Pricing Floating Rate Loans Using Libor or Prime: What's the Best Approach?

December 20, 2017 Joel Rosenberg

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As rates began to rise in 2017, Libor moved up faster than the Prime. Loans priced on Libor, therefore, were more profitable. We wondered, as did many of our clients, whether this was always the case.

To find out, we set up a simulation to answer the question: Do loans priced on Libor outperform loans priced on Prime? We’ll go into much greater depth below, but the short answer is this: Sometimes yes, sometimes no, and over the long run, there’s really no difference between Libor and Prime.

How We Set Up the Simulation

Before we dive into the details, let’s start with some background on the methodology used in this simulation.

Sample

We sampled information on one- and three-month US dollar Libor rates and Wall Street Prime from early January 2000 to the end of December 2016 (Simulation Period). This information was obtained from the “Fred” economic site maintained by the Federal Reserve Bank of St. Louis.

Survey

We surveyed several of our clients on how often and when they change the interest rate on a floating rate commercial loan using these indices. Although there are several approaches that, depending on the loan type, can vary within an institution, the main methods are:

  1. Bank Prime. Sometimes called Reference Rate, this changes whenever Wall Street Prime is readjusted. This generally occurs within one day of the Federal Reserve announcing a change in its targeting of Fed Funds. The rate on loans backed by Prime is modified at that time.
  2. One-Month Libor. These quoted Libor rates typically change daily. However, rates on loans backed by this index are modified monthly, usually on the anniversary day of the loan origination. In this simulation, we followed this practice of changing the rate every 30/31 days or the next business day if the anniversary date was a weekend or holiday.
  3. Three-Month Libor. We used the above method with this rate as well, except the readjustment occurred about every 91 days.

Assumptions

We ran many simulations to track what would have happened on floating rate commercial loans made during the Simulation Period. We assumed that the banker had an option of making a loan at the Prime rate compared to one- or three-month Libor. Since the Prime rate is almost always higher than Libor, we added a spread to Libor to equal its difference from Prime. In the few cases where Libor was above Prime, there was a negative spread added. We made a minor modification to this general structure for three-month Libor, which we will discuss below.

We ran many simulations where we assumed new loans were made every business day with a floating rate basis of either Prime, one-month Libor, or three-month Libor. These loan terms were for a period of one year. These loans were assumed to be interest only, with a 0% CPR (no early prepayments) rate. During the term of each of these loans, we compared the difference in the loan rate charged each day. These observations included both business and non-business days (weekends and holidays, where any difference would be the same as the prior business day).

(Note: All interest rates were adjusted using an actual over 360-day interest count method.)

For example, during a period of stable Prime rates (2008 to the end of 2015), there would not be any difference for the first 30 days between a one-month Libor loan and the Prime-based loan. However, every 30/31 days thereafter, there would likely be a difference depending on the movement of one-month Libor.

If Libor moved above its original value, there would be a positive change. If it moved lower, there would be a negative change. These differences were summed over the one-year period. We ran simulations on loans originated from the beginning of 2000 to the end of 2015. During a period of movements in Prime, the difference could change not only monthly, but whenever Prime was reset.

Repetitions

We did the same procedure for interest-only, three-year and five-year term loans. In the case of the three-year term, we stopped making loans at the end of June 2015. Since loans made between January 2014 and June 2015 would not have data for a complete three years, we took the results for the time they were outstanding and normalized to three years’ time frame. We took a similar approach on five-year loans, where we stopped making any new loans after June 2014.

We were interested not only in the average results for the entire period, but also for periods of rising and falling rates. There were three complete time frames (as defined by the change in Prime) where rates rose and stayed steady, or fell and then stayed steady. This was from January 2001 to June 2004 (falling rates); July 2004 to middle of September 2007 (rising rates); and September 2007 to December 2015 (falling rates). We wanted to see if these would show different results.

Finally, we tested what would happen if the bank set a floor equal to the original rate on all the scenarios described above. The results with and without floors are described later in this article.  

