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The Case for Booking Low-Margin Loans

Commercial bankers customarily work hard to protect margins on their loans. But in the current environment, is there a case to be made for booking deals even if it means giving on margin and coming in below return targets? We explore that question in this episode of The Purposeful Banker. 


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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 on the minds of today's best bankers. I'm your host, Jim Young, Director of Content, PrecisionLender. I'm joined again today by Dallas Wells, our EVP of Strategy.

In today's episode, we're going to be talking about an interesting LinkedIn article by Chris Nichols of SouthState Bank. It's titled, "Consider This Strategy Before You Turn Down Your Next Low Margin Loan." So Dallas, I'm just going to start this off with a spoiler. Chris essentially says book those loans.

So in this episode, I want to discuss sort of the merits of his arguments in a moment. But before we even get into that, basically this reflects, I think, from talking with Anna-Fay Lohn when we do those market updates, the conversation she's having with clients, as well as the data that we've been compiling, it seems like that basically commercial lenders are taking this approach. Margins are low, but that's not stopping them from booking loans.

Dallas Wells: Yeah, that's definitely the case, both statistically and anecdotally. So we see it across our data, we see it across the Fed data, we hear it in conversations with clients. We just recently had our client advisory board meeting, universally across that entire group finding loan growth was the number one issue for everyone. So, I think generally the industry feels both good about where we are in the credit cycle and that there's plenty of liquidity to be lent out and they're willing to, which is kind of what we'll get into, but they're willing to take a little less to make that happen. So, absolutely the case.

I think Chris' logic, and this is a good article, but the way he lays it out is essentially the same thought process that just about every bank is going through and kind of wrestling with are these exact issues.

Jim Young: I'll be honest with you, there's a part of this that makes me a little uneasy, and so I'll let you sort of talk me through it and let me know by the end whether I'm just being a little bit of a chicken little or whether there's some cause for potential concern, even if the arguments are all very sound. So let's talk about that first, which is one of Chris' arguments is that you want to book loans at the start of an economic cycle in the recovery growth stage.

Can you kind of spell out the thinking here, and also are we truly in a recovery? I ask that more from a maybe because of where we are with the unprecedent pandemic, do we feel confident now saying, yep, this is where things are and this is where they will progress from here?

Dallas Wells: Yeah, so this one has been strange, in that the timeframes were all really compressed, but if you look at kind of any measure of was there a recession? Yes. Are we in recovery mode? Yes. So, we are recovering and we're kind of in that growth stage. So in this article, Chris has the chart of the economic cycle and his argument is if you want to get aggressive somewhere, where do you want to do it?

So if we go back to the financial crisis, that's our model we always seem to go back to, but it's because it's in the rear view mirror, we can kind of chart the outcomes there. But even leading up to all of the bad real estate loans, early in that cycle, you're talking 2003, 2004, things were already getting, in hindsight you can see it, getting a little frothy and banks were relaxing standards and doing things that they hadn't been doing before. But early in the cycle, they were okay.

The ones that were dangerous were the 2006, 2007, even 2008 vintages of things, where it was like, okay, it was clear that we were past that growth stage and we were in, Chris's chart, kind of the slowdown phase where we were coming to a top there. Those bad decisions at the top are extremely painful, and that just doesn't appear to be the case of where we are. Again, by all the measures that we have of GDP growth and local economic expansions and activity and hiring, and all the metrics and gages are pointing to we're kind of in an early growth stage.

Banks have to play through the economic cycle and through the credit cycle, it's just the nature of the business. So if you're going to get aggressive, and I think by aggressive we just mean if you're going to grow, if you're going to push, this is the time to be a little looser with standards, rather than at the slowdown part or as you're heading into recession, those are the times to tighten the reins.

The logic is pretty simple. We still have some room to kind of grow through these and some time to kind of earn your way through even some skinny spreads. You want to win some business now early in the cycle. So all that logic is sound and is kind of banking fundamentals, really it's just that this is what it looks like playing out in real-time.

Jim Young: Gotcha, okay. So the next one I struggle with a little bit, where it basically says, and let me know if I'm oversimplifying it, but essentially says like, look, this is the trajectory. Margins are shrinking and excess liquidity is growing, so essentially book now while you still can, because if you don't like it now, you're going to like it even less in the future.

I guess my question though is, is that inevitable trajectory? Because, I mean, we just finished talking about the cycles, and I guess in theory if it's a cycle, at some point it would go the other direction. So, am I again oversimplifying this? Probably.

