Finally! Interest Rate Effects Start to Take Shape

In this episode of The Purposeful Banker, Alex Habet and Tony Hernandez discuss results of the most recent review of Q2 PrecisionLender data and how the current rate environment is affecting pricing.

 

 

  

 

Video Podcast

 

Helpful Links

[Blog] Commercial Loan Pricing Update (July 2022)
[Article] Fed Lifts Rates by 0.75 Point Again
[Blog] Should Investors Trust the Latest Rally?
[Article] Unusually large U.S. jobs number stokes case for 'unusually large' rate hike
[Article] Benchmark Rate SOFR Has Caught On. But One Version Is Costing Companies More to Hedge 
[Article] Fed expected to stick with hawkish rate hikes until data show further slowing in inflation

Transcript

Alex Habet

Hi, and welcome to the Purposeful Banker, the podcast brought to you by Q2 PrecisionLender, where we discuss the big topics on the minds of today's best bankers. I'm Alex Habet, your host for today.

So I figured I would kick things off by going a little bit behind the scenes. I tend to do that, if you haven't noticed in recent episodes. But after the team collectively sat down to prepare for the show, we made a little bit of an audible. We called an audible pretty much late in the game. We said, "Let's scrap the idea that we had on the table and let's refocus on the market rather than lump in one of our market updates as part of another episode with, perhaps, an unrelated topic."

You might have noticed that in recent shows, when you catch these commercial market updates, despite there being a lot of news, the activity wasn't changing from episode to episode, right? We were seeing a lot of strong resiliency in the data. There was elevated volumes; profitability was there. There was healthy pricing taking place, for lack of a better term. But as every other subsequent rate hike came in, we were finally expecting to see some new anomaly or change come in on the data front, but it wasn't happening, right? We were just seeing the same trends. They were strong trends, but it was the same trends. And, frankly, we couldn't justify putting yet another episode out that had pretty much the same moral of the story that you've been hearing. It wouldn't have been a very exciting podcast episode. But, alas, we have some bucking of those trends. And so rather than tack on a market update on that unrelated topic of an episode, we said, let's scrap, let's focus on the reaction that we are now observing with the latest moves.

But even more importantly, we want to talk about how we should think about how we're positioning and bankers are positioning their books of business in light of the insights that we're learning from this data. And what better way to do that than to invite the deal doctor back to the show to help us unpack that info. That's right. I made a promise internally to more than one person to see if we can make that nickname stick. Hope that's cool with you, Tony Hernandez, Q2 senior solutions' consultant. Welcome back to the show. AKA the deal doctor.

Tony Hernandez

Alex, thanks for having me. And with that nickname, I'm starting to feel like Dr. Nick from the Simpsons around here. Do you remember him?

Alex Habet

Oh, classic, classic. But let's just hope you're a better practitioner than Dr. Nick was. Well, Tony, thanks again for being on the show. I said, I think, at the end of the last time we recorded, and I was like, probably won't be too long until we saw you. So it's been pretty much just a month. So thanks for coming back on. And, actually, since we last met, there has been some news, right? I mean, I wasn't in the opening remarks suggesting that there was a lack of news. I was suggesting that there was just a lack of new reaction to the data, at least that we have visibility into. But since we last talked, there's been another rate hike, 75 basis points, they're obviously continuing on this reversal of easy money policy.

But one thing I will point out is, it was a 75 basis point hike, right? If you recall the last one, not too long ago, I was like, I feel like our Slack channels were catching fire. People were just so abuzz about that rate hike. And then in this last one, it was crickets. I don't know. I guess it's like, 75 basis points is, I guess, normalized now, for all intents and purposes. It was a unanimous decision by the Board of Governors. The fourth rate hike in five months in response to generationally high inflations, 40-year high in inflation. So, interesting thing that started to happen, right? Equity markets were rallying, right? And a lot of people were starting to question, well, what's driving that. There was certainly no indication in the Fed's minutes, or in any of the public comments, that there was going to be any easing of this, of this path that they were on. But something was happening, and it prompted a few institutions like Morgan Stanley and BlackRock to really intentionally publish their perspectives on this.

So I'll give you an example, Lisa Shalett, who's a chief investment officer for the advisor group at Morgan Stanley, said that despite the indicators pointing to a softening on inflation, right, the gas prices are down. It's actually down, I think, every day this summer, which is fantastic. The commodities are in bear markets. There's a lot of things going on, but we have not yet felt the full impact of a lot of these new policies. The Fed has to simultaneously manage the rate hikes, while at the same time reducing the size of its balance sheet, which is, as she points out, uncharted territory. But most of all, there's just a ton of unknowns, right? I mean, think of these unique headwinds, right? The conflict in Ukraine, the Chinese economic recovery.

