Pub. 6 2018 Issue 2

Issue 2. 2018 23 fixed rate loans without increasing asset durations. As interest rates increase, these hedges allow banks to benefit from rising interest income without the deterioration in debt service that typically accompanies rising rates (assuming all other credit factors remain unchanged). 10 Year Variable Loans Consider a $1 million variable rate loan at Prime + 0.75% (currently 5.50%) that is issued for a 10 year term with a 20 year amortization. Without a hedge, a +100bp increase in Prime will increase the borrower’s monthly interest payments by about 20% on average, reducing debt service coverage. With a hedge in place, interest income received on the hedged loan increases by about 20%, however the borrower’s payments remain the same (fixed rate). This stabilizes debt service for the life of the loan. It is also an important way to meet both your bank’s needs related to funding and rate risk as well as those of your customer. Jeff Goldstein SVP, Regional Manager Phone: (415-517-1012) jgoldstein@pcbb.com www.pcbb.com Dedicated to serving the needs of community banks, PCBB’s comprehensive and robust set of solutions includes: cash management, international services, lending solutions and risk management consulting services, including CECL. In addition to fixing the rate, extending maturity on amortiz- ing loans reduces credit exposure associated with repayment risk at maturity (i.e. ‘ballooning’ risk). In a credit stressed environment, short term loans with large balloons are prone to repayment default and external refinancing at that point in time might not be available. That is because the stressed credit has declined below underwriting guidelines. 5 Year Balloon Loans Consider a bank that did nothing but 5 year balloons. In any given year, 20% of the portfolio would be subject to ‘ballooning’ risk. However, if the bank were doing 10 year balloons, that risk would decline. Better yet, if the bank were doing fully amortiz- ing loans, there would be no ‘ballooning’ risk. A net result of this ‘ballooning’ risk is potentially higher reserves. CECL’s Impact on Long Term Loans There is some concern about CECL’s impact on reserves for longer term loans, but nothing is that simple. Some banks are considering shortening loan terms (foregoing more certain long term revenue) to avoid incremental reserve expenses. One eco- nomically beneficial alternative is to offset the reserve expense with non-interest income generated via a hedged loan. Let’s revisit the $1 million, 10 year term loan at Prime + 0.75% discussed prior. Assume the CECL impact is $2,250 in addi- tional reserves and the present value of 1bp on a hedge for this loan is $750. The bank can convert about 3bps (0.03%) of value from the hedge into $2,250 of immediately recognizable non-in- terest income to offset the reserve expense. As seen here, this is an important – and not wholly obvious -consideration as you prepare for CECL and continue under- writing longer term loans. To summarize, banks can utilize interest rate hedges to benefit from rising variable rates while fixing the loan rates for bor- rowers. Interest rate hedges also provide a vehicle for banks to generate non-interest income. Depending on the specific details of each loan, the additional income can be used to offset some or all of reserve calculations for the loan. Although not all together evident, there are ways to manage your bank’s loan loss reserves under CECL, without shortening the term of your loans. For more information on CECL or hedging, contact Jeff Goldstein.