Derivatives: Darth Vader's Revenge Message Board

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Non-Tech : Derivatives: Darth Vader's Revenge

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To: accountclosed who wrote (830)	3/24/1999 7:36:00 PM
From: Henry Volquardsen	Read Replies (2) of 2794

Antoine, It is worth noting that commercial banks were never big at lending at fixed rates for term maturities. As we discussed in the past their main lending to business was prime and that is by definition a floating rate. Their one major major fixed rate lending practice was fixed rate mortgages and almost all banks were badly burned by their fixed mortgage portfolio when interest rates became very volatile in the 70s and 80s. This has given many bankers an almost genetic aversion to fixed rate lending. Traditionally fixed rate lending has been the province of investment bankers not commercial bankers. There are also a number of structural reasons that commercial banks face. First is one you refer to. Most banks are a swamp of bureaucracy and internecine warfare. The lending units are part of one area, the funding area another and the capital markets group (the investment banking arm of commercial banks which do the swaps) are yet a third. Often they have little incentive to promote each others product offerings and are battling with each other over profit splits, cost allocation and access to the customer. Even in situations where the bank is trying to work and play well together the organizational issues get in the way. The lending unit wants certain language in the loan documenatation that suits their needs, such as credit calls. The swaps area will have its own set of documents that it wants to use. Co ordinating this legal work and negotiating internal is tougher than you might think. It is far easier just to push the competing legal issues and paperwork off on the customer. Another issue that no banker will admit to is linkage vs transparency. Banks like linkage not transparency. If the bank bundled the funding and credit isues with the interest rate swap the entire package would become transparent. You would see one rate at which you could borrow for term. This would make it fairly straightforward to do a little comparison shopping. By offering the unbundled version this becomes more difficult. It is a trickier issue for most people to understand the pricing on a swap and comparison shop. How many borrowers will know how to look at t+55 semi swap combined with a 3 month libor plus 150 loan from one bank and compare it to a term rate let alone another package with slightly different terms. Also the deal becomes linked. This is particular key with non prime borrowers. They focus on approving the floating loan first. Once you have the loan it is much easier to do the swap with the same bank, afterall they have already done the credit work. At this stage the bank's pricing pencil is not as sharp as it was before. I'm not suggesting that the commercial banks avoid fixed lending because they are consiously aware of these issue, most aren't. But it certainly doesn't give them an incentive to. The final issue is more related to the evolving nature of commercial banking. As we discussed before, one of the main trends over the last few decades has been the disintermediation of the capital markets. The other trend has been the tightening of capital requirements for commercial banks. During the 70s and early 80s the commercial banking system were weakened by bad lending practices and losses on fixed rate mortgage lending in a long term rising rate environment. The central banks of the world in accord with the BIS developed more stringent return on asset and capital requirements. US banks in particular are much stronger today because of this. These two trends presented banks with a difficult challenge. On the one hand disintermediation is tightening spreads and reducing the profitability of traditional lending. On the other hand the central banks are requiring more capital and a higher return on capital in order to pass audit. The banking industry has responded in several ways; securitization, fee income and off balance sheet business. This impacts your issue in a couple of ways. Banks love to securitize loans, package them up and sell them to investors. This allows them to capture much of the spread revenue and get the asset off their book and improve their return numbers. But securitization thrives on simple and straightforward. Short term floating rate loans are exactly that and very easy to securitize if the bank wishes. Fixed business loans are trickier to package. As far as the swap the bank is very happy to keep that on their books. It is off balance sheet and does not count against return on asset numbers. In fact the earnings help. And if the bank decides to keep your loan on their book it still helps them to have the loan split up. Capital ratios are complex. While the economics of a fixed loan may be identical to the borrower the capital requirements for the bank may be differnet. Just to give you a flavor of this lets look at a ten year fixed loan to a non rated borrower. These are not precise numbers but will give you the idea. A ten year loan to a non rated borrower is very risky and the capital requirement can be as high as 50%. A three month loan is much less risky and may require as little as 5% capital. The swap is also considered less risky, it has cross default language and other credit enhancements. A swap will also have its capital requirement change based on whether it is in or out of the money. So on day one the capital requirement for the swap will also be low, less than 5%. And if the swap goes against the bank the capital requirement will decline. If the swap goes in the banks favor they will have to put up more capital and may wind up putting up even more capital than on the fixed loan. But on day one the initial capital hit is much less and makes it more attractive to the bank. So there are a number of diverse reasons that make the unbundled approach more attractive to banks.

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