How the Commercial Loan Market Fared in Q1 2021

April 19, 2021 Jim Young

Taking a look at our last Commercial Loan Pricing Market Update from the first quarter of 2021 - what are the trends so far this year and what do they mean? 

  

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Questions? Comments? Email Jim Young at jim.young@q2.com

Transcript:

Jim Young: Hi, and welcome to The Purposeful Banker, the podcast brought to you by PrecisionLender, where we discuss the big topics on the minds of today's best bankers. I'm your host, Jim Young, Director of Content at PrecisionLender. Joined again today by Dallas Wells, our EVP of Strategy.

Today, we're going to be a little self-referential because the focus of this conversation will be actually our most recent commercial loan pricing market update. And for those of you who might be unfamiliar with this, twice a month, Anna-Fay Lohn dives into our proprietary database and charts trends and key market metrics, such as pricing volumes, coupons, cost of funds, spreads to live or prime, et cetera. Anyways, it is one of our most popular pieces of content. So if you haven't checked it out before, I recommend you do that. We'll have a link to it. And also to let you know, actually the day after this podcast comes out, we'll have a new market update to come out as well for the first half of April.

 
But for today's podcast, we're actually going to look at the last update from the first quarter of 2021 and talk about some of those trends and what they mean. And in these updates is my analogy, because I have to always do this, Anna-Fay really largely plays the role of reporter. She gets those facts. She digs them up and presents them.
 
Today in the podcast, I'm going to ask Dallas to sort of play the role of the columnist to give us his takes on what these numbers mean. Dallas, you'll be happy to know that in my old existence at a daily newspaper column, this made a lot more money than reporters.
 
Dallas Wells: All relative of course. Right?
 
Jim Young: Touche. Alrighty. Okay. On that note then, onto the numbers. The first thing that jumped out to me is pretty sharp jump in pricing volume in March. And just to clarify, this is a measure of deals priced on our platform. Not necessarily deals closed, but still pretty good proxy for market activity and March's numbers were, and we've had this basically comparing each month since July of last year, which is really kind of the point where we felt like, okay, things settled down a bit after rates dropped. And then PPP came through. Since July, we've been measuring this. And if that is sort of the baseline, basically since then, we've had an average of course across those eight months. And March was 34% higher than that average. So what gives there? What's your theory on why that is, that volume has suddenly jumped up?
 
Dallas Wells: So I think part of this is just going to be typical seasonality where it's springtime and there's lots of borrowers who will be kind of getting back to business. But I do want to clarify that this will look a little different than ... You can track numbers from the Fed that show commercial loan balances outstanding, but that will incorporate things like draws on revolving lines of credit. It's true credit being accessed. What we're evaluating here is actually new loan opportunities being priced and negotiated. So those two will be correlated as activity picks up, those with pre-existing lines will start to draw on them. But also this is new projects, new working capital, new term loans, new construction loans, and a little bit of a thaw here, one seasonal from the weather and then just a continuing thawing of the economy from all pandemic related stuff, which you see in all the other economic activity.
 
So it wasn't a surprise to see a jump in March. We always see some increased activity in the spring time, but that's a sharp jump. It is bigger than usual. And I think this is the part that a lot of banks and a lot of bankers are kind of holding their breath to see is how much activity is there really? How much loan demand will there really be? So there's this notion out there of sort of maybe we're entering the next roaring twenties and there's all kinds of healthy things about the economy. Loan demand is yet to be one of them. So we're kind of waiting to see if that will pick up alongside that. So this was encouraging and good to see, especially since it was fairly widespread.
 
Jim Young: Yeah. That sort of leads into the next part of this. Anna-Fay sort of did the next level of due diligence and I kind of think about this when I think o f... We thought about it a little bit for a while and, "Hey, the stock market's up." And it was well, yeah, like three companies are carrying the entire market here. So Anna-Fay was kind of curious about, okay, could this be a case of maybe some big banks blowing the curve here on this and distorting things just by sheer size? And what she found was that, yeah, the bigger banks actually did have the higher growth rate and bigger loans had the biggest increase, but still growth across the board pretty much all size of banks and all size of loans. So can we draw any conclusions from this?
 
Dallas Wells: Well, I think on the small end of the market, you're still seeing some suppression in what I would call traditional lending because PPP round, whatever round at this point is still a thing. And that's still soaking up a fair amount of the usual credit activity in that space. So again, it wouldn't surprise me that it would skew more to the large size and especially given the size of the jump, it would have to be driven by some of those bigger credits. But when Anna-Fay broke it down by loan size, those loans over 25 million were 56% higher than in February, right? So that month over month jump was huge for those biggest sizes of loans and really pulled up that overall number quite a bit. So I think we, again, do see typically some seasonality in those, but also you're seeing that outside of PPP, there is some real economic activity and some of the bigger players starting to move into action and get back to business.
 