Dallas Wells: Well, again, I think the pandemic is what's made everyone a little jumpy, because what he's essentially saying here, there's more aspects of this that we'll get to later, but I think this point is really that this is the trendline and there is no clear indicator from where we sit today that this is going to change anytime soon. The reason we're all a little jumpy is because the pandemic was this strange thing that just showed up kind of out of the blue on our doorstep, and it changed all the trend lines abruptly.

There are economic shocks like that that happened, but really that's why banks hold the capital levels that they do is for those unexpected losses. They kind of expected through the cycles stuff, that's all part of the business model and you can kind of plan around. So basically if you're sitting and waiting and saying I want to wait for spreads to get better, I think the question here is, well, what are you waiting for? What do you see near-term around the corner that's going to cause this trend to change?

Because it's been like this for, remove the pandemic wonkiness, kind of that year-long timeframe, this was already the trend and now it's just picked up steam even. Since we did have the COVID shock to things and now we're in recovery mode, it was a lot more liquidity all of a sudden dumped into things, but the credit is back to being generally in pretty good shape. So everyone's lending into this, the trend is clear and there's no sign that there's a change in the near-term.

Jim Young: Okay. Next argument he had I felt like honestly was the most compelling one, and it's one that I know that, again, Anna-Fay and the discussion she's had with bankers is really one of the big ones they make for why they're doing some really thin margin loans. Which is I've got to put this money somewhere and I don't see anything better, in fact, I see a lot of things worse.

Dallas Wells: Yeah, so the alternatives are essentially 0% yields rounding, you're going to make nothing. That is in essence, to over simplify it, but I think it is the intention this is why the Fed does what they do with interest rate policy. You push to zero, because it does force people to take some risk and to spur some economic activity. Investors are yield seekers, and that's what banks are doing here, is they are trying to find a place to find some yield.

So if they could park it in Fed funds and make 4% there, that's where all the money would be sitting in Fed funds, and there would be no loans to businesses and no growth and economic activity being generated there. Banks will essentially, after all the costs and everything settle out, if you park it at the Fed, it earns nothing, banks will get a lot less choosy about where they invest that money. They will put it somewhere where it is generating new activity, it is helping a small business or a, I mean, heck a municipality, a large business. Wherever it's going, it's generating some sort of activity.

So this is the Fed inaction and kind of getting what they've asked for, which is even though they flood the system with liquidity, that's step one. Then step two is to actually get that liquidity, to get it in motion, right? To get it flowing through the economy, rather than just sitting at the Federal Reserve. So to get it flowing, they have to push banks to get outside their comfort zone a little bit and get that money into the economy. That's what's happening, and that's what bankers are feeling is that giant push from the Fed.

Jim Young: Yeah, I guess now you put it that way, it really does sort of feel ... I might be a little bit resentful. I mean, we talked about with PPP and everything, I mean, just an enormous amount of liquidity on it, and then, "Oh, by the way, we're going to completely cut off any other options you have." I mean, it does sort of feel a bit like a gun to the temple, doesn't it?

Dallas Wells: It does. It's lend it or else, and the or else is you're losing money. You're kind of bleeding capital if you don't do something with it.

Jim Young: Yeah. Also, again, we're kind of falling through some logical arguments, which is opportunity cost, right? That you can sit there, and even if you do really feel like, okay, I feel pretty confident this is going to flip, and then in a few months there's going to be something better out there than what I've got right now, there's still that cost of waiting at that point. I guess what Chris is essentially arguing is, is that that cost is too high.

Dallas Wells: Yeah, so this is a concept and a practice that banks do a really good job of in their investment portfolios. So in the portion of their asset book that is put into the bond market, they have these concepts of a breakeven yield. Which is as you're comparing different options, especially as you're expecting rates to someday be higher in the future, you have to make a decision of do I buy something now and kind of tie up that capital and forego the ability to benefit from those rising rates, or do I sit and wait? I'll wait until the perfect moment, and then as rates are rising, I'll kind of jump aboard at the right minute.

So they follow some rules and there's lots of math involved, and there's really good thought process around that. It's a little messier on the loan side of the book, because you're not just picking up your phone and calling a broker and saying, "Yeah, give me a slug of that thing right there that's out in the marketplace," and it settles out in two days. Instead, you have humans on the other end in a market and competition.

