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Listen as Joel Rosenberg, SVP of Delivery & Client Success at PrecisionLender, walks us through the simulations he did to answer the question: Should I price with Prime or LIBOR?
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Jim Young: Hi, and welcome to The Purposeful Banker, the podcast brought to you by PrecisionLender where we discuss the big topics in the mind of today's best bankers. I'm your host, Jim Young, Director of Communications at PrecisionLender. Today I'm joined by Joel Rosenberg, Managing Director of Delivering Client Success at PrecisionLender.
Joel is our resident bank nerd and we use that as a term of respect, maybe a term of adoration here. To that end, if there are numbers that need to be crunched in an article or a blog post, Joel is usually the one we turn to. And that was the case last fall when several of our clients came to us with a question. Should they be pricing their loans based on prime or based on LIBOR?
Joel put together a blog post examining the two scenarios. It's been one of our most popular one in recent months, and it'll be linked in the post for this show. We decided to have a podcast to discuss his findings. Joel, thanks for coming on the show.
Joel Rosenberg: It's my pleasure, Jim.
Jim Young: Before we begin breaking down LIBOR versus prime matchup, Joel, can you tell the listeners a little bit about your background and how you eventually came to work at PrecisionLender?
Joel Rosenberg: Sure, I'd be happy to. By the way, in terms of resident bank nerd, I figure I'm number five on the list at PrecisionLender. I just write more than others, but I'm still proud of being a banker.
I have a long career in banking. I spent the first 25 years of my working career as a banker, primarily as a treasurer, Federal Home Loan Bank of Boston, a community bank outside of Boston. I worked for Prudential Insurance banking some, and about 15, 16 years ago, I joined a little company called US Banking Alliance that did loan pricing solutions, and that's actually where I met Carl Ryden, and so for the last 15, 16 years, I've been in the loan pricing business. So that's a quick background.
Jim Young: All right. Prime versus LIBOR. I mentioned this was a question first posed to us by a few of our clients. What was the reason behind the question, and what was sort of, I guess, the impetus? Why did this come up in the latter half of 2017?
Joel Rosenberg: Actually, this question's been asked for a few years now. And it related to the fact that you had certain volatilities between prime and LIBOR, and in fact, during really since about 2010 until recent couple of years, you had no volatility on prime, but LIBOR would pop up and down periodically, and so as more and more community banks, in particular, have gone to leaving prime as their main pricing index for floating rate loans and go on to LIBOR, which most of the large banks use for commercial loans, the question is well, are we leaving a better index in prime and going to a worse index in LIBOR, or should we have gone to LIBOR many, many years ago?
Jim Young: Okay. To answer the question, you set up a simulation. Can you walk us through the specifics of it and why you set it up the way you did?
Joel Rosenberg: Sure. Well, this is here we get into a little bit of bank nerdiness. I wanted to see over some longer period of time, is there an advantage to prime or LIBOR? I pulled data from January 2, 2000 through the end of December 2016. There's a great site. It's called the FRED site. It's run by the Federal Reserve of St. Louis, and they have economic data and interest rate data on a lot of factors, and so I pulled their quotes for one and three month LIBOR, as well as their quotes for prime.
And then taking that data, I assumed I, as a banker, would make a new loan each business day during this period, which we refer to in the article as the simulation period. And because we looked at one year, three year, and five year interest only loans, we stopped making loans in the case of one year at the end of December 2015, so we'd have all of 2016 data. We stopped a little bit earlier in the case with three and five year loans.
And we said okay, let's take prime as an index and see what would happen if we made a new million dollar loan each business day during that period, and let's take LIBOR, both one and three month LIBOR, and see what the results would be. In the case of one and three month LIBOR, it's almost always lower than prime. There's been three cases during this entire period, during the height of the financial crisis, where it was higher, but it tends to be about 2-7/8% lower than prime during most of this period.
We assumed that the loan would be made with a rate that was equal to prime, and in the case where we used LIBOR, we just determined to spread the difference typically between one month LIBOR and prime, and we added that spread to our index. And then we would let the loans go ... we'd look at each day of the period that the loan would be outstanding. Looked at what prime was. Looked at what LIBOR was.
In the case of prime, whenever prime changed, we changed the rate on the loan. In the case of one and three month LIBOR, because they're, in effect, fixed for either one month or three month respectively, we only changed the rate every 30 or 31 days in the case of one month LIBOR and every 91 days or so in the case of three month LIBOR.
We tested both with and without a floor, floor being what is the lowest rate it could go to. We tested first saying, if there's no floor, if the rates go up, if the rates go down, the rate on these loans go up, the rate on the loans go down. In another case we tested and said all right, let's set a floor which is equal to whatever prime is at the start of that loan, and we won't let rates go below that.
And so we had about 4,000 business days to look. We discovered there's very high correlation, not unsurprisingly, between prime and LIBOR, and in the end what we discovered is over this 4,000 business day period, over the 16 year period, whether you used prime or one month LIBOR, in terms of profitability, it really didn't matter. There was no significant difference. There was a little bit of difference in the case of three month LIBOR, but not much.
