There is a potential danger lurking in many of the loans that banks have on their books, and most directors probably can`t identify it. The problem isn`t credit risk. Nor is it some new legal peril emanating from Washington. This hidden threat can be found in something so innocuous that it rarely attracts anyone`s attention, and has very likely been overlooked by many senior managers as well. It is the market index used to reprice many of the loans that commercial and mortgage lenders makeâ€”and it may turn out to be a time bomb that could cost banks a bundle in lost income. It has long been the practice in banking to use an index based on U.S. Treasury bonds of varying maturities to reprice longer-term commercial real estate loans. Here`s how the process usually works. Let`s say a bank has made a term loan to a local business establishment, with an agreement that it will be repriced in five years. The repricing benchmark that the bank probably wrote into the loan contract was the five-year Constant Maturity Treasury index, which is the average yield of all actively traded five-year Treasury notes. When the loan is repriced, the bank will use the five-year CMT, plus a previously agreed upon spread to compensate it for the inherently higher risk of a commercial loan, to calculate a new rate. Because the CMT index was specified in the loan document, it will not be possible to replace it with a different index so long as that index is still available. But what happens if in five years the CMT index is no longer an appropriate repricing benchmark because a secular change in the capital markets has distorted its historical relationship with other indices? Or, to put a sharper point on it, what if the CMT index produces a new rate that is lower than it should be and that leads banks to undercharge some of their borrowers? And what if they have lots of loans in their portfolios with the same feature? One would probably say those banks, not to mention their boards of directors, are in big trouble. This is a serious problem that bank directors need to look into now. It is likely that few directorsâ€”or their chief executive officersâ€”are aware of this dilemma and its ramifications. Here is the underlying cause. The Office of Management and Budget estimates that at current projections, the nation`s budget surplus, combined with ongoing repurchases of Treasury bonds, could eliminate all publicly traded treasuries in 10 years. Some private economists have predicted that all outstanding treasuries could disappear even sooner than that. The irony here is that a scenario that would be extremely beneficial for the country could turn out to be bad news for many of its financial institutions. The Treasury yield curve has long been the benchmark of choice for loan repricing because it was always assumed that its yield would move in concert with other market rates, and there would always be a plentiful supply of notes and bonds available. Treasuries enjoy the added advantage of being free of the credit, liquidity, or tax issues that can effect the historical yield patterns of other securities. But with the government cutting back on its issuance of new bonds while also buying back outstanding issues, the law of supply and demand has already kicked in. Even though it may take 10 years to eliminate Treasuries altogether, one can already see that yields are diverging from other market rates. Picking one day at randomâ€”March 11, 1996â€”the spread between treasuries and U.S. agency bonds across a three-month to 30-year spectrum was never greater than 30 basis points, with treasuries yielding slightly lower. Look at the same chart exactly three years later and one clearly sees that spreads had widened considerablyâ€”to as much as 200 basis points, with treasuries yielding substantially less than agencies of the same maturity. Again, it`s the law of supply and demand at work. As the stock of outstanding treasuries diminishes, their demand goes upâ€”which drives down their yield since the federal government does not have to offer as high a rate to attract investor interest. The repricing dilemma is actually somewhat different for commercial and residential loans. While both tend to reprice off of the Treasury yield curve, the problem is more immediate for commercial loans. Term loans that have reset mechanisms, where the rate is recalculated at specified intervals, are still widely used throughout the industry. The initial rate is usually influenced by competitive conditions at the time, but the repricing is usually guided by the yield on Treasuries plus a spread. If projections of budget surpluses hold true, a bank that writes a term loan with a reset tied to a Treasury bond may find a few years later that the loan no longer approximates other assets of the same duration. This has already been happening with commercial loans that were written in the mid-1990s and have repriced within the last year. Many lenders have been forced to renew their commitments at what is essentially a spuriously low rate. The most obvious solution is to switch to a new index, which several financial institutions have done. But each alternative is less desirable than treasuries in some way, and this needs to be taken into consideration. The most likely alternatives include the interest rate curve for Federal Home Loan Bank advances; the U.S. dollar swap curve; the U.S. agency yield curve; yields on AAA-rated corporate securities; the prime rate; and the London Interbank Offered Rate, or LIBOR. When a bank chooses an alternative, it should keep in mind the importance of borrower acceptance. Many business owners, particularly if they`re running small companies, are going to be unfamiliar with some of these indices. Yields on Treasury bonds and notes of varying maturities are printed every day in the Wall Street Journal, which gives the borrowers the ability to track them on their own, thus bringing a degree of transparency to the process. The alternative index that most borrowers are probably familiar with is the prime rate, which is usually set at 300 basis points over the