Tell 'em a hookah-smoking caterpillar has given you the call…
Go ask Alice, I think she'll know
When logic and proportion have fallen sloppy dead
And the white knight is talking backwards
And the red queen's off with her head
Remember what the dormouse said
Feed your head, feed your head
“White Rabbit,” Surrealistic Pillow, Jefferson Airplane 1967
In Lewis Carroll’s classic children’s story “Alice in Wonderland,” Alice follows a rabbit into its hole and ends up in a world where nothing makes sense. The 1960’s band Jefferson Airplane (later know as Jefferson Starship, and later just as Starship, rockin’ the keytar and big moustaches) also followed the mind-blowing “Alice In Wonderland” theme in their song “White Rabbit.” When I decided to write a blog about how interest rates are “built,” I had no idea that I would feel like I was walking around in Wonderland. It is a complicated world that makes the Mad Hatter seem like my sensible Uncle Donald. So, follow me down this rabbit hole of madness and pull me out if I get stuck.
A number of different factors determine the interest rate the bank charges the borrowers. There are two sources of funds for banks to relend – customer deposits and borrowing from the Fed Borrowing Window. The cost of the customer deposit is the interest rate the bank pays on your CDs. The cost of borrowing from the Fed is the Fed Funds Rate, which is the interest rate the Federal Reserve charges banks to borrow money. Right now the Fed Funds Rate is hovering between 0% (not a typo, 0%) and .25%. This means at this point in our history, banks can borrow money for free (or nearly free) from the Federal Reserve. On top of this base cost, lenders must include a rate to reflect micro-economic variables like competition and credit worthiness of the borrower (lower credit, higher rate), to arrive at an interest rate that is then offered to the borrower. Conventional loans are usually variable and are readjusted after 3 or 5 years. Though most are capped at the amount they can increase, these adjustable loans move up and down and do provide a little wiggle room in case a miscalculation was made.
Competitive factors are also reflected in interest rates. It is not uncommon for banks in highly competitive urban areas to have lower interest rate offerings than banks in less competitive rural areas. This is easy to explain since banks, theoretically, compete against each other for every loan. Rural areas have less competition and less demand, so their rates can be higher. This is especially true for conventional commercial loans where, unlike home mortgages, it is difficult to go online and search for loans for their business. Unlike mortgages, searching online for a commercial loan while sitting on your couch in your underwear with your best friend, a green puppet, is not practical or feasible. Most all commercial loans are made from local lenders and are, therefore, subject to competitive pressures.
Ok, whew…I am glad that’s over. Seem complicated? Yep… Understanding 504 interest rates has to be much easier, right? Ummmm…. If I say “Yes” will you keep reading?
The 504 loan is very different from other loans because of the way the capital to fund the borrower is raised. 504 loans are bundled together and sold “at market” as debentures, or bonds, to investors. Since these bonds have are fully guaranteed by the federal government, they are attractive to mutual fund managers, insurance companies, etc. that are looking for the next best thing to a T-bond. Because the funds are raised through the sale of long term bonds, the interest rate for 504 loans is fixed for 20 years.
So, let’s continue down the rabbit hole and build a 504 interest rate.
Here is the formula… Debenture Rate = treasury rate + spread over treasury rate
The 504 is based around the Treasury Rate, which is significantly different from the Fed Funds Rate used by conventional banks. The Treasury Rate is the interest rate on Treasury Notes that the United States Federal Government must offer to borrow money from lenders. Treasury Notes are marketable U.S. government debt security with a fixed interest rate and a maturity between one and ten years. The fixed interest rate mentioned in the previous sentence is the key piece to the puzzle.
The Selling Agent negotiates the spread over the treasury rate every month. The spread is the difference between the Treasury Note Rate and the rate a debenture buyer would accept as a premium to buy the bond. This bit of magic happens behind the curtain and we don’t need to understand any of it, happily. Once this Debenture Rate is set, the Fiscal Agent, Underwriters and Issuing Agent begin marketing and selling the securities on the market.
Once the debenture rate has been determined through this negotiation process, the Note Rate for the borrower is calculated by adding the debenture rate to the ongoing servicing fees (Central Servicing Agent fees for collecting and disbursing the funds and payments, SBA fees for a loss reserve and CDC fees for ongoing monitoring and servicing). The fees allow the program to pay for itself and the fees are paid by those that benefit from the program – an aspect that is very unusual in any sort of government financing or funding.
Because of the government fully guarantees the sales of the debentures that fund the SBA 504 loans, the spread over Treasury is the lowest of any other funding option, including FNMA, mortgages and Baa Corporate fundings. This allows the SBA 504 loan program to offer the lowest possible 20 year fixed interest rate to small businesses.
Done. Understood? The process is probably not as difficult to understand as I originally made it out to be. Still though, I think the next blog will focus on puppies and kitties.