Losing Good Loans to Larger Banks? Try an Interest Rate Swap

Many community banks are reluctant to consider interest rate swaps due to perceived complexity as well as accounting and regulatory burdens. But, in a record low interest rate environment, the most desirable customers almost universally demand something that is hard for community banks to deliver:  a long-term, fixed interest rate. Large banks are eager to accommodate this demand and usually do so by offering such a borrower an interest rate swap that, together with the loan facility, delivers the borrower a net long-term, fixed rate obligation and the lending bank a loan with an effective variable rate.  

The alternatives to using swaps are not appealing. A community bank can limit its product offerings to only variable rate loans or short-term, fixed rate loans and thereby lose many good customers to larger competitors. The bank can offer a long-term fixed rate on the loan and then (a) sell the loan and lose ongoing earnings and the customer relationship, or (b) borrow long-term funds from the Federal Home Loan Bank to match that asset with appropriate liabilities, a choice that significantly erodes profit on the loan and uses up precious wholesale liquidity.

If a community bank wants to compete using interest rate swaps, then there are three general methods for packaging an interest rate swap with a typical loan offered by a community bank. There are several regulations that apply to swaps, including changes to the Commodities Exchange Act enacted by the Dodd-Frank Act and the numerous related rules and regulations promulgated by the U.S. Commodity Futures Trading Commission (the CFTC).  If the community bank is under $10 billion in assets, then all three swap methods described below should qualify for an exemption from regulatory requirements that interest rate swaps be cleared through a derivatives exchange. Avoiding clearing requirements saves considerable costs and operational effort.

The first is a one-way swap in which a community bank simply makes a long term, fixed-rate loan to its borrower and then executes an interest rate swap with a swap dealer (such as a broker-dealer affiliate of a larger commercial bank) to hedge against rising interest rates. In a one-way swap, the community bank is subject to fair value hedge accounting, which requires the bank to mark the swap to market on its balance sheet and run changes in fair value through its income statement.

The second is a two-way swap, otherwise known as a back-to-back swap, in which the community bank makes a variable rate loan to its borrower and enters into an interest rate swap with the borrower that, together with the loan facility, delivers the borrower an effective fixed-rate obligation and the lending bank a loan with an effective variable rate. The bank then enters into an offsetting swap with a swap dealer. Even though the terms of the two swaps in a two-way swap may be identical economically, the two swaps can present quite different credit risks to the community bank and the bank may still have to, under accounting rules, track a significant variance between the two swaps.    

Both one-way and two-way swaps have some other disadvantages. Under the CFTC’s proposed margin (collateral) regulations , financial end-users of swaps such as community banks likely will have to post initial and variation collateral to secure obligations under swaps. In one-way and two-way swaps, the borrower and the community bank must maintain records that are complete, systematic, retrievable and include, among other things, all records demonstrating the bank qualified for an exception from swap clearing requirements. Also, in a two-way swap, the community bank must ensure that the swap is economically appropriate to reduce the borrower’s interest rate risk and fulfill the bank’s reporting obligations to swap clearing organizations.  

The third method is an outsourced swap product designed for community banks.  Under this model, the community bank makes a variable rate loan and the borrower signs a simplified swap-type agreement with the swap provider, which results in the bank receiving its preferred variable rate and the borrower paying a net fixed rate. This third method generally does not carry the disadvantages of the first two methods if the provider has properly designed the product.

Once your bank has decided which method or methods it wishes to use with interest rate swaps, the bank must supplement its policies and procedures (at least its interest rate risk, asset/liability and accounting policies) and train its board, management and applicable staff in several key areas. All of this requires careful study and execution, but it can be done.

Buying into trouble? Experts give their advice on FDIC acquisitions

Buying a failed bank can be a brutal experience. There may be opportunity to grow your bank, but there also is risk and hard work to do in a short amount of time. Plus, all that work can feel like a waste, if you lose the bid to buy. As the final post in a series on FDIC-assisted bank acquisitions, we’ve summarized advice for those considering such a deal from the final session of Bank Director’s May 2nd conference in Chicago:


Walt Moeling, partner in law firm Bryan Cave, says that bankers looking to do transactions “really need to focus on strategic planning in the big picture sense.”  Are you large enough to handle the acquisitions you want to do? If you double in size, how many people on your team have ever worked at a bank that size? “You can see banks struggling with the staffing issue two years out,’’ Moeling says. He also tells bankers to communicate regularly, or start networks, with other bankers who have done FDIC-assisted deals. If you run into a problem, they might have advice. Also, remember that communication isn’t great between all the different regulatory agencies. Don’t assume your regulator knows what the FDIC knows, and vice versa.

Jeffrey Brand, principal and an investment banker at Keefe, Bruyette & Woods, says figure out what the costs of bidding for a bank will be, emotionally and financially, and develop a team with clear responsibilities. “It’s a very intense, two-week period,’’ he says. “You get very invested in the process. You might not win (the bid), and you need to be prepared if the wind comes out of the bag.”

Rick Bennett, a partner at accounting firm PricewaterhouseCoopers, tells bankers that FDIC-assisted deals continue to be highly accretive to bank balance sheets. The more acquisitions a bank makes, the easier the process becomes. But some bankers underestimate the amount of people and resources needed to acquire failed banks. “Ask yourself, if I am successful, what does that mean for me from a resource perspective as well?” he says.

