June 2012

Just What the Doctor Ordered — A Closer Look at Duration Based Pricing

By Dr. Thomas J. Parliment of Parliment Consulting Services, Inc.

The following article was prepared by Dr. Thomas J. Parliment, Chairman & CEO of Parliment Consulting Services, Inc. Dr. Parliment is an economist and has served as a commercial banker, investment banker, consultant, and educator to the financial services industry over the past four decades. He has also served as a director on several community bank boards. Currently, Dr. Parliment is serving as Interim Chief Operating Officer of a $300 million bank. He is noted throughout the business community for his colorful speeches and articles covering a wide range of financial and economic issues. His often humorous and always thought-provoking point of view is regularly enjoyed by readers.

I’d like to share with you some thoughts regarding how to originate 15- to 20-year term fixed-rate mortgages in the commercial real estate markets by pricing these loans using duration as the index for interest-rate risk. Additionally, we will look at hedging 20 to 25 percent of fixed-rate loan flow using a ladder of longer-term FHLBNY advances. Given this yield curve, we didn’t wait to ladder advances (at least at my institution)—we started in January.

So, how did we arrive at these decisions? First, it was tiresome wallowing in liquidity—two years and counting. How much longer are institutions going to be required to sit on below 1% yields for securities with durations shorter than 3 years? Second, most are tired of losing the best credits in the commercial real estate markets to competitors that are willing to make 5% plus fixed-rate loans for 15- to 20-year terms…while others struggle to make 5-year balloon, 25-year amortizers in the low 4’s!

As for me, I changed my perspective. I decided for as long as the yield curve is in its current configuration, we needed to originate high credit quality loans priced as investment surrogates. I know, I know, it’s usually the other way around (buying securities as loan surrogates). The key is to price the duration of the actual cash flows of the loans and not to price the term of the loan, which after all, only tells me the date of the very last payment.

Contractual Terms in Years

The table to the right shows the durations (Macaulay durations) of various terms of loans ranging from 30 years down to 10 years for various prepayment speeds ranging from 0% up to a 6% conditional prepayment rate (CPR), assuming a 3-year ramp to get to the CPR.

Actually I started using such a table when offering 10-year fixed-term “debt buster” refinance loans to homeowners. So many people were scared by the depth of the recession and the decimation of their retirement returns that they just wanted to follow Dave Ramsey1 into a debt-free world. I obliged them. Even now, I am offering 10-year term home mortgages at 3.15%. Even at a nominal prepayment speed, durations of around 4 years are to be expected. For this type of credit quality, loan-to-value ratios, and debt-to-income ratios, these loans might as well be investments. And considering the total cash flows generated from these loans, these cash flows can actually be repriced in a rising rate environment.

But now back to the commercial real estate dilemma. You see, aggressively pricing my 5-year balloons was problematic. The really good credits can renegotiate upon re-pricing at the balloon. And, an uncomfortable number of my 5-year balloon renewals are not cash flowing because of the low square footage rental rates in certain markets. I have to move loans to collateral dependency with all of the depressing devaluation problems that presents. So I decided to compete for commercial credits in the 15- to 20-year term bucket as the durations were only 6 to 7 years under modest 2% prepayment assumptions. The main feature was that I was getting real cash flows reinvested in the event of rising rates, as well as placing my institution in an improved collateral position after 5 years compared to the balloon. Besides, we were able to attract demand for our 15-year term in the low 5’s and 20-year terms in the high 5’s.

The final piece of my attitude adjustment came from the realization that the retail deposit markets were never going to give me the opportunity to lock in low funding rates, apart from the longer duration checking accounts. So I began a tactic of laddering in 2- to 7-year advances for approximately 20 to 25 percent of my originations of all loans that were 10 years in term or greater, with the fulcrum of the advance ladder being the duration of the pipeline of loans that I was funding. Oh, sure, I ran income simulation and market value simulation “what-if” forecasts to test my rate sensitivity. But, sorry, I still remember the beating I took in 1979 to 1982 (yes, I am that old). So as cheap as these advances are right now, I am laddering!

For questions regarding this article, contact Thomas J. Parliment, Ph.D., Chairman and CEO, or Janet Frankl-Lockwood, President of Parliment Consulting Services, Inc. at (508) 881-7002, or visit

1David L. Ramsey III is an American financial author, radio host, television personality, and motivational speaker. His show and speeches strongly focus on discouraging the use of debt.