Hobson’s Choice: A Definition from Merriam Webster Dictionary

Etymology: Thomas Hobson died 1631 English liveryman, who required every customer to take the horse nearest the door, or take none at all
1 : an apparently free choice when there is no real alternative
2 : the necessity of accepting one of two or more equally objectionable alternatives

You’ve been there before. It’s 5:00 on a Friday afternoon. Your top-producing loan officer has some good news and bad news. A longstanding “A” credit, the owner of several fully occupied commercial buildings, would like to refinance his portfolio with a new, five-year, fixed-rate facility. Now for the bad news: The borrower has been approached by your arch-rival who is offering a competitive structure that does not require the insertion of prepayment language. That is to say, the borrower would retain the right to prepay the loan at any time.

As you ponder the consequences of losing this lucrative customer, you face a tough choice. Should you accept the loan and live with the ill effects of a prepayment should rates decline? If so, you may find yourself saddled with a higher-than-market, fixed rate of interest on your funding, while forced to invest in a new asset that has a lower relative rate. You could be left with expensive funding and no assets to show for it!

Are there any other options, short of allowing this longstanding customer to bolt to the competition?

The answer is “yes,” you have another option, if you match fund the new Prepayable asset with the Seattle Bank’s Prepayable Loan Advance. The Prepayable Loan Advance would allow you to match fund the Prepayable loan in a way that will allow you to terminate the funding in concert with the loan that you have made to your top customer. Great! Now you can protect yourself against prepayment risk by having the option to terminate potentially unneeded funding and replace it at a cheaper level should rates decline.

Let’s get back to the 5:00 meeting. You tell your loan officer that the customer may be offered two loan structures:

1. A fixed-rate, five-year bullet loan structure that is indexed to the Seattle Bank's five-year fixed-rate advance, which includes a pre-payment provision. The prepayment provision would require the borrower to pay you an amount that would allow you to reinvest the funds at the original rate of interest, such that you can earn the same amount of interest that would have been earned if the borrower had not prepaid the loan. This payment could be based upon a defined-yield maintenance prepayment premium that would equal the net present value of the difference between the original loan rate and the prevailing rate at which your institution could reinvest the prepaid funds.
2. A five-year bullet loan structure that is indexed to the Seattle Bank's five-year Prepayable Loan Advance. Under this option, the loan would permit prepayments according to a schedule that mirrors the match-funding advance. As an example, you could fund the loan with a five-year Prepayable Loan Advance with a one-year lock-out period. After the one-year lock-out period, you would be permitted to prepay the advance without any prepayment penalty on a quarterly basis. You would simply offer the loan under the same prepayment terms as the Prepayable Loan Advance.

Table 1. Potential Loan Structures and Sources of Matched Funding (with and without Prepayment Premium Provisions, assuming a spread of 250 basis points over funding cost)

The Seattle Bank will publish the new Prepayable Loan Index on the bank’s Rates page, on a twice-weekly basis. The index will include three-, five-, seven-, and 10-year maturities with one-year and two-year lock-out periods.

When your top customers demand extrication of prepayment penalty language, all too often you are faced with a Hobson’s Choice of either exposing your balance sheet to unacceptable risk or having your customers fall into the hands of the competition. Now, you have the choice to protect your balance sheet and preserve the lucrative customer franchise that your financial institution richly deserves.

John P. Biestman, CFA, is Director of Business Development at the Federal Home Loan Bank of Seattle.

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