Mitigating Commercial Lending Rate Reset Risk Through Hedging

Today’s elevated interest rate environment is challenging banks with managing their interest rate risk while meeting the needs of their customers, especially commercial borrowers. With interest rates constantly fluctuating, navigating these complexities to stay competitive and protect relationships may seem difficult. But combining loan hedging and forward rate lock (FRL) strategies can allow banks to mitigate rate-reset risk, protect against unexpected rate fluctuations and stabilize debt expense for their borrowers.

A forward rate lock is an agreement between a borrower and a bank to set a fixed rate for future financing. The FRL eliminates the risk of the borrower’s rate changing before financing begins, while incorporating a forward rate hedge preserves the bank’s loan pricing spread. Banks use FRLs most often to fix rates on permanent financing following construction and to fix future rates on existing resettable loans, which span up to 36 months or longer into the future. These strategies, often called “swaps,” are particularly useful when the yield curve is inverted or when rates have risen — both of which conditions currently exist.

The Federal Reserve has expressed a commitment to continue its tight monetary policy until inflation declines to its 2% target. Fed Governors have stated that rates will likely be higher for longer. However, bond market activity implies that the Fed will deviate from its current policy path sooner rather than later. This current disconnect between the bond market and Fed projections is reflected in an inverted yield curve, where short-term rates for floating rate loans are higher than fixed rates for mid- to longer-term structures. The market is ripe for lenders and borrowers to take advantage of this irregular trend. Here are three primary benefits of FRLs for both borrowers and banks:

1. Eliminating future rate uncertainty. Banks typically mitigate interest rate risk stemming from longer-term loans by adjusting the fixed rate every 5 years. However, with rates rising by 500 basis points in the last 16 months, these resets pose significant credit risk for the bank and market risk for the borrower. A FRL allows the borrower to set their rate today, but it’s not effective until the loan’s repricing date. This solution gives the borrower time to prepare for the higher debt service through cutting costs or increasing rents. Regulators will appreciate banks having a strategy in place to manage their reset risk.

2. Protecting banks and borrowers from credit stress due to higher reset rates. Although most banks stress test their loan portfolios, the magnitude of rate hikes over the last year means that some loans may be approaching debt service covenant limits or will at least create credit stress for both the bank and the borrower. Fixing the rate with an FRL before rates increase further helps the bank reduce credit stress for customers and itself. Regardless of what happens to rates in the next 12 to 24 months, borrowers are guaranteed a fixed rate they can budget around.

3. Preventing net interest margin (NIM) compression. In recent years, when interest rates were low, cost of funds didn’t become a significant issue for banks. This time, as rates have risen rapidly and higher than expected, banks are increasing the rates on their deposits to remain competitive. The substantially higher cost of funds has compressed NIM. Without hedging, banks have to wait for the reset period (e.g. a 5-year reset on a 10-year term loan) to reprice their loans, while paying higher rates on their deposits in the meantime. An FRL can help reduce that risk by essentially converting conventional loans that reprice at longer intervals to loans that reset every month, effective at their next reset. As rates go up, deposit costs increase, but they are matched by rising interest income on the loan — with the borrower still benefiting from the fixed rate.

Mitigating rate-reset risk is crucial for lenders in today’s financial landscape. Implementing the right commercial hedging strategy and utilizing forward rate locks can safeguard a bank and its borrowers from the impact of interest rate fluctuations. These solutions provide borrowers with stability and lenders with risk mitigation, ensuring long-term success and financial well-being.

Safeguarding Credit Portfolios in Today’s Uncertain Economic Landscape

Rising interest rates are impacting borrowers across the nation. The Federal Open Market Committee decided to raise the federal funds rate by 75 basis points in its June, July and September meetings, the largest increases in three decades. Additional increases are expected to come later this year in an attempt to slow demand.

These market conditions present significant potential challenges for community institutions and their commercial borrowers. To weather themselves against the looming storm, community bankers should take proactive steps to safeguard their portfolios and support their borrowers before issues arise.

During uncertain market conditions, it’s even more critical for banks to keep a close pulse on borrower relationships. Begin monitoring loans that may be at risk; this includes loans in construction, upcoming renewals, loans without annual caps on rate increases and past due loans. Initiating more frequent check-ins to evaluate each borrower’s unique situation and anticipated trajectory can go a long way.

Increased monitoring and borrower communication can be strenuous on lenders who are already stretched thin; strategically using technology can help ease this burden. Consider leveraging relationship aggregation tools that can provide more transparency into borrower relationships, or workflow tools that can send automatic reminders of which borrower to check in with and when. Banks can also use automated systems to conduct annual reviews of customers whose loans are at risk. Technology can support lenders by organizing borrower information and making it more accessible. This allows lenders to be more proactive and better support borrowers who are struggling.

Technology is also a valuable tool once loans is classified as special assets. Many banks still use manual, paper-based processes to accomplish time consuming tasks like running queries, filling out spreadsheets and writing monthly narratives.

