Subprime Time

In some cases, banks are declining to renew loans for borrowers who are in default, who have made frequent late payments, or who the bank deems too risky. “They’re getting out while they can, before circumstances change,” Turnquist says.

Banks consider other factors, of course, but the rates they charge borrowers are largely determined by price they themselves pay for capital.

For banks—often large ones—that generate capital by securitizing and reselling mortgages, the cost of capital has gone up significantly. “Large banks have put too much inventory, in the form of large credit transactions, on their balance sheets,” says Brad Huckle, president of the North American Banking Company in Roseville. They anticipated reselling those loans on Wall Street to hedge funds and other investors. “But because of the fallout from the subprime market, investors don’t want to buy these types of transactions, or they’ll buy them, but at a discount,” Huckle says. “The capacity those banks once had to book new loans starts to get exhausted. When they look at new transactions when they have a pretty full loan inventory, they will charge higher rates for the remaining capacity they have available.”

That’s already begun to happen, says David Austin, president of MFG Mortgage Services, LLC, a commercial mortgage broker and originator in Minneapolis. “Historically, commercial banking pricing is based on an index plus a margin, and those margins were pretty stable,” he says. “Now, the indexes have gone down, but the margins have increased.” As a result, the cost of a new or refinanced commercial mortgage on a downtown Minneapolis office building has gone up, moving from around 130 basis points more than the ten-year Treasury bill for a ten-year, fixed-rate loan with thirty-year amortization before August 2007, to 180 to 200 basis points more than the ten-year Treasury rate for the same loan now.

Other banks, primarily small ones, don’t securitize their mortgages. Instead, they loan deposited funds and keep the loans on their books—a model that gives them an advantage over lenders who get funding from the financial markets, Austin says. Because the interest rates paid on deposits haven’t spiked, these banks haven’t seen a sharp increase in their cost of capital—so they’re still able to issue competitively priced loans.

“Banks that aren’t depending on pooling and securitizing to Wall Street and investors aren’t as affected by what’s going on with Wall Street—we’re doing business on Main Street,” Huckle says. “Local banks are subject to local conditions.”

In addition to raising money through mortgage-backed securities and deposits, banks also commonly borrow from each other. The U.S. interbank loan rate typically tracks closely to the Fed Funds rate, with the difference between them known as the TED (or T-Bills and eurodollars) spread. The TED spread is currently near a 20-year high, Huckle says, meaning that banks are charging each other relatively high rates. Those rates get passed on to their customers.

Countering that upward rate pressure, the Federal Reserve lowered the benchmark Fed Funds rate by a surprise fifty basis points in September and another 25 in November, leaving a benchmark U.S. interest rate at 4.5 percent. That move will tend to lower the cost of funds—and it’s hard to know which trend will ultimately most affect business borrowers.