The Data and Rate Movements

The graph below shows the movement of Libor and Prime over the past 17 years. Except for a few short periods, these rates tend to move in a similar fashion.

The Libor rates tend to move even when Prime is flat. The next graph shows the movement in Libor during a period when Prime was stable at 3.25%.

There were slightly more than 4,000 business days during the past 17 years. The table below shows the number of instances for the spread between Prime and one-month Libor. As noted, there were 3 cases where the spread was negative and 17 where it was over 3.375%. However, almost three-quarters of the time the spread was between 2.876% and 3.125%. 

The table that follows shows the results for one-month Libor plus a spread compared to Prime. This table displays individual results for a series of one-, three-, and five-year loans, with and without a floor.

Over the entire period of January 2000 to December 2016 when loans were originated, there was no significant advantage in either method. A series of one-year loans without a floor showed slightly less than one basis point (0.01%) annualized advantage to the Libor strategy, while a series of five-year loans showed somewhat less than 2 basis points annualized advantage to Prime.

With a floor, the Libor strategy for the series of five-year loans showed slightly less than 2 basis points annualized advantage. The three-year loan results were close to zero with or without a floor, as was the one-year with a floor. Examining the various time periods, the advantage of one strategy over the other was somewhat larger. At a maximum, there was an almost 11.5 basis points annualized benefit for Libor on a series of three-year loans with no floor during the rising interest rate environment of 2004 to 2007 and a similar benefit to Prime on a series of five-year loans with no floor during the falling interest rate environment of 2007 to 2015.

The Questions on the Floor vs. No Floor Strategy

Setting a floor in these simulations equal to Prime at the beginning of the loan results in higher income in both the Libor and Prime strategy. However, during certain periods there was some advantage in one pricing strategy over the other.

Why does the Prime strategy become the preferred method during the rising rate environment of July 2004 to September 2007? 

During most of this period, there was no difference in using Prime or Libor as an index. However, in the case of one-year loans, those made after September 2006 had at least some of their life during the rapidly falling rate environment of late 2007 and 2008. The dynamic of falling rates showed that Prime fell quicker than Libor during most of this period. Thus, a floor had a greater advantage to the Prime strategy in increasing income.

A similar situation existed for the three- and five-year loans. Libor did not match the decline in Prime after its peak, from September 2007 until December 2008.

Could a bank maintain a floor of, say, 8.25% into 2008 and beyond?

Based on experience, many banks had a 5% and even a 6% floor during that period. It is likely that a bank that set a higher floor would have had to renegotiate it with their clients during the period of falling rates. A similar statement could be made on the floor strategy during the early part of the falling rate environments, starting in 2001. Thus, the simulated advantage to the Prime strategy with a floor might not exist during those time frames, based on likely actions.

In most cases, the bank determined the spread a month or two prior to when the loan actually closed. Did this change the results?

Given the way we did the simulations, while each individual loan would have a different result, over the entire period there would be no material change, even over the falling and rising rate periods. If there are some benefits to one method at one date, it is likely offset one or two months later.

Finally, with the three-year loans made between January 2014 and June 2015, we normalized the results through the end of 2016. It is possible that the average effects during 2017, and for some of these loans early 2018, might be different than the earlier results.

A similar statement can also be made on the five-year loans. The effects should be relatively insignificant over the entire time period, but could affect what we are showing for these two loan maturities during the falling rate environment from 2007 to 2015.

The Three-Month Libor

In the case of three-month Libor, we started by first simulating the results based on a spread of the difference between Prime and three-month Libor. However, in approximately 87% of the time periods studied, this spread would have been lower than that of the one-month Libor loans. This does not make sense to us, especially since the three-month Libor fixes the rate for a longer period than one-month Libor or Prime.

Typically, longer term rate adjustment loans have a higher rate. As such, we decided to set the spread equal to the greater of a) the difference between Prime and three-month Libor or b) that used for the one-month Libor loan. Typically, this resulted in an initially higher overall rate for the three-month Libor loan compared to Prime.

