach for yield, underlining the concerns raised recently by Fed Governor Jeremy Stein.

Reuters says that the firms most impacted by lower rates are smaller and regional banks.
 

and:

One strategy the smaller firms have employed is extending duration. That is they have begun buying assets with longer maturities. In Austrian Economics circles, this is considered a reliable outcome of artificially low interest rates because Austrians believe investors begin to favour investments in more “roundabout” methods of production when rates are low. 
 

The entire post (find it here) is well worth your time, as is most of the stuff Harrison posts on his site.   He is a smart guy and often has takes on economics that will differ from the mainstream media.

Shorten Those Amortization Schedules

by Dallas Wells

As the competition for loans gets tougher, we continue to see banks stretching on terms and structure.  This is especially true on the stronger credits, which have figured out how desirable they are and seem to be shopping their deals more than ever before.

We have mentioned the duration drift, prepayment penalties, and general underwriting in other posts.  However, another structure piece that banks rarely price correctly is the amortization schedule on commercial loans. 

As the terms of loans have stretched longer, we have advised our clients to shorten the amortization schedules if at all possible.  For example, where deals previously might have been 5 year terms with 20 year amortizations, borrowers might now be seeking a 10 year fixed rate term.  Instead of leaving the 20 year amortization, we have been pushing bankers to reduce the size of the balloon through an am of 15 years, or even fully amortizing deals if at all possible.  This shorter schedule obviously increases the payment amount, and the bank receives much higher cash flow.  The added cash flow helps to partially offset the interest rate risk of the longer fixed term, as the bank has more cash to redeploy if rates rise, and less hanging at the end (in this case a decade away) waiting to be repriced.

The important thing, though, is to make sure that amortizations get priced correctly.  A 10 year loan that is fully amortizing in 10 years is a much different interest rate risk than a 10 year loan on a 20 year amortization schedule.  The cash flows all fall much shorter on the yield curve, and can therefore be priced cheaper.  How much cheaper?  We turn to the swap market, and amortizing LIBOR swaps tell us that the fully amortizing loan can be priced 46 basis points lower. 

We as bankers tend to think that borrowers are payment shopping at all times.  We have found, anecdotally anyway, that this is not as common now as it was prior to the financial crisis.  If a borrower gets a loan offer at 4.50% for 10 years fully amortizing, or 4.96% for a 10 year loan with a 20 year amortization, you might be surprised at how many take the shorter deal with higher payments.

A $1 million loan with the 10 year am would have payments of $10,364 per month.  The same loan with a 20 year am and the higher rate would have payments of $6,577 per month.  Yes, it is significantly less.  But, many can be sold on the merit of taking advantage of this low rate environment to build wealth by quickly reducing debt.  Especially if the structure is priced properly, and saves them 46 basis points.  After all, the down side of the lower payment is that in a decade instead of being debt free, they will have to start a whole new loan for the remaining balance - a whopping $617,269.  That number speaks pretty loudly, and might just help you shorten your loan portfolio and offset some of risk we are all taking on in today's strange rate environment.