Jim Young: But you mentioned a little bit of a difference. There were, I guess, some specific situations, and I guess my question for that is, is are those things that you could actually anticipate or are those things that only in retrospect you could say oh, wow, that would have been nice if we'd used it?
Joel Rosenberg: Well, clearly retrospect is always good, but we did notice a couple of things where timing may have made sense, and primarily when the Federal Reserve was likely to take action to either raise or let rates drop, there probably are some actions you should take.
Generally, if rates are likely to rise, you should avoid setting your spread prior to likely Fed raising announcement. However, in a falling rate environment, set your spread early before they announce, and you'll tend to be better in terms of how to price. But in general, there wasn't a lot of significant difference that we can say.
Jim Young: I guess my other question is how often did customers care in that regard?
Joel Rosenberg: Well, most customers are familiar with prime. They're much less familiar with LIBOR. That is changing, and we're seeing, anecdotally talking to some of our community banks, more and more are talking about their customers asking for LIBOR type loans, but pretty much all customers know prime. It tends to be announced if you watch some of the business news channels or you read the Wall Street Journal, you can see where prime is. You can also see where LIBOR is. It's just a little bit harder to find.
But in terms of certain derivative actions that banks take, LIBOR is much better to use. If you're looking to do interest rate swaps, buy floors or caps, LIBOR tends to be a much more liquid market, something that's much better to be used.
The banking world is going more and more to using LIBOR versus prime. If you were to look to get a commercial loan from a large bank, a Bank of America type place, a Rabobank type place, TD type bank, you'd be probably very hard pressed to get a prime-based loan. In the case of smaller community banks, yeah, many of them have prime-based, but more and more are going to LIBOR.
Jim Young: Okay. I guess I'm having a little bit of trouble, though, reconciling that with some of the talk that I'd seen about LIBOR being eventually replaced. Do you think there's credence to that, and if so, is that cause for concern?
Joel Rosenberg: Well, certainly we had a problem with LIBOR where it was managed during the financial crisis in 2008, 2009, and that caused a lot of concern, obviously. Some people and organizations were punished for that, and it always was advertised as sort of a free market. It could move. It wasn't controlled. Prime is controlled by really what the Federal Reserve does. Prime typically is 300 basis points or 3% over where the Fed wants federal funds to be priced at. And whenever the Fed takes rate actions, prime moves. And so it's a controlled rate to a large degree.
LIBOR can move up and down, and we certainly have seen some fairly dramatic moves during the crisis. But there was a feeling that well maybe it's not free wheeling. We ought to have something else, and there has been talk about other indices. I know the Treasury's put out, the Federal Reserve has put out some documents, and I think this year or next year they're going to start publishing an index that they hope will replace LIBOR. The British banking organizations have talked about putting something out. The Central Bank of England has talked about putting an index out that could replace LIBOR.
I think it may happen, but whether it'll happen by early '20, '21 or '22 that they talk about, I think that's a big question. If, however, I was doing a loan and basing it on LIBOR, I would certainly have some wording in there that if the LIBOR indice does disappear, I can choose an alternative, liked-minded indice. I think a bank needs to be protected from that point of view, but at this point, especially if you're talking about a there year loan or a five year loan or certainly a one year loan, I don't think I'd have any problems making a LIBOR-based loan.
Jim Young: Okay. You ran through this study. You crunched the numbers and you found the outcomes. Was it what you were expecting? Was there anything in this study that surprised you at all?
Joel Rosenberg: One of the things, and it's not overly unexpected, but clearly the spread between LIBOR and prime does change over time, and one of the words of advice that we have is if you're basing your spread somewhere between that relationship between LIBOR and prime, if that spread is between 2-7/8 and 3-1/8, you're okay, using whatever spread you want to set up. I would be much more leery if it's on either side of that, because that's outside the norm.
While there is a high correlation and at least 75% of the time the spread between, for example, one month LIBOR and prime, like I said is between 2-7/8 and 3-1/8, there are times where it's different and I mentioned there were three instances where one month LIBOR was above prime. Very unusual, but if you're looking to set a spread, be careful when the spread is outside of the norm. Otherwise, there's really not much difference between using the two, but like I said, the world seems to be going to LIBOR more, at least on commercial loans, and probably if I was a bank, I would tend to use LIBOR or whatever may eventually replace it.
Jim Young: Right, exactly. Makes sense. That's good advice. It's good stuff, Joel. I appreciate it. And Joel is, like I said, he's the one who tackles these more complex questions. I'm sure we will have him on again in the future for some other interesting looks at again, what we lovingly call some of our bank nerd content here at PrecisionLender.
Well, that'll do it for this week's show. If you want to listen to more podcasts or check out more of our content, you can visit our resource page at explore.precisionlender.com, or you can just head over to our homepage to learn more about the company behind this content. Finally, if you like what you've been hearing, make sure to subscribe to the feed in iTunes, SoundCloud, Google Play or Stitcher. We love to get ratings and feedback on any of those platforms. Until next time, this has been Jim Young for Joel Rosenberg, and you've been listening to The Purposeful Banker.
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