Pricing for the Duration

Done efficiently, pricing commercial credits on cash flow expectations rather than loan terms sometimes provides a winning margin

By Katie Kuehner-Hebert

For many community banks, net interest margins are in the basement. Pricing competition for loans has been remarkably tough for years, particularly for commercial loans.

“Community banks are throwing their hands up in the air, crying, ‘How in the world can [competitors] do such stupid pricing?’” says Tom Parliment, chairman and CEO of Parliment Consulting Services, a community bank consulting firm in Key West, Fla. “Maybe they’re just so big or they have access to the derivative markets to hedge the risk, such as swaps or caps?’”

For community banks that repeatedly lose commercial real estate loan deals to larger regional banks that offer lower interest rates—as low as 3.5 percent in some cases—a more competitive loan-pricing alternative to consider is to price based on the duration of expected cash flows, Parliment says. Duration pricing factors a loan’s pricing based on considering the present value of all expected cash flows (planned amortization as well as prepayments), not on the term of the loan.

This is how asset-backed securities are priced in the capital markets, Parliment points out: “I tell bankers that they have to price the cash flows of CRE loans—and not price on term. For a 20-year fixed-rate mortgage on a CRE loan, bankers think they will be stuck with a fixed-rate loan for 20 years—that the term of the loan represents the bank’s exposure to interest rate risk. But the term of the loan only considers the date on which the final payment is expected to be made.”

Crunching the numbers

To use duration pricing, community banks should consider the timing of cash flows associated with the expected amortization as well as some expectation of prepayment. The cash flows must be discounted to get a present value, Parliment says. Duration is expressed in months or years of the average life of the loans within a portfolio. For instance, while the term of a 20-year, fixed-rate commercial real estate loan is 240 months, its duration would be calculated to be 5.7 years, assuming a 6 percent expected prepayment speed.

While it is true that each individual loan will either prepay or not, duration pricing involves repayment patterns within a portfolio of similar loans.

In reality, regional and money center banks have conducted duration loan pricing in which they calculate the average prepayment period of the loans within their portfolio and then price new loans according to the prepayment trends they find. Such a pricing method can sometimes allow a bank to offer greater discounts safely, effectively reducing the long-term interest rate risk for such loans. That is if their funding calculations are correct, and the prepayment patterns in their loan portfolios hold true.

Denmark State Bank in Denmark, Wis., uses duration pricing on some of its CRE loans, says Carl Laveck, the bank’s executive vice president. The $400 million-asset bank recently had a customer interested in a 10-year, fixed rate on a 15-year amortizing loan, but the bank’s lenders knew the customer well enough that they anticipated that the life of that loan was going to be quite a bit less than 15 years.

“A lot of the pricing is just guessing what the true life is going to be,” Laveck says.

Denmark State Bank uses the constant prepayment rate (CPR) to estimate that a CRE loan would likely be on the bank’s books for about five or six years. Then it prices its cost of funds over five or six years rather than over 10 years, allowing the bank to price the loan more aggressively.

“Banks have gotten themselves into trouble in the past by pricing long-term loans off short-term deposits,” Laveck says. “As deposit costs rise, they start to lose money on the loans. Banks should simulate new pricing strategies in their asset liability model to assess interest rate risk exposures before implementing duration pricing.”

However, even if Denmark State Bank uses duration pricing for a CRE loan, some risk of course remains that the borrower will use the loan’s entire contractual term to repay the loan as interest rates rise over the same period, Laveck points out. As such, banks need to have the sufficient capital base and balance sheet to handle that possible scenario.

Denmark State Bank often hedges its duration-priced loans by buying a low cost-of-funds deposit from the Federal Home Loan Bank. This enables the bank to better compete with bigger banks. “We are not going to win every deal because they are doing the same thing, but at least we’re on the same ground,” Laveck says. “We won a CRE deal the other day, but it was very skinny—we maybe won by five to 10 basis points.”

Know your options

Some community banks are making CRE loans with five- or seven-year balloons built into financing deals with longer terms as a hedge against interest rate risk, says David Powell, president of Vitex Inc., a bank consulting firm in Mooresville, N.C. To lock in the short-term spread, banks typically try to match the lower rate by funding the loan with a five-year certificate of deposit. However, “they can improve their odds by doing things like duration pricing and funding with FHLB advances as a funding source,” Powell says. “A five-year advance from the FHLB is actually cheaper than the average rate on a five-year CD today.”

Still, many community banks today have excess deposits and would rather deploy their deposits to fund loans, believing they would make more money by making loans versus investing excess funds into government-backed securities at a very low yield.

“Yes, duration pricing can help them do a better job of competing with the regionals, but [community banks] are more limited in how much they can actually compete without subjecting themselves to additional risk,” Powell says.

Jim Kleinfelter, president and senior consultant with Young & Associates Inc. in Kent, Ohio, says community banks should consider duration pricing on longer-term, fixed-rate loans only on a case-by-case basis. “Like all risk management, banks shouldn’t overcommit to this concept or they will likely become improperly gapped, and have net interest income issues prior to these loans maturing or paying off,” he says.

Community banks considering this pricing tactic should also hedge their decisions on a case-by-case basis, at some pre-determined limit. “They can buy an interest rate swap as an insurance policy against rates going up if the loan is of enough size, but it has to be done for the right customer—one that has good credit quality and is loyal to the bank,” Kleinfelter says.

Katie Kuehner-Hebert is a writer in Running Springs, Calif.