While necessary for managing special assets, these processes can be cumbersome, inefficient and prone to error even during the best of times — let alone during a potential downturn, a period with little room for error. Banks can use technology to implement workflows that leverage reliable data and automate processes based directly on metrics, policies and configurations to help make downgraded loan management more efficient and accurate.

Fluctuating economic conditions can impact a borrower’s ability to maintain solid credit quality. Every institution has their own criteria for determining what classifies a loan as a special asset, like risk ratings, dollar amounts, days past due and accrual versus nonaccrual. Executives should make time to carefully consider evaluating their current criteria and determine if these rules should be modified to catch red flags sooner. Early action can make a world of difference.

Community banks have long been known for their dependability; in today’s uncertain economic landscape, customers will look to them for support more than ever. Through strategically leveraging technology to make processes more accurate and prioritizing the management of special assets, banks can keep a closer pulse on borrowers’ loans and remain resilient during tough times. While bankers can’t stop a recession, they can better insulate themselves and their customers against one.

How to Find the Right Title Service Provider

In a highly competitive market, bank title service providers can have a tangible impact on business outcomes. Below are several considerations for selecting a title provider who can help institutions navigate today’s challenging market.

It’s important to know that the title provider your bank selects remains consistent, whether the market is up or down. Decades of experience, minimal claims and strong financial backing all contribute to the stability of a settlement service provider. “There’s an element of risk lenders can avoid by working with a title partner that has a history of producing instant title with minimal claims. How long have they been doing it?” says Jim Gladden, senior vice president of origination strategy at ServiceLink. “What does their track record look like?”

Each file matters. After all, a home is likely your borrower’s biggest investment; making sure a purchase, refinance or home equity transaction goes smoothly is critical. For that reason, it’s important to ensure that title service providers take the unique needs of the bank’s team and borrowers into account, and prioritizes each transaction.

One way to do that is to work with a firm that dedicates individuals to working with the same lenders and loan officers, so they can understand the unique expectations each of them has, according to Kristy Folino, senior vice president of origination services at ServiceLink.

Prioritizing the Borrower Experience
The real estate lending industry is increasingly competitive; attracting and retaining borrowers is critical. Investigate how different title providers think about your borrowers, and whether their service ethos and technology prioritize the borrower throughout the transaction.

Check out the 2022 ServiceLink State of Homebuying Report to learn more about today’s borrowers. Dave Steinmetz, president of origination services at ServiceLink, says the study suggests a growing number of buyers embrace technology.

“Many are open to new pathways to achieve homeownership. This indicates there is an opportunity for lenders to provide more targeted resources and guidance to buyers throughout their home buying journey.”

Operational Efficiency
In leaner times, banks need to maximize margins on each transaction. Consider where your title service provider has automated their processes, and how that shows up in your bottom line. For example, instant title technology speeds decisioning and enables shorter rate lock periods by quickly clearing the way to the closing table. In fact, many lenders are surprised at how many of their loans qualify for fast-tracking through the instant title process.

Integrating technology and approaches like instant title into your processes could allow you to improve your workflows. Using instant title complexity decisions can help prioritize clear-to-close files, getting them to the closing table faster.

In the past few years, the mortgage industry has seen how quickly volumes can change. In this volatile environment, it’s critical to partner with settlement service providers who can flex up or down with their financial institution partner as the market necessitates. The size of a provider’s signing agent panel impacts their scalability — as does their ability to allocate vendors to your operations at critical times, like month’s end.

Geographic Footprint
Being able to use one provider for transactions in all 50 states can simplify bank operations. Partnering with a title service provider with national scope ensures that a bank and its borrowers have a consistent experience, wherever they’re located. Gladden pointed out that national coverage is especially important for lenders with portfolios that are geographically diverse.

Strict adherence to local, state and federal guidelines is critical to ensuring compliant transactions. Security around data must be airtight to protect lenders and their customers from potential breaches or other security incidents.

“Each title provider uses a platform that is aggregating both public and nonpublic consumer information. It’s important to know how that information is protected,” says Gladden.

Data quality
It’s important to look at the sources of title service providers’ data. While speed is essential, assurances from your title providers about data quality is paramount, particularly when it comes to instant title.

“The product is only as good as the data source, so the quality and depth of the data is the biggest factor to look out for. Instant title providers may all be racing toward the same goal, but the methodologies we’re using to get there — whether technologies, processes or the decisions we’re making — differ significantly,” says Sandeepa Sasimohan, vice president of title automation at ServiceLink.

Breadth of product offering
When you’re considering adding to your slate of providers, consider what value can be gained by onboarding a particular vendor. Banks that partner with organizations that offer a comprehensive suite of services — including uninsured and insured title products, flood and valuations — can benefit from increased efficiencies.

These considerations ladder up to one critical theme: partnership. Your title service provider should be a strategic ally who works alongside you to navigate market conditions.