fed funds rate. But from the lender`s perspective, the prime rate is less desirable than a Treasury indexes because it can be influenced by national monetary policy in ways that treasuries cannot. If prime is used as the repricing benchmark, a bank wouldn`t want its commercial loans resetting just when the Federal Reserve is aggressively slashing rates to head off a recession. Moreover, prime is not a term rateâ€”it slides up and down depending on economic circumstances and, again, monetary policyâ€”and most commercial loans are written for a specific term. As much as possible, banks want to use an index with the same duration to the loan`s repricing interval. Of all the alternatives, the one most reflective of what`s occurring in other markets is the U.S. dollar swap curve, which is based on a AA credit rating and is largely exempt from the supply and demand pressures that can distort other indices. But it`s unlikely that many small-business or middle-market borrowers are familiar with it. The other alternatives are also lacking in one way or the other. The U.S. agency yield curve is based on a AAA credit rating and has the backing of the federal government, but it is subject to both supply and demand and political pressures. Moreover, there is an ongoing debate in Washington as to whether Fannie Mae and Freddie Mac should lose their federal guarantee, which would surely distort the historic yield patterns of their securities. The yields on AAA-rated corporate securities will vary from sector to sector over time, which reduces their effectiveness as a repricing index. And LIBOR, while it has come to replace prime as the base rate for many corporate loans, is still relatively unknown to most individuals and, like prime, is not a term rate. The best alternative may be the Home Loan Bank advance rate, since a growing number of banks are borrowing from the Federal Home Loan Bank System to fund their lending. The banking industry has a growing liquidity problem that will force many institutions to rely even more on Home Loan bank borrowings, and it makes sense to match loan rates with the cost of funds as much as possible. Two disadvantages of this index are that it`s not as well known as the prime rate and that different Home Loan banks post somewhat different advance rates, which can confuse borrowers. What should a bank do about this pricing index dilemma? First, board should have a serious discussion about whether to continue using a Treasury index as the reset mechanism in their term commercial loans. The best alternative, it appears, is to use the five-year Federal Home Loan Bank advance rate for five-year term loans. Another option is to avoid the repricing issue altogether by offering only balloon loans, which pay off at the end of their term. This would allow the bank to renegotiate the loan`s price, along with its terms and conditions. But there are competitive issues that may force banks to continuing offering term loans to their best business customers. Most borrowers dislike balloons precisely because they do require them to renegotiate the entire loan, and if one bank offers another bank`s most valued customers the option of term loans, it may have little choice but to do likewise. It might also be possible to reduce all reset intervals to one year or, if the borrower insists on using a Treasury index, stating in the loan document that an additional spread will be built in to the reset price. This would give the bank some protection should the disconnection between the Treasury index and other market rates continue over time. The situation is somewhat different when it comes to residential mortgages, where the ramifications of losing Treasury bonds as a pricing index might take longer to manifest themselves. Most adjustable-rate mortgages are repriced off the one-year CMT index, which is the average yield of all actively traded Treasuries with one year of maturity remaining. This is the repricing benchmark used by both Fannie Mae and Freddie Mac for most of their one-to-four family conforming mortgages. The simplest solution is probably for banks to sell all of their conforming mortgages to either Fannie or Freddie. By keeping the loans out of their portfolios, they would avoid the reset problem altogether. But many banks prefer to keep their ARMs in portfolio because it`s generally a good earning asset, and here the situation become more difficult. It is possible to deviate from the one-year CMT index by writing five-year ARMs that included the higher of two reset mechanismsâ€”either the one-year CMT plus 275 basis points, or the FHLB advance rate plus 225 basis points. But these no longer qualify as conforming loans, which may restrict that bank`s ability to sell them later. Because they exert so much influence, the mortgage repricing issue won`t be sorted out until Fannie and Freddie change to a new index. When the U.S. Treasury eliminated its 52-week auction last year, this cut off the supply of new one-year T-bills. Fannieâ€”which says that only a small percentage of its $27 billion portfolio of ARMs used the one-year T-bill as a repricing mechanismâ€”switched to the one-year CMT Index instead for its outstanding ARMs. (Language inserted into most of its ARMs allowed it to make this change.) But over time, the growing divergence between the yields on Treasury bonds and other securities may force Fannie and Freddie to abandon the one-year CMT index altogether. If this resulted in a significant impairment in the value of those ARMs held in portfolioâ€”since this would be a tacit acknowledgment that these loans could no longer be repriced to a market rateâ€”the agencies might required to mark down the loans` market value and take a charge against their capital. Unfortunately, there are no easy solutions to the loan repricing dilemma. Indeed, it`s primarily an exercise in choosing the least objectionable alternative. But as a director, it`s crucial that you understand the problem and discuss it with your management team. A failure to do so could be an abrogation of your responsibilities as a member of the board.