In the immortal words of Alec Baldwin’s Blake from Glengarry Glenn Ross, “coffee is for closers, only.” Have you given your lenders the tools to be closers, or are you incentivizing them to continually lower your margins?
The Wrong Way to Use a Model
In most banks, mentioning the words “pricing model” will get you some sideways glances. Pricing models, or really models of any kind, are associated with all kinds of negative connotations, and rightfully so in many cases. Lenders are especially skeptical of pricing models, and that is almost always due to the way in which the models are implemented.
In most banks, the end users of the model are given very little autonomy over structure. Instead, lenders are asked to use a predefined set of “canned structures” that have been created by the powers that be. Any structures outside of that norm require approval, and the lender loses all control of the negotiation process. They are now relegated to the classic used car salesman routine, where they have to take deals back to the manager to see if they can be approved. The result is that lenders stick to the canned structures, meaning that there is only one variable to be negotiated, which is rate.
When the only tool you have is a hammer, everything looks like a nail. In this case, the only tool a lender has to win a deal is a lower rate. This relegates the pricing model to simply another piece of software in which to enter my deal terms, and my incentive is to give my borrower the lowest possible rate that still clears my hurdle. Sound familiar? And when every bank in town plays this same game, you can guess at what happens to net interest margins.
Ford’s Cautionary Tale
This predicament reminds of the travails of Ford Motor Company in its earlier days. When Ford adopted the moving assembly line, they revolutionized the auto industry, and in the process became one of the world’s most iconic companies. With the production time of each Model T cut from 12 hours to 2, Ford was able to crank out massive amounts of high quality vehicles at a fraction of the previous cost.
By 1920, half of all automobiles on the road in the United States were Model T Fords. However, Ford focused on efficiency at the exclusion of everything else. One of Henry Ford’s most famous quotes sums up the philosophy: “Any customer can have their car painted any color that he wants, so long as it’s black.” You see, offering multiple colors would slow down production time and add incremental cost. Black just happened to be the color that dried fastest. Ford’s only response to the competition was a lower price; their strategy had been reduced to a single variable.
As the industry matured, Ford’s competitors began offering customers far more choices, including luxuries such as multi-speed transmissions, 4-wheel brakes, and yes, colors other than black. By 1927, Ford had fallen back to the competition, and decided to finally retire the Model T. All of their factories were shut down for months in order to retool for the Model A, at an estimated cost of $250 million (that is over $3.3 billion adjusted for inflation). While their plants were idle, both General Motors and Dodge surpassed Ford in market share. They nearly went out of business in the 1930s, and in fact were not meaningfully profitable again until ramping up production for World War II.
Pricing Models as Sales Tools
So, how do banks avoid the same fate? The answer lies in changing the way that we use our pricing models. Pricing models should not be used as another way for us to hold our lenders’ hands and make sure they color inside the lines. Instead, we should use them as sales tools that enable our lenders to be trusted advisors and business partners to our borrowers. That is, after all, what most banks promise their customers. What if instead of just beating a competitor’s rate, we could adjust the structure in order to create a custom deal that works for both the borrower and the bank? For example:
- Use the slope of the yield curve to your advantage. Your borrower comes in looking for a 60 month fixed rate with a 240 month amortization. Can we beat the rate by offering a 53 month loan with a 240 month amortization? Does your borrower care about that 7 month difference that is 4 years away? Probably not, but the bank certainly cares given how much cheaper that funding will be.
- Will a variable structure work if the rate is lower? Perhaps instead of a 10 year fixed rate deal, we can fix it for 5 years and then have it adjust annually over CMT with caps. If our borrower is just seeking payment certainty on the front end of the deal, and is less concerned about the back end (when the balance will be lower), we might be able to offer a significantly lower rate while still generating a better risk adjusted ROE for the bank.
- Can we alter the collateral or guarantees? Maybe rate is important to our borrower, but not quite as important as the fact that the other bank is requiring their father-in-law to guarantee a portion of the loan. Or perhaps we can minimize the risk by adding a small amount of cash as collateral, allowing us to reduce the rate while still generating the required ROE.
The important thing to remember is that pricing models are just tools. A well designed model should allow our lenders to easily quantify the impact of various deal components. With this information in hand, they can craft a customized solution that both works for the borrower and allows the bank to meet its defined ROE targets. Give your lenders the proper tools, and turn them into closers. They will appreciate the coffee that comes with it.