The table that follows is set up like the previous one. In almost all these cases the three-month Libor loan is more profitable than using Prime.

 

Pricing Near the Time Prime Changes

During the past several decades, Prime only changed when the Federal Reserve decided to set a new Fed Funds target. We examined whether there is a significant difference between loans made right before and right after the Federal Reserve actions.

Typically, we see Libor rates moving before the change in Prime, by either increasing in a rising rate environment or decreasing in a falling rate environment. Of course, it’s never certain when and by how much the Federal Reserve will take actions. While these changes often occur in conjunction with scheduled Open Market Committee meetings, they do occasionally occur on an ad hoc basis.

We examined the difference between one-month Libor and Prime five business days prior to and five business days after a rate change action. Since the beginning of 2000 to the end of 2016, there have been 22 actions to increase rates and 23 to decrease them. With one exception, the actions to increase have been in 25 basis point increments. During a period of falling rates, however, the declines in rates have ranged from 25 to 75 basis points.

The table that follows shows that, in a rising rate environment, waiting to set the spread (assuming it is based on the difference between Prime and Libor) makes sense.

The calculated spread is approximately 25 basis points lower prior to the rate change announcement than afterward. Thus, on a one-year loan for $1 million, the pretax earnings would be approximately $2,500 lower if made in the business week before the rate change than in the week afterward. The opposite on average is true in a falling rate environment. However, it is more complex since the benefit ranged from 76 basis points to negative 53 basis points.

There were three cases where it made nearly no difference and three cases where the opposite happened to what would have been expected. Because the rate changes in a falling environment were not consistently 25 basis points (as in the rising case), the effects varied with the movement in rates. The Table above shows the number of instances where negative or positive income would be achieved by setting the spread on a Libor-based loan within one week prior to a Prime rate change compared to one week afterwards.

Conclusion

There are several reasons why banks would use Libor over Prime:

  1. Its movement better matches the bank’s cost of funds.
  2. It has wider acceptance among larger borrowers.
  3. The swap market is slightly more efficient using Libor.
  4. The rate is not primarily controlled by a central banking authority.
  5. Using this rate allows more efficient loan syndication and securitization.

However, banks dealing with smaller prospects in more rural areas sometimes find Libor-based loans harder to sell to their customers. Banking is also tradition bound, and while Prime-based loans have been around for many years, Libor is still thought of as “the new kid on the block.” There has also been recent discussion around replacing Libor with a new pricing system. This could make some borrowers more hesitant to agree to this index if it will go away in the future and they are not certain about the replacement.

We can make several conclusions following this study:

  1. In the long run, it doesn’t seem to make a lot of difference if the index used on a floating rate loan is one-month Libor or Prime.
  2. During certain economic environments, using a particular index does make some difference. However, knowing when you are in the right economic environment can be difficult.
  3. If you base your spread on a floating rate loan on the difference between Prime and Libor, you should avoid setting that spread just prior to a likely Fed Reserve rising rate announcement. However, in a falling rate environment, before is better than after.
  4. The spread for a three-month Libor loan should generally be the same or higher than that of a one-month Libor loan.
  5. If you are seeking to match Prime on a Libor-based loan, a spread under 2.875% should generally be avoided, regardless of what the current difference is indicating.
  6. Floors on floating rate loans are generally good, assuming you don’t also have to give a cap. However, during a higher interest rate period, make sure your floor is reasonable.
  7. Commercial lending is tending more toward pricing with Libor, and the swap market is more liquid with this index.
  8. Libor can show some amount of changes even during a period of stable Prime.

Having different interest rate options for borrowers is becoming more important over time as information continues to expand. It does not make sense to lose a deal because a borrower wants it to be Libor- or Prime-based but the bank doesn’t offer that option. It is important to understand how to price effectively with both indices.

 

Interested in learning more?

Visit PrecisionLender.com

 

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