But the concepts are the same, and that's really what Chris lays out here, which is that I'll use round numbers, but if I can make a spread of 200 basis points today, and I say, "Well, I think maybe in the future I'll be able to make 250." Well, in the meantime, the opportunity cost is that 200 that you forego, and instead you're going to make zero, right? You're going to park it at the Fed and you're going to wait.

So if you just do the simple arithmetic on that, every day that you wait, you have to make more to make up for that opportunity cost, that time of dead earnings in between. Chris lays out the math on that, and it's pretty compelling, right? Every couple months that you wait, or in this case, by waiting what you're doing is saying, "I don't feel like booking this loan at that 200 basis point spread, because that's too skinny. I think if I wait around, I can find a better deal." Well, every day that you wait, now that deal has to be better and better and better. It kind of goes back to the first point, which is the trend line is clear, so it would take something pretty drastic for you to be able to make up that difference.

The example he lays out is wait two years for the cycle to kind of turn, you'd have to fund that future loan two years from now at 50 basis points more of margin. That goes against every long-term and short-term trend that we're seeing right now, and that is essentially why banks are holding their nose and jumping in right now and saying, "I don't like it. It's below where I built my entire financial plan for the year, but I have no choice, I have to book things at these levels."

Then that's a vicious cycle, where once everybody in the market's making that same decision, everybody's chasing those credit spreads down. That's, again, the nature of the cycle and it's because everybody's facing the same circumstances.

Jim Young: Yeah, and that gets to a little bit of my sort of chicken little thing of it's the little bit of a self-fulfilling prophecy, right? Of we've got to book these low margin loans, because they're going to be lower in the future, and they're going to be lower in the future because we're booking those low margin loans now.

Dallas Wells: Yeah.

Jim Young: One thing I should mote, that he put this sort of caveat in there, which was, again, this is premised on making enough margin to be compensated for the credit risk. So maybe that's my bigger chicken little part of this, is we just talked about going to the temple and the pressure of you got to get this money out there and get it working. Like you said, it's not a, "Hey, can you go ahead and get me 200 basis point spread loans at good risk rating. Thank you, I'll take 100 of those." Boom. You know what I mean? You've got, "Hey, I've got this, and then, well ..." I guess how much should we be concerned that it's not the low margin part of it, it's the low margin and maybe higher risk? Because again, there's so much push to get stuff out there.

Dallas Wells: Yeah, I think that's where some banks kind of get paralyzed by this, is they kind of try to lump everything together into one decision. To be effective with this, you really do have to break it into its component parts, and it's why banks view these pricing decisions on risk-adjusted terms. So, on a risk-adjusted basis.

What that means is that we're going to make an assessment of how much we think the potential credit cost for this is, and we're going to build that in, right? So we'll have to hold more capital for the riskier loan, and we will also provision more into our loan loss reserves for riskier loans. After that cost is accounted for, how much spread do we want to make above and beyond that?

So, that's where you kind of have to trust that you are making the right credit evaluation and that you are putting back the right amount in the provisions. If you trust in that, then you're making a credit spread above and beyond that. That's kind of a market-based decision, and that's really what we're talking about here, is after we've paid a little bit for the really safe loans or a lot for the riskier loans, once that credit cost has kind of been consumed, the spread I want to make above that, I'd love for it to be 280. I'm not going to get that, I'll shoot for 250. Now, what we're seeing is that the market's coming well inside of that.

For high potential relationships, basically where there's the ability to potentially cross-sell and grow that relationship, the spreads are well below 200 on deals like that. So if you feel like you're off in the credit evaluation, it kind of doesn't matter what the credit spread is. If you don't have that loan loss provision process to where you trust it, that's a whole separate thing. That's the kind of decision process that goes in, as you're in the recession, part of that cycle as you're coming down, that's when you're saying, "Okay, did we get all these right?"

In the meantime, we will kind of circle the wagons and make sure that the balance sheet is protected until we are confident that we have all the new updated inputs of what the economy looks like, what our businesses look like, what our industries that we have exposure to look like, and we kind of reevaluate that. But as you're booking them, you have to trust that that process is right.

Jim Young: Now I'm going to throw in one last question here off-script, so we may edit this one out later on. We'll see if it makes it off the cutting floor. But you're talking about, again, the cycle of it, and I'm thinking back to, oh, last year, as you mentioned, sort of the compressed cycle of where we were when it was, hey, we're really going to start to be really, really careful about what we're putting out there right now.