Yeah. And frankly, how we're learning, which is still confusing, how to deal with COVID here at home. And then add to that, there's just a strong labor market. Ultimately it's good for people like you and me, Tony, right? Or people looking for work out there, there is a strong labor market. And that's, of course, going to have a downward pressure on profitability. But again, these sort of things could also be read as a soothing of the fears on recession, right? But the Fed ironically might have to do more ultimately to tame the prices. Right. So according to Reuters, the inflation worries, motivating the Fed will only be heightened by the recent jobs report in July, which is 528,000 jobs in July. I mean, what do you think about all this so far, Tony? What's your kind of gut reaction, being an observer yourself of what's going on in the market?

Tony Hernandez

Yeah. I think it's quite a change from the headlines that we were getting, call it February, March, perhaps, into April. And on the headlines, I remember, there was we need to prepare for the hurricane that's coming. And maybe it is very similar to tropical storms, right? Where this one, maybe they're thinking that it's not going to be a category five, right? Maybe there's still the potential for something to happen, but perhaps to a lesser degree. So to your point, I think that there's definitely been a softening on the tone. And with some of the updates that we'll share here, I'm hoping that we're able to illustrate the point there.

Alex Habet

Yeah. I'm really glad that we didn't get in the business of predicting this stuff, because even a month ago I don't think we would've said some of what's going on right now. So again, the equity market is kind of seeing what it wants to see. There are strong data indicators that things are starting to work, maybe, and that ... But some are saying, well, maybe the aggressiveness will be toned down. But true watchers in the space are pretty much in agreement that the opposite is true, and the Fed has to continue aggressively. One last thing before I end my prelude rant here: It's important to call out that just a couple of days ago on August 16, President Biden set the Inflation Reduction Act, which is a $430 billion package aimed to reduce the deficit over the next decade by $300 billion.

Now, what's interesting about it—and given the title of the legislation itself—it actually targets a wide array of policy changes, including things like the subsidies for Affordable Care Act, climate and energy incentives, initiatives for prescription drug price reforms, and the closure of some really popular, let's call it tax loopholes. But then some do argue that the inflationary fighting effects of this legislation won't actually be felt for quite some time. Some say maybe two or three years. We're going to have to leave it to the Fed to be the main quarterback in this whole battle. Right. So let's shift gears a little bit and let's talk about, in light of all these macro-level events, we got our latest reading from our commercial banking data set. The largest on the planet, might I add. And Tony, before we dive into some individual points of interest that we're observing, what's the big picture? Well, how would you summarize it in a few seconds about what's going on?

Tony Hernandez

Yeah. At a very high level, the surgent volume that we've seen this summer has taken a breather. I don't think it's anything to worry about just yet, but it's a change of pace nonetheless, and we'll get into that. Second, and following the ongoing rate hikes, short-term indices have risen and are accompanied by longer-term rating versions. And third, we're starting to see evidence that liquidity costs have been trending higher. And these are very interesting, particularly, as we're looking at the trend of what's going on in the fixed-rate environment. And we also observed some compression on fixed-rate spreads, excuse me, while floating rates have continued their upper trajectory. So, I think that if we go back to that conversation we had a month or so ago, there's still some opportunity for our bankers to be creative and kind of to set the pace when it comes to how they go to market.

Alex Habet

All right. Well, it's good. That's what we want to hear. We want to be able to at least say, "Hey, here are some options versus just, hey, you're kind of backed into a corner." Right? Well, let's dig into those volumes first, because that was actually, I don't know, it's a very simple one to kind of analyze. But I was just keenly watching it the last few months just at how elevated our volumes have been.

Tony Hernandez

Yes.

Alex Habet

I mean, it was incredible. So what's going on there? What's the update?

Tony Hernandez

Yeah. And I want to kind of preset that I'm hesitant to call it a drop, right? But it's definitely a change of pace. So to really help us illustrate that point, let's establish a base on comparison. And let's use July of 2021 as our anchor for that. So to remind everyone that starting in March of 2022, that is really when we observe the volumes rally, and start to grow. So for those four months from March to June, the index run rate was of about 143. So think, July 2021, $100, call it loan. During those four months, it was more like $140 all else being equal. And now this break could be caused by many factors, inclusive of deals working through the system, perhaps a summer lull, etc.

