How to Use Fees In Lending To Offset a Flat Yield Curve

As the yield curve flattens, the difference between Prime and ten-year fixed commercial loans rates gets smaller. Community banks face a dilemma in how best to manage interest rate risk – which affects both the bank and the borrower. Banks are further challenged to offer loan structures that maximize their competitive advantage and differentiate their product from multiple competitors. We see one specific strategy that community banks are deploying that utilizes upfront non-interest income in structuring owner-occupied and investor CRE term loans for ten to 20 years, eliminating both the bank’s and borrower’s interest rate risk and increasing the immediate yield for the bank.  

The Forward Curve

Currently, the forward curve is relatively flat as shown in the graph below. What this means is that the principal and interest (P&I) payments for a borrower are almost the same for three-year and 20-year fixed rate loan. This is motivating borrower’s to finance long-term assets (such as real estate) at the long-end of the yield curve.

This borrower behavior creates particular challenges for community banks as the cost differential between five and ten years is only two to five basis points (bps) depending on the amortization term. Therefore, many banks are using hedging instruments to offer long-term fixed rates but eliminate the interest rate risk. However, the yield curve is not flat during the first year of the loan, and, therefore, the bank’s yield is lower during the first year than it would have been if the bank kept the fixed rate on balance sheet. The current economic difference is depicted in the graph below.

The graph above shows the yield on an average CRE loan at 5.41% fixed and the yield of that same loan to the bank when hedged. While in years two through ten, the yield to the bank is expected to be almost identical between fixed and floating, the initial yield give-up in year one is approximately 80 bps. This reduction in yield in the first year is sufficiently painful that many banks prefer to book three and five-year fixed rate to avoid providing the structure favored by many borrowers. However, there is a very elegant solution that many community banks are currently deploying to overcome this challenge.

The Solution

Smart bankers are generating a fee that may be recognized in income in the first reporting period of the loan to eliminate the initial yield give-up of the hedge. The concept involves reduction in credit spread for a hedged loan in later years and monetizing that value upfront. The graph below shows the same yield comparison between a ten-year fixed rate and a hedged floating loan, but now the floating rate is reduced by 15 bps for the life of the loan to generate a 1.0% upfront fee, and that fee is recognized in the first reporting period for the loan.  

The annual yield to the bank is a little higher initially on a floater than it would have been on a fixed rate. While the conversion from fixed to floating reduces the yield by about 80bps, the hedge fee increases the yield by about 100bps in the initial period giving the hedged loan a higher initial rate. 

As rates are expected to climb in the first year, the yield for the bank only improves during the first year. In years two through ten, the expected yield on the floater has been lowered by 15 bps. Nonetheless, the yield between on the two loans is expected to be almost identical during the last nine years of the loan.

The advantage of this strategy for the community bank is as follows:

1. The bank can offer more compelling structures that include ten, 15 or even 20-year fixed rates without taking interest rate risk on balance sheet;
2. By differentiating its product offering, the bank can be more competitive and retain better customers;
3. The borrower eliminates repricing risk for the borrower; and
4. The bank can recognize higher yield in the first year on a floating loan asset than a fixed loan asset. The expected yield in subsequent years is comparable.

Conclusion

Recognizing the unique shape of the yield curve allows banks to cater to borrowers’ current needs and differentiate the bank from its competitors. By generating hedge fee income in the first reporting period, banks can structure loans that carry a higher yield in the initial period and still eliminate interest rate risk and mitigate refinancing risk for the borrower. Lastly, after the initial year of the loan interest rates are expected to be substantially higher giving the bank additional earnings lift.  The strategy is not suitable for every commercial loan but has wide application in today’s competitive environment.

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