Jim Young: Okay. All right. And again, I want to make sure our listeners know. This might be a follow along podcast, really, because I will do my best to mention the numbers that we're referencing, but it's probably easiest if you have a commercial loan pricing market update March 16th to 31st open while you're listening because then you'll know exactly what numbers I'm referring to. But yes, Dallas refers to the chart which shows 56% growth for loans priced over 25 million.
 
All right. So now for another behind the scenes moment, because I put together these updates with Anna-Fay Lohn and she basically qualifies for sainthood because each one of these, I will ask her questions similar to what I ask Dallas each week on the podcast. But perhaps even more simplistic is sort of explain this to me, walk this through for me so I understand it. So she spent probably 30 minutes of her life that she'll never get back trying to explain to me some of the funding cost metrics that we were looking at. So now Dallas, it's your turn.
 
You can tell I really sold this one on you. So the first is we typically look at the three-month LIBOR swap curve as sort of a proxy of the funding curves to give a sense of what's going on there. And it's continued to steepen. That is a trend that has been happening again since, going back definitely to September of 2020, we've seen some market steepening of that curve. What we also saw in March, our March 31st snapshot, was that in the past that steepening had pretty much always been happening in about the 36 month mark. Anything shorter than that was pretty much hadn't moved much, but now we're starting to see that steepening happening at the 24 month mark. So got it. All right. That steeping, funding curves were rising, steepening cost of funds rising. I was good at this point.
 
Then Anna-Fay said, "Well, let's check on what we keep at PrecisionLender, an estimated liquidity curve." And this gets back into some of our conversations about the deposits and the glut there. We looked at that, the liquidity premium, and again, banks have lots of cheap cash on hand. So that number is pretty much down near zero. And this is what I'm still not quite understanding. We said cost of funds rose 22 basis points in March. But I feel like I just said that there's funding that banks have that is essentially free. So I'll be a radio show caller and just hang up and listen at this point.
 
Dallas Wells: Okay, fair enough. Anna-Fay is far kinder than I am, so I appreciate her patience and I'll do my best to follow along there. So you're right. That is a little bit of a, to use some of the Fed speak, a bit of a conundrum of why are banks so awash in cash? And yet we're talking about increases to their cost of funds. So for many of you, this will make sense and it's a concept you're very familiar with because you kind of live it and breathe it every day, but we get more questions than maybe you would expect from commercial bankers on this exact topic. What I find interesting is that, Andi, the bot inside of our software gets more questions than the humans do. So I think is a concept that's not as widely understood as maybe most bankers will pretend like it is.
 
So they're asking questions about like, "Hey, what is a liquidity premium anyway?" So we'll do a little basics of what these things are and why banks use them. So you mentioned the LIBOR swap curve and that's as good a curve as any, at least for now, as an indicator of term based interest rates. So you can create a curve from that because there are settings from one month out to one year, and then there are deep derivatives markets and tons of transactions where then people are swapping fixed for floating rates. So you can back into, well, what's the comparable five-year rate, 10-year rate, all the way out to a 30-year rate? So you can create a full curve across all of those durations. So that's a pretty good proxy for just market interest rates. Again, we're talking about US-based financial institutions. That would be market rates.
Then there's this concept of a liquidity premium. So as banks are figuring out what should we use as a funding cost for our loans? How much is it going to cost us to get the money on hand to loan out to our customers? There is a premium placed for funds that are highly liquid. And if you think about funding a loan, it's not like you go out into the bond market and you buy a bond. And if you decide the next day, gosh, I'd rather have the cash back. I'll just call up my broker and I'll sell the bond that I just bought and he'll send me the money back. We're talking about commercial borrowers. You fund the loan and the next day they've paid their suppliers and their employees. And they've started breaking dirt on the next construction project. And that money is poof, out into their project.
 
So if you call them back the next day and say, "Hey, it turns out I'd just like to have that cash back." They're going to say, "Too bad. I ain't got it anymore." So that's essentially why there needs to be a premium for that. What you're funding is an asset that is not that liquid. You can't turn it back into cash. You have to wait for them to pay you back or to sell their loan or to refinance it or whatever the case may be. But it's going to take some time to turn it back into cash. So banks take that interest curve and then they add a liquidity premium onto it. And all those things have market influences on them.
 