With few growth opportunities, Ameris Bancorp went on a shopping spree

Ameris Bancorp sits squarely in ground zero for the bank financial crisis: Georgia. But unlike its peers getting gobbled up by the FDIC and competitors, Ameris Bancorp is growing after buying six of its weakened peers since the fall of 2009, taking branches and market share in Georgia and Florida.

The Moultrie-based bank has gone from having $2.4 billion in assets at the end of 2008 to $2.97 billion in the first quarter, essentially driven by acquisitions of failed banks in the region at a time when traditional banking had come to a standstill.

“We couldn’t find any good customers to grow the balance sheet,’’ said Dennis Zember, executive vice president and chief financial officer of Ameris, at a Bank Director conference May 2nd in Chicago.

ameris-fdic.jpg Left: Jeff Schmid; Right: Dennis Zember

With the acquisitions, the bank took $1 billion in assets at fair value and $52.4 million of bargain purchase gains, essentially the value of the assets beyond what was paid for.

The FDIC took 80 percent of the losses for each failed bank, while Ameris is responsible for disposing of the bad assets over time.

It hasn’t been a cake walk.

In one instance, the FDIC allowed only five Ameris bankers two and a half days to walk into a failing bank’s branches and assess what they were buying before the sale. One Ameris banker wrote down the addresses for every piece of real estate on the loan books and emailed them to colleagues so they could drive around and look at them.

Other bankers have had unwelcome surprises.

One of the clients of attorney Jim McAlpin of Bryan Cave bought a failed bank, but found out after the closing that half of the drive-through teller infrastructure and half of the parking lot had been sold by the bank in a last ditch effort to raise capital.

The FDIC will tell you what it knows about the bad bank, but it doesn’t know everything, he said.

Jeff Schmid, the chairman and chief executive officer of Mutual of Omaha Bank, which has become a $5 billion bank in five years after buying failed banks, said a lot of banks aren’t worth buying, but his bank still looks at every institution that comes up for sale. Many banks have little value because they’re only a few years old and funded real estate loans almost exclusively through brokered deposits, so do not have a sustainable deposit gathering franchise.

He urged bankers to be strategic in their acquisitions, identifying what they wanted and where to grow, before jumping after every failed bank that comes up for sale.

“You’ve got to decide where you want to go rather than fall in love with something that falls out on a sheet,” he said.

Schmid suggested doing research before banks end up on the FDIC’s for-sale list, finding out which banks have high Texas ratios, a sign of stress, in the regions where you want to grow. Then, go visit the executives.

“They’re worn out and their boards are worn out,’’ he said. “If a (traditional) sale doesn’t go forward, you’ll have so much more intelligence when the FDIC does put it on their list.”

Profit outlook for 2013: Still hobbled

Size and location will matter

What’s the outlook for community banks for the next few years? Well, not so great. That’s the view of about 30 investment bankers, equity analysts and consultants surveyed by Atlanta attorneys Jim McAlpin and Walt Moeling of Bryan Cave recently.

McAlpin said he was struck by how similar the respondents viewed the future for banking.
Community banks in particular have the worst prospects for profitability, in part because a lot of them relied too heavily on commercial real estate lending. Plus, bigger banks have more diversified income sources.


“We do have some community banks that are doing very well,’’ said McAlpin. “The challenge has been the significant increase in community banks in large urban areas, where it is more difficult to compete. We believe there is going to be opportunity in suburban and rural areas (instead).”

In fact, the consistent view of the industry analysts was that banks with less than $500 million in assets will have a tough time competing anywhere outside a rural area.

“Size and scale will increasingly matter in the world of community banks,’’ the attorneys wrote in their survey summary.

The expectations for profits are more dismal the smaller the bank. The survey respondents on average expect 2013 returns on assets to be:

  • For banks under $500 million in assets: .50 to .85 percent.
  • For banks between $500 million and $1 billion in assets: .7 percent to 1 percent.
  • For banks between $1 billion and $10 billion: 1 percent to 1.25 percent.
  • For banks above $10 billion in assets: 1.25 percent to 1.3 percent.

Industry analysts also expect mergers and acquisition pricing to stay lower for years to come.

“1.5 (times) book will be the new 2.5 (times) book value of a few years ago,” Peyton Green of Sterne Agee wrote in response to the survey.

Nobody expects huge rebounds in earnings and growth, so there’s not much premium buyers will be willing to pay, analysts said.

What was the prediction for pricing in 2013?

  • Banks with less than $500 million in assets: lucky to get book value.
  • Banks with between $500 million and $1 billion in assets: 1.25 times book.
  • Banks with between $ 1 billion and $10 billion in assets: 1.25 times book to 1.5 times book.

Because of the lack of organic growth opportunities in a slow economy, bankers will focus on profitability and cutting expenses, some industry observers said. Core deposits will be significant drivers of value, the attorneys said.

“There will continue to be consolidation but viable communities will always recognize the need for a ‘local’ bank,’” the report said.

For more information, you can read the final report provided by Bryan Cave.