Lending in 2020: a strong defense is the best offense

June 1, 2020 Bob Newman

Bob Newman

Mention the “Steel Curtain” in Pittsburgh, or “Monsters of the Midway” in Chicago and even a casual football fan will recognize that you are referencing two of the most feared NFL defenses. But statistically speaking there is another defensive unit that just might top them both: The Norwalk (CT) Central Catholic High School Cavaliers of 1978. While the 1985 Bears are considered by many to be the greatest defense of all-time by holding opponents to an average of 12.4 points per game, consider that the CCHS Cavaliers allowed only 37 points during their 10-game season in 1978 – an average of 3.7 points per game – which earned the number one ranking in Connecticut. With such a dominant defense, the Cavs were able to overcome a weak link in their offense, namely an under-sized tackle on the right side of the front line who hung up his cleats in ’78 and went on to a career in banking and derivatives (yes, yours truly!).

In the midst of pandemic fallout, commercial lending teams looking at their 2020 growth goals are feeling much like a football team punting after another three-and-out. In the struggle to get the ball across midfield, it is going to take a heroic effort on the part of the bank’s defense to win the battle at hand. For good reason, the defensive instincts that first kick in during economic uncertainty are credit related, making sure that cash flow and collateral are sufficient for any relationship that is experiencing hardship. But when we think about the measuring stick used to compare elite defenses in football, we need to also consider taking the necessary steps to prevent competitors from putting points on the scoreboard.

As the list of borrowing clients who are thriving during the crisis shrinks, the companies on that list will quickly become attractive targets for competing banks looking for a quick score by picking off a high-quality asset. Complicating this challenge are the aggressive actions by the Federal Reserve to provide liquidity, resulting in its benchmark falling back to the zero range in mid-March. Much like homeowners who have triggered another mortgage re-financing boom, commercial borrowers with strong balance sheets and black ink on the bottom line are going to expect to benefit from lower market interest rates.

The ability of a competitor to woo away your best borrower with a lower price by simply using current market rates creates an interesting dilemma: should you wait until your phone rings and there is a deal on the table to take you out, or should you hit this head-on by initiating a re-pricing and re-structuring conversation? Consider a $5 million fixed-rate loan that was closed two short years ago. On a 10/25 structure if the loan is priced at 5.00%, it was initially set at two points over the then-current 10-year swap rate. With current market swap rates trading in the 0.50% to 0.60% range, it is possible that an aggressive competitor might approach with a rate of 3.00% or lower. Even if the current note includes a prepayment penalty of 4% or 5%, it would not be enough to deter a savvy borrower from taking the new deal. But what if you initiate the conversation instead? With interest rate swaps in your toolkit you could offer the borrower a restructured deal at an all-in fixed rate of 3.90%. In doing so you could accomplish the following:

  • Allow the borrower to reduce funding costs by 110 basis points
  • Increase the bank’s credit spread by 100 basis points (from +200 to +300)
  • Recognize an up-front swap fee equivalent to 1 ½ to 2 points
  • Retain a strong profitable borrowing relationship
  • Remove yourself from future prepayment negotiations due to swap make-whole features

Without a doubt, the actions of community banks over the past three months have been nothing short of heroic. From processing countless PPP loan applications to providing needed loan payment deferrals, bankers have served their clients and communities sacrificially. As economic activity begins to resume this summer, banks should consider taking proactive steps to protect their best relationships from hungry competitors. Especially in 2020, a strong defense can be the best offense!


Disclosures

Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal/notices/.

Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved. 20-0171

About the Author

Bob Newman

Bob Newman is Managing Director for Chatham’s Financial Institutions business which specializes in interest rate risk management, hedge accounting and investment advisory for banks. Prior to joining Chatham in 2003, Bob spent 20 years in commercial banking, helping to start the derivatives operation at Maryland National Bank and expand the derivatives effort at SunTrust. He graduated from the College of William and Mary with a BA in Economics and has earned the Chartered Financial Analyst (CFA) designation.

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