But looking at July, our index is clocking in at a 130, right? So $130 loan. And exactly like you said, we're not in the business of predicting. So we'll be keen to continue observing, to see if this becomes a trend, or if it's reversed, as we really are going to high gear into the third and fourth quarter to wrap up 2022.

Alex Habet

Yeah. So when I was looking at this number, and you hesitate to call it a drop by, I guess, a more historical standard. And I wasn't the only one—we talked about it openly here—that the elevated volumes perhaps were due to panic buying. Let's say with the anticipation of higher rates, maybe people or businesses were wanting to lock in, right, some loans at a lower rate. And maybe we're now just starting to see some of that rush taper off, perhaps. Anyway, I guess we will continue to watch it. And we'll probably try to investigate that a little bit further to see what kind of drove that swell that we saw over the past few months.

Tony Hernandez

Absolutely. And I think that you see that many times happen, right? When the interest rates start to go up, if you had a borrower that was on the fence of, do they do something now, do they pre-fund certain projects? That might just be the push that they need to go ahead and lock up that financing before the costs really start to just skyrocket. But to your point, there's a lot of factors that go into that. So excited to see how that all plays out.

Alex Habet

Yeah. So let's now shift to maybe some of the rate-oriented things that we're looking at. So you mentioned a little bit about fixed rates, and I think there's been an interesting observation lately on the coupon trend. Finally, there's kind of a little bit of a buck there, so why don't you just dig into that a little bit further?

Tony Hernandez

Yeah. Definitely a break in the trend there, as well, whereby the funding curve decreases on those longer terms, reduced rates in July compared to June, giving weight to a reduction of nine basis points. And this paves a way to that convergence over the past months, across the various structures that we follow here. Previously, fixed-rate coupons led by about 130 basis points, which is quite steep, where now, we're looking at about a 50-basis-point difference. And that's big. I'd call that a drop, right? And that's primarily led by prime. And so for base loans showing higher coupons, month over month, overall tracking their underlying indices. That's all to say that these structures continue to respond to the changes in their underlying indices. And as part of that, the coupon is reflecting what's happening in the funding companies. Quick note on mix: July showed virtually no change compared to June with SOFR structures at 33%, fixed at 32%, prime at 15% and swaps holding at 6%.

Now, quick note on fees and SOFR: Particularly the SOFR structure showed an increasing borrowing cost, not only increasing the spread so that more of the debt direct profitability to the bank, but also increasing the fee amounts and increasing those yields to 79 basis points, higher than June. This led SOFR to do that 50 basis points lower than we're seeing on the fixed rates. And again, narrowing that 130-basis-point gap in June.

I think the point here to make is that bankers are flexing their strengths on these structures. And you may be wondering, well, kind of what's our take? What should we read on this? Well, bankers have expanded pure SOFR spread just by six basis points alone in July to 251 basis points. And to me, again, this expansion demonstrates that eagerness to protect profitability and returns, and leaning into the credits that make sense depending on their bank's risk appetite. And again, I think it warrants that we state just how well SOFR has been adopted since the inception. Bankers have not really missed being on this and do continue to win where possible.

Alex Habet

Yeah. As we meet and talk about some of this stuff as insiders here, I think, on several occasions, we've kind of heard cheers at how well SOFR ... I mean, do you remember, maybe a year ago? I mean, Tony, you and I, we meet with banks for a living. And it felt like there was no movement happening on SOFR for the longest time. Or we were just like waiting to see what everyone else was doing before they actually did anything. And look, we both worked in a big bank before. We kind of, in the back of our minds, just realized, hey, this is probably just going to become some fire drill based on the lack of urgency that we were observing kind of on the surface from where we are.

But it turns out, everything ... Look, I'm not suggesting there wasn't any fire drills and stuff like that. Obviously, there was. But at a macro level, and certainly when we look at the quality of the deals coming through the system and the structures and the profitability behind them, it's a really positive story to tell about this transition. I mean, wouldn't you agree?

Tony Hernandez

100%. Yeah. And look, I think it does pay to be prepared. But to your point, late 2020, early 2021, it was almost like popcorn, right? Every other week or month, it seemed like there was a new alternative reference rate that was introduced.

Alex Habet

Yeah.

Tony Hernandez

First it was SOFR, then it was BSBY, Ameribor. And it just seems like everyone was trying to rush to come up with the replacement.

Alex Habet

Right.