So those are kind of the components of the curve. Now, why do banks use that curve at all? Because as we've talked about, they've got gobs of deposits sitting inside the bank that they then need to invest and make some money on. Well, a lot of those are checking account balances at this point or savings account balances. So they're low cost. They also do not have a maturity date. And again, they can be withdrawn at any time. So banks have some liquidity risk there as well. And what they can end up with is this sort of no maturity, have to respond to the interest rates on the deposit side, and then they're making fixed rate loans or floating rate loans over an index on the asset side. They have interest rate risk and potential mismatches between those.
 
What banks are trying to do is really calculate a risk adjusted profit on that loan, which means we want to take how profitable those deposits are to us out of this picture. We will measure that separately. What we need to know is these loans on a standalone basis. How profitable are they all on their own? So we create this curve of what does it cost us to go borrow the money at one rate and then lend it out at a higher rate? That's how much we make on the loan. Separately, we decide, "Hey, we actually don't have to go borrow that money because we have deposits that cost us a little less. We'll use those instead." But we want to measure that profit. We want to tie that profit to those deposit accounts. So it's a matter of tying the profit to the right decision that we're making. Which one are we getting paid for? Making sure that if we decide to take that risk and mismatch our funding, that we're getting paid for that risk, and it doesn't just sort of get swallowed into the profitability of that loan.
 
So it's really about kind of... Consider it cost accounting, right? We're trying to measure, how much are we getting paid for the credit risk? And then how much are we getting paid for the interest rate risk? Those are two separate things. We want to keep them as two separate numbers. So it creates this whole sort of middleman function inside of the bank where you have... And it's actually called this in a lot of the larger banks. You have a funding desk. So that funding desk goes out and tries to pay for and raise deposits, and then sells that money essentially out the door in the form of funding for loans and that gap in between there, it's that funding desk job to kind of maximize the difference between those. But the lenders just pay attention to credit spreads and the funding desk, it's their job to kind of maximize the spread on how do we actually fund it? Two separate risks, two separate profit centers.
 
Jim Young: Okay.
 
Dallas Wells: Clear as mud? So to now get back to like, okay, well, what's that mean over the last couple months? Market interest rates have been going up, and as you look at that curve on the long end of the curve, we talked about the curve getting steeper, you're talking about an increase over the last less than six months of a hundred basis points. It's a big move. That was in the early portion of this concentrated way out on the curve. As the economy has gotten healthier and we've sort of gotten over the initial shock and fear of the pandemic of, how bad is this going to be? How long is it going to last? Some of that optimism has returned and saying, "Okay, we're going to return to healthy growth and our expectation of that keeps marching forward." So what was a movement at the five-year part then moved to the three-year part of the curve.
 
Now, as you pointed out, we're seeing some steepness at the two year part of the curve. So money is still cheap and essentially free overnight. You go out to about two years, you start having to pay for it a little bit because we expect there to be higher interest rates down the road. And then 10 years out, we're talking about a hundred basis points move over the last few months. So steepness in the curve. And then the further out on that curve you are lending, you have to pay for that funding. Again, using the concepts we talked about there. So that funding is more expensive to you. It's an internal entry at this point, but it is on a risk adjusted basis causing these loans to be... You're making less money for the credit risk because part of that is now being consumed by the interest rate risk that has shown up all of a sudden.
 
Jim Young: All right, again, just going to have faith that our listeners followed that better than I did. And that's totally okay. If you didn't, then thoughts and prayers with you on that then. All right. Let's move on then to... What we're talking about here is really about fixed rates. You mentioned we're talking 24 months, 36 months. We're not talking about one month LIBOR here, which has been essentially unmoved in terms of those costs. Really, most of the story, good and bad and in some cases ugly, has been about fixed rate loans on these updates recently. You just mentioned funding costs are up. I don't necessarily totally understand why, but Dallas has explained why. And the coupon is up, but not enough to keep margins from falling and they're down to 2.39%. That is just, again, from our measurements here, 40 basis points lower than our measurement was in September of 2020.
 
And meanwhile, back at that same point or close ... I should say back in the summer, fixed rate NIM was pretty much just about on top of LIBOR based floating rate NIM. And now there's about a 34 point gap between those two. So again, what does this mean? Are these trends that are reversible for fixed rate loans? Or are we entering into sort of this new world where man, if you have to do a fixed rate, okay. But if not, just avoid it at all costs.
 
