Profit from C&I loans

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Randy Cameron and David Wood

TThe payroll protection program has created an artificial – if critically needed – bulge in banks’ commercial loan books. However, even after more than $ 730 billion in loans in 2020 and 2021, total commercial and industrial loans from banks declined. In fact, as of May 24, $ 279 billion in PPP loans had been written off. Soon, the balance of these loans will be forgiven or a maturity date will be set.

In addition, the pace of industry consolidation accelerated following the 2008 global recession, resulting in a marked reduction in the number of small community banks and a reallocation of assets among larger banks, affecting both banks and their communities.

Community banks weathered the storm through a combination of technology, new delivery methods, adapting to changes in consumer behavior, and complying with new banking laws. Clean organic growth also helped. But they found an additional strategy that proved to be quite helpful.

We are constantly analyzing the results of consolidation. How will this affect our banking clients? How can we help them compete? What are the implications of a shrinking market for small community banks in rural communities?

Investment case for pre-emptive loans

Banks today are overflowing with cash. Given the ongoing dovish monetary policy, it is likely that banks will need to strategically find places to place their deposits. Do they want to invest in long term fixed rate loans or securities? Not necessary. All other things being equal, banks would like to take quality loans.

So where can banks find safe platforms for lending products? It is difficult to rely on historical cash amounts and earn as little as zero to 10 basis points when the value of funds in the industry typically exceeds that profit by sufficient margin. If a bank wants to grow, where will it come from? Do you regulate rates and risks, limits and product range? We believe the answer lies in the syndicated loan market to secure C&I loans. It is a major capital market, a well-established asset class, active and growing.

However, before a large or small regional bank makes a leap, it must answer some questions. Among them: Is your growth and asset structure, especially loan types and concentration, in line with your investment policy? Are there investment opportunities in your market and are they available within your service area?

Preemptive Loans Defined

Typically, these borrowers are national or large regional companies, and the loans are substantial – in the form of national syndicated loans that help finance the big deals like corporate takeovers and mergers that you see in the financial press. The market is bustling. In fact, in the first quarter of 2021, sales in this category were at a record.

Large borrowers have some inherent advantages over smaller borrowers, including operations spanning multiple economic regions, a large client base, deep supply chains, access to multiple public and private capital markets, and resilience during difficult times.

Loans are usually provided by the largest banks in the country. The sponsor or borrower is involved in the creation process and initiates a transaction with the agent bank. This bank structures the transaction and negotiates it, ultimately setting prices and timing, and then collects a syndicate from other banks and institutions to complete the transaction. Institutions that acquire a significant portion of the transaction include larger commercial banks, asset managers, and other institutional investors.

Usually all loans have floating rate and index spreads – historically this is the Libor rate, although this rate is in progress obsolete… Loans usually have a maturity of five to seven years, are fully or partially amortized and generally have strong, proven cash flows and attractive interest coverage ratios. Although many borrowers are more leveraged than their investment-grade counterparts, debt is usually secured by the first collateral on all assets.

Firms like Voya work directly with agent banks to consolidate all borrower data, such as agent information memoranda, as well as third party industry data, borrower data, and economic data. Voya analysts are re-underwriting transactions in accordance with banking standards for their client banks. The institutions that receive these loans also review and re-guarantee them according to their own standards – which means there are many analysts involved in each particular transaction going through the structure. In addition, rating agencies review and evaluate these transactions. Regulators verify transactions during Shared National Credits exams.

Result? It is rare to see a poorly structured or managed transaction, but there is a clear spectrum of risks from low to high in the industry. Within this spectrum, there is a clear and large volume of loans that meet “bank requirements” across the entire market. While the rare case of black swans does occur, even when looking at how these transactions have fared over the past 15 months compared to the regional mid-market portfolio, this market remains a good place to influence C&I.

Another advantage? Once the primary transaction is closed, these loans are traded in a very active and deep secondary market – banks can get a loan from one of the syndicating banks, or the institution can refuse a loan that was previously received. In other words, there is always a liquidity outlet.

To be fair, it should be noted that if the focus is on the loan, then the sale price will be market, not nominal. But if a bank applies best practices and tries to get rid of credit at the first sign of stress, there is a good chance it can sell at near par and avoid this potential problem. Compare this scenario to a loan that a bank received from another bank and now wants to sell. Almost the only option is to sell the loan back to the original bank, which may or may not want to.

Benefits for banks

Historically, these loans have performed well and have good returns, especially in this low interest rate market. When you look at these loans in terms of risk-adjusted returns, the syndicated portfolio compares well to a typical local C&I portfolio in a small market.

Secondly, it is an affordable way for credit growth. Traditionally, this asset class has been the prerogative of the large money center banks, and they have kept it to themselves. These banks, guided by volume and efficiency, would invite other banks that could take large and efficient positions on these loans and help the deal to complete the syndication smoothly. This is changing.

Instead of earning low yields on Treasuries or mortgage-backed securities, why not consider investment-like loans to complement or become the cornerstone of your commercial loan portfolio? The relative value and performance of this portfolio, coupled with liquidity and flexibility that banks simply do not have with a local C&I portfolio, make these products something that local banks should consider.

Randy Cameron and David Wood are co-managers of the Voya Investment Management Banking Advisory Group.

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