Like Buying Flood Insurance in the Sahara Desert

The economic whirlwind that ensued from COVID-19 has left banks figuring out how to make profitable loans. Borrowers need to understand how they are now impacted by new loan terminology. Suddenly, published benchmarks that theoretically represented a bank's cost of funds fell substantially below what those banks were paying their own depositors. No one expects a bank to loan at a loss but the methods they choose to protect themselves can have profound impacts on borrowers and need to be understood to avoid paying unnecessary (and sometimes exorbitant) costs. 

The most common protective measure instituted by banks is the "floor.” A floor is a synthetic minimum cost of funds that is above the actual benchmark. As an example, 30-day Libor is currently about 0.15% but many banks are using up to 1% as a floor. The impact is the monthly differential between the actual Libor rate and the floor, in this case, 0.85%. Things become more difficult when trying to understand if it is better to accept a lower spread with a greater floor (e.g. Libor + 1.75% with a floor of 1.00%) or a greater spread with a lower floor (e.g. Libor + 2.50% with a floor of 0.25%).  They will both have the same rate in the first month (2.75%) but may differ substantially depending on how Libor moves during the course of the loan.

Another level of confusion arises when banks fixing rates with swaps provide the borrower an opportunity to “buy out” the floor. This practice may seem appealing but needs to be thoroughly explained and quantified before a decision is made. A bank in Florida recently offered to buy out a floor on a $42 million loan for 24 bps. That would have amounted to almost $400,000 in present value and would have only paid for itself had Libor gone negative by at least 3 bps for the entire loan.

For those seeking a better understanding of this topic, a great source can be found on a podcast episode featuring JP Conklin, founder of Pensford and former head of the Los Angeles swap desk for Wells Fargo. JP takes listeners through a clear and concise explanation of what to watch for and how to make the right decisions. Listen here.

If the application of floors was not enough, borrowers are also faced with banks beefing up underwriting and “credit spreads” to provide a cushion for anticipated losses. A banking term that has become increasingly prevalent and utilized as an explanation for this increase is “liquidity premium” or “term issuance premium”. The end of March 2020 saw a hefty increase in each bank’s liquidity premium – around 50 to 70 basis points – that was not reflected in the underlying indices banks use to price their loans. 

The bottom line is that borrowing with a clear understanding of the terms and cost of a loan has become a more difficult task. Don’t be hesitant in asking banks for explanations and for examples and don’t be timid about seeking out expert advice. It’s simply called leveling the playing field.