Dallas Wells: Well, I think what you're seeing is what always tends to happen during sharp movements and rates like this. So again, a hundred basis points in about a six month timeframe. That's a fairly sharp change and those funding costs, those are modeled. Those are reacting kind of live and real time to the market out there because that's when you have to go get the funding. The actual loan pricing, the actual fixed rate loan pricing will often lag that a little bit.
 
So think of it instead of thinking about banks with all these sort of wonky numbers, think of it as your local gas station. So they all put their price up on the sign 50 feet in the air, and they can all see what each other is charging, as can everyone getting off the interstate and deciding where to get their gas. So their costs may all go up the same from the supplier overnight. Somebody's got to blink first and change their sign. And they know that when they do, if the others don't follow suit, they're going to lose some business.
 
That's effectively what's happening here with fixed rate loans is the banks are waiting to see who blinks first. Especially because there's such a lack of loan demand to this point. Again, we saw the spike in March, but until then, it's been kind of dead for quite a while. Outside of PPP and related items, there hasn't been a lot of activity. And there's lots of deposits sitting around with which to try to soak up some loans. So there's a lot of pressure to keep the volume going. Don't lose out on business. So as funding costs are inching up, we don't want to blink first.
 
So these will even out some over time, but you're also talking about the continuation of a 30 year trend in the industry. So it'll even out to some degree, but to also to some degree, it's just like, yeah, it marches on. Right? And we keep marching overall lower. So yeah, floating rate loans are more profitable right now, but you're also seeing that, especially for those top notch, high quality borrower's rates are still relatively low, but they can see as that curve steepens, that's a sign that higher rates are coming. So what they're saying is I want to lock in my borrowing costs now while it's still relatively low. There's more demand for those fixed rate loans and they're from the best borrowers and the banks are blinking. So that's kind of it in a nutshell.
 
Jim Young: All right. Okay. So speaking of nutshells then, do you look at this... And I think you've sort of hinted at this or maybe you just came out right and said it, and I wasn't listening quite closely enough. Do you look at this and say, "All right, this is an optimistic picture. This is better"? I mean, you kind of mentioned about spring. And I take with that all the literary analogies of new growth and rebirth and all that sort of stuff. But we did also just walk through about banks blinking with unfixed rate coupons. Do you look at this update and you go, "Yeah, I think things are... If I'm a commercial banker, I'm feeling better about what lies ahead in April and May"?
 
Dallas Wells: As the market moves, there's some compression. There's some timing issues with those, right? But all in all, this update is a really optimistic one. So you've got more activity and you have the possibility of higher rates on the horizon. So low rates, at least at the low rate levels that we've seen recently, it's really hard for banks to generate a reasonable spread. You're kind of bound by zero on the lower side, and there's not a whole lot of room in between. And all the excess liquidity. Spreads are just really tough to generate. So the fact that interest rates are... That hundred basis point increase out in the curve is great news for the banks. They're sitting on a ton of cash at near zero. They can take some interest rate risk and get paid for it. That's positive. There's loan demand showing up based on our March activity and a place to go with some of that money.
 
All of that is optimistic and I think has a lot of bankers feeling like they can see around the corner a little bit and they can see brighter days ahead. So good update this month.
 
Jim Young: All right. Good. Hey, we don't always end this show on a positive note. Sometimes it can be a little dark. 
 
Dallas Wells: I did my best this time.
 
Jim Young: Let's take this one. Let's take this win while we've got it and run with it.
 
Dallas Wells: Yep.
 
Jim Young: All right. Well, Dallas, thanks again for coming on.
 
Dallas Wells: You bet. Thank you.
 
Jim Young: And thanks so much for listening. And now for a few friendly reminders. If you want to listen to more podcasts or check out more of our content, you can visit the resource page at precisionlender.com or head over to our homepage to learn more about the company behind the content. If you like what you've been hearing, please make sure to subscribe to the feed in Apple podcasts, Google Play, or Stitcher. And of course, we love to get ratings and feedback on any of those platforms. Until next time, this is Jim Young for Dallas Wells. You've been listening to The Purposeful Banker.

About the Author

Jim Young

Jim Young, Director of Content at PrecisionLender, is an award-winning writer with experience in a range of positions in media and marketing, from reporter to website editor to content marketer. Throughout his career Jim has focused on the story – how to find it, how to understand it, and how best to share it with others. At PrecisionLender, he manages the many ways in which the company shares its philosophy on banking and the power of relationships. Jim graduated Phi Beta Kappa from Duke University and holds a masters degree in journalism from Columbia University.

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