Tony Hernandez

Now we kind of had a Hail Mary pass with SOFR also creating Term SOFR. That more closely resembled or allowed banks to resemble a Libor-like structure that everyone can kind of rally behind without introducing too much complexity to what can already be a complex loan agreement. And also makes for an easier conversation with their clients. So overall, I think a win for the borrowers and a win for the bank at that.

Alex Habet

Yeah. You mentioned Term SOFR, I guess, versus overnight SOFR. We have a little channel on our Slack here, where people just pass around interesting or geeky, banky, articles. And one that just happened to cross by yesterday was really interesting. Talked about the hedging strategies with SOFR. And distinguishing between that, and also, with Term SOFR, how there's kind of a forbidden on hedging that. And as a result, it's become some of that added cost, because the banks are bearing all that risk. They're passing it on to their customers. Right. So on the one hand overnight SOFR, the activity, I believe, actually, on the derivatives have surpassed those linked to Libor in June, which is kind of a big deal.

I feel like that's the milestone that we should be talking about a little bit more. But then now, you're kind of comparing SOFR overnight to whether you want to do that or go with a Term SOFR structure, where it's a little bit more predictable in terms of what your expenses might look months out. But given that, it's more expensive for the borrowers. Are they going to start to look elsewhere? I mean, if you think about a Term SOFR structure for a big ticket item—let's take a billion dollar ticket here—when you're talking about three or four basis points higher versus the overnight SOFR rate. That equates to a million and a half of added interest. I mean, that's a few jobs right there that you could have alternatively done. Right. So something to just keep in mind and I thought worth mentioning on the show, given that we're talking a little bit about SOFR. But, I guess, let's pivot back. Is there anything else you would maybe call to  attention as we kind of wrap up the summary of what happened in the last month in the data?

Tony Hernandez

Yeah. There's one more point that kind of showed up, right? And while fixed rate cost of funds had bucked that upward trend, the interesting story here is how liquidity costs have been driven up. We measured the cost of broker CDs in the background across term structures and compared to interest rate swaps. This gives us a proxy of liquidity costs across our population of banks. This liquidity curve of sorts had shown very little movement until the recent Fed hikes. And the last couple of months there have been rapid increases in broker CD rates that are driving those costs up. Now, there's evidence that big dollar amounts are being moved here. And perhaps it's the borrowers trying to take advantage of those rising rates for the cash research that they might have. I think that this is a noteworthy point to bring up, since liquidity costs do contribute to overall borrowing cost. So just as we continue to keep tabs on what is happening with our data, this could be a topic that we kind of put a pin on and see if we see correlation to coupons in the coming months.

Alex Habet

Yeah. Yeah. So let's talk about what all of this stuff now means for the bankers. Right. We gave some advice last time we chatted about this. If you were to wrap it up, how would you be reinforcing your message enough if a banker were to call you and ask for some advice?

Tony Hernandez

Yeah, I think I go right back to that conversation and think that our bankers keep on the path. Again, have options in terms of structure, even if they're just used internally. You may need to react to client concerns on rising borrowing costs, perhaps, how much tolerance they have for variable rate debt or other things that might make them worry. So along those lines, if we're looking at a fixed-rate structure versus a swap, which option is going to give our client some relief on that borrowing cost, while also not negatively impacting the bank on profitability? Like we mentioned earlier during our conversation, continue to encourage others to be curious and to challenge themselves on how they can get that win. For a while, I feel that there is a very thin line, but it's there where a structure benefits the borrower, but also the bank.

Alex Habet

Right.

Tony Hernandez

And also, like we mentioned earlier, we've observed with SOFR that bankers are able to win on fees. So just encourage them to lean into that as we are winning there. But other than that, Alex, thank you for inviting me again. Always enjoy this time, nerding out over the banking phase, and catching up, even if it's just virtually.

Alex Habet

Yeah. As if we haven't been doing that now for a while. So I appreciate it again. Great discussion. Deal Doctor, Tony Hernandez. I look forward to having you again, very soon, and I suspect that it's going to be very soon. More to come on that. So ...

Tony Hernandez

Spoiler alert.

Alex Habet

If you want to catch more episodes of the show, please subscribe to the show wherever you like to listen to your podcasts, including Apple Podcasts, Spotify, Stitcher, iHeartRadio, and more. And if you have a minute spare, let us know what you think in the comments. You can also head over to q2.com to learn more about the company behind the content.

And don't forget, mark your calendars and plan to join us in Austin in November at the in-person 2022 BankOnPurpose conference. Visit bankonpurpose.com for more information, and you can save $100 off the registration if you use the code "podcast." Until next time, this is Alex Habet, and you've been listening to The Purposeful Banker.

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