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What's happened to the prime rate?

Could 18% prime whack you and your customers in this lifetime?

The other day I read an article in The Wall Street Journal that told how William Zeckendorf, principal in the NY real estate development firm Webb and Knapp, in 1946 arranged the sale of his property on New York's East River to the United Nations. The story reminded me of Mr. Zeckendorf's fascinating autobiography Zeckendorf (1970). The tales of his wheeling and dealing--but also the instances of his vision and energy--were well told in his own words.

 

He was a chronically underfinanced developer who created both enormous risks and opportunities in his projects in how they were financed. One day in the 1960s when the prime rate was at that moment 6% someone asked him, "Mr. Zeckendorf, why do you borrow money at 18%?" 

 

Without batting an eye, the magnate answered:

 

"I'd rather be alive at 18 than dead at prime." 

 

This is an example, I suppose, of "pricing for risk."

 

Remember the prime rate?

This brief rumination on Bill Zeckendorf's career brought me back to the point of wondering what has become of the prime rate. I never hear it talked about any more and I actually was not sure I could correctly quote the current "WSJ prime rate." 

 

My memory was quickly refreshed by a Google search and I noted that it continues to languish--as it has for a very long time--at 3.25%. I wonder, though, if it still has much relevance in the world of finance and corporate lending?

 

Many lending contracts provide for a reference to the prime rate--but who actually qualifies for prime anymore?  Do corporations actually borrow today at the prime rate? I wondered.

 

A couple of brief inquiries to active practitioners brought me reassurances that the prime rate is still alive. While small business borrowers seem reconciled to paying a premium over prime for many deals, the folks in private banking want to know how much under prime their deals will command.

 

(If that's not exactly upside down from the way I learned things I don't know what is.)

 

When the prime was a prime topic

When I was a "hot shot" young lender many years ago, everyone talked about the prime rate.

 

My smaller borrowing customers used to lament "Everybody talks about prime but no one offers it to me." 

 

My bigger customers often qualified for prime, given the size and quality of the customer base of The Bank of New York, and later, at the big flagship bank of Southeast Banking Corp. in Miami. So I've had plenty of experience in explaining the arcana of loan pricing using prime as a reference point. It's not necessarily easy to do, as the customers understood what the banks were doing, my own and everyone else's. The customers played dumb and seemed to enjoy my discomfort during these discussions.

 

Where did prime come from?

The history of the prime rate has interesting parallels to today. In the early 1930s, bank loan demand had virtually dried up as a result of the Great Depression that had taken hold of the country following the stock market collapse of 1929.

 

The establishment of the prime rate was actually a successful effort by large banks of the day to put a "floor" under the borrowing rate. The floor gave the lenders a benefit by assuring them of some predictability in their net interest margins. As the practice caught hold, gradually a system of "pricing for risk" grew up, with borrowing rates scaling up from prime to multiples over prime.

 

Borrowers qualifying for prime rate found that to be a source of considerable pride and so it was both a point of economic importance and a source of bragging rights.

 

As price competition intensified among commercial banks in more recent years, adaptations on the idea developed.

 

Terms like "small business prime" or "business borrowing reference rate" sprang up into common usage. Mostly these were an effort to enhance pricing by lenders and to differentiate smaller borrowers from larger ones.

 

To a degree, this made sense as servicing costs of large credits tended to be less labor intensive on a dollar of principal basis, at least in my own experience as a commercial lender.

 

Will history repeat itself?

But, as I think about today's environment, I'm impressed at how we seem to have come full circle. Today community and regional banks are struggling to maintain net interest margins and even where loan demand is beginning to strengthen, the competition among banks to build earning assets has never seemed more intense in the many years since I first went to work for The Bank of New York.

 

I wonder how this cycle will end.

 

Will we have an orderly transition to higher rates driven by legitimate demand for business credit? 

 

Or will the forces of inflation somehow undermine our best efforts and bring a return to the environment remembered not very fondly by those of us active in lending at the end of the 1970s?

 

The operative term for describing those days is "stagflation," a combination of a stagnant economic environment (characterized by very low growth) and a relentless inflation of an annual 3% and 4% and occasionally more for some industries.

 

The Federal Reserve Board took the prime rate to 18% back then to break the back of inflation. Can those circumstances repeat themselves?

 

Preparing for a potential rerun

How do we prepare ourselves for that sort of a potential outcome in the next year or two?  It's scant comfort to simply think that if rates spike up due to inflation as opposed to improved loan demand, we'll have more problems to deal with than merely managing our net interest margins over the next rate cycle.

 

This is the subject for a future column and the answer lies to some degree in pricing for risk.

 

That's a discipline not regularly practiced these days, judging by the stories I hear from bankers of how some relatively long duration loan paper is finding its way into loan portfolios at remarkably low rates.

 

This could be a serious problem for our industry and it's time we started thinking about how to avoid the worst mistakes that history suggests can repeat themselves.

Ed O’Leary

Veteran lender and workout expert Ed O'Leary spent more than 40 years in bank commercial credit and related functions, working with both major banks as well as community banking institutions. He earned his workout spurs in the dark days of the 1980s and early 1990s in both oil patch and commercial real estate lending. O'Leary began his banking career at The Bank of New York in 1964, and worked at banks in Florida, Texas, Oklahoma, and New Mexico. He served as a faculty member and thesis advisor at ABA's Stonier Graduate School of Banking for more than two decades, and served as long as a faculty member for ABA's undergraduate and graduate commercial lending schools. Today he works as a consultant and expert witness, and serves as instructor for ABA e-learning courses and has been a frequent speaker in ABA's Bank Director Telephone Briefing series. You can e-mail him at etoleary@att.net. O'Leary's website can be found at www.etoleary.com.

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