From, again, looking at Anna-Fay's market updates, they held the line on margin, it went up a little bit, but I guess what I'm saying is it feels like with these cycles, the period of when NIM should be rising, it rises a little bit. In the periods where NIM should be falling, it falls quite a bit. Which kind of gives the longer term eventually, you can't see this thing, but we're going downward on that. That's, I think, where I get sort of the chicken little thing of the logic all makes sense here, but it feels like the long-term trend is still eventually pushing towards too thin.

Dallas Wells: Yeah, that's why banks have had this multi-decade push around efficiency and why they're making the technology investments that they are. Yes, a lot of the technology stuff is customer-facing and meant to add convenience and all that stuff, but really what it boils down to is it's about efficiency. It's about being able to do more with kind of fewer head count or the same head count, right? We don't have to keep adding people as we grow the business.

That's because, you're exactly right, the long-term trend, and we're talking back to the 1930s when we first started having somewhat reliable data, the trend is margins lower over time. So there's the cyclical stuff if it goes up and down in the short-term, but long-term, it is lower. You referenced last year, and we did see this little mini super compressed cycle through last year, and essentially it was through the summer of '20, where really what banks were waiting for is, and when banks get tight with things, it's because they can't see what's really going on around them, right?

Things are changing, things are in flux, and so they need to stop and be able to evaluate which of our customers are credit-worthy and which ones are not. So, there was that period there over the summer where it was like, "Well, we don't know," right? Because there's these economic shutdowns, we don't know which businesses are going to be okay and which ones are in real trouble, and we had to wait and see kind of what the response from the government was. There was all this support through PPP and Main Street Lending and all the other various programs.

Once that settled out and bankers had, really it didn't take long, 60, 90 days to kind of get a feel for, there was a few industries that were clear trouble and still are, and most of the rest of them were okay. So then it's like, yes, the math has changed, the risk levels have adjusted a little bit, but at least we can understand them. Once we can understand them and measure them, that kind of goes back to that, well, now we know how much to provision, we know how much capital to hold. All the models now make sense, and we can go back to kind of doing our business of we pay ourselves for the risk and we try to make a little spread above that. It's that unknown time where things get wonky.

So right now, the picture's fairly clear, so everybody's using a pretty similar model. As we always say, there's nothing proprietary about this math, it's really about execution of generating new business, evaluating the risk, and then being smart and disciplined in how you price that risk. It's all about executing that same standard industry formula. Right, now everybody's model's kind of pointing the same direction. Hence the cycles, hence the tighter deals and hence the competition for every good loan that you want to make, all the models look at that and say the same thing, which is book the loan.

Jim Young: All righty, I like how you subtly pointed out that, "Hey Jim, you just picked up on a trend that's been there for 90 years."

Dallas Wells: Congrats.

Jim Young: I'm on it. All right. But yeah, it's good to know. It's an interesting thing, because I think sometimes the knee-jerk reaction is, is low margin bad, right? You know what I mean?

Dallas Wells: Yeah.

Jim Young: But again, as Chris points out in this and as we kind of discussed, that there's a logic to it as long as you're following it, again, as part of ... understand why you're doing it and how you want to do it is the most important thing.

Dallas Wells: Yeah, it's one of those things where nobody loves it, but it's the right decision. That's kind of what it comes down to is, is for right now is the right call? Again, it's just about being disciplined, and if it takes spreads of 190 to win deals, book them at 190, not 160, right? That's where banks get themselves in trouble, is where they get sloppy in this evaluation and they get panicked a little bit in this evaluation.

Dallas Wells: So you still need to have your line in the sand and you still need to have some accountability around those lines that you draw, it's just that the lines are moving and they're trending down. All that's okay, again, as long as it's on purpose, as long as it's intentional and as long as you have kind of clean execution around where that tolerance level is.

Jim Young: Yep, yep. All right, well, that will do it for this week's show. Dallas, thanks again for coming on.

Dallas Wells: You bet, thanks Jim.

Jim Young: Thanks so much for listening, now for a few friendly reminders. One thing we referenced, Anna-Fay Lohn's market updates several times in this discussion. We've been doing this twice a month, we're going to kind of go to summer hours on this, so the next one will be coming out ... we'll do a review of June and really a review of the first half of the year that'll be coming out the first part of July. Makes for some nice 4th of July reading for you, so you can look for that next update then.

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