Making below-prime loans has become a fact of doing business with some small firms for Marty Uschold of Bank One Akron.
Mr. Uschold, like others, has seen the pricing on loans to companies in the upper end of the small business market tumble so much that some bankers have started basing interest rates on the London interbank offered rate. The problem for bankers is that booking loans at these rates hurts their return on assets.
But banks within the Banc One Corp. system have found a solution. Through an off-balance-sheet mechanism called Capital One Funding Corp., created by Banc One Capital Corp., bankers like Mr. Uschold are able to lend at competitive rates and boost return on assets by selling these low- yielding loans - with credit enhancement - as floating-rate option notes to institutional investors.
"With the Capital One program, we can improve ROA by not having to reserve against the loan while still generating ongoing fee income," said Mr. Uschold.
So far, lenders and borrowers have seemed to like the program. Since 1990, 11 different banks, including 10 banks outside the Banc One system, have issued letters of credit used in the program.
In total, Banc One Capital has completed 40 offerings under the Capital One Funding mechanism, raising $565 million for nearly 100 different borrowers. Mr. Uschold said his bank alone has ushered more than 25 borrowers into the program.
The mechanism was developed in 1988 as a result of 1986 tax law changes that made it more difficult for small companies to receive tax-exempt financing through the sale of industrial revenue bonds.
The idea of the program was to use the bank's credit rating in the same way it was used in industrial revenue bond financings. Through this kind of offering, however, the small borrower would not get the tax-exempt status of an IRB, but would still get the advantages of the capital markets.
"It's a way to do commercial paper offerings for small borrowers very competitively," said Peter Paras, managing director of the special products group at Banc One Capital.
According to Mr. Paras, the notes are priced at rates approaching the 30-day discounted commercial paper rate, plus about 15 basis points. Companies using the program can choose fixed or variable rates.
What is unique about the Capital One Funding program, however, is that Banc One Capital pools a number of borrowers to make the note offerings more marketable.
"We attract a larger group of investors by selling larger deals," said David Fumi, a vice president with Banc One Capital and project manager for the program.
While the Capital One Funding mechanism is designed for multiple borrowers, Banc One Capital does stand-alone offerings for companies with large enough borrowing needs. In fact, most of the offerings the group has placed for non-Bank One affiliates have been single-company offerings.
But these deals are rare because of the program's costs. Borrowers must pay up-front fees amounting to 183 basis points for such things as legal, trustee, and placement expenses.
Borrowers are also required to fund their pro rata share of the estimated $23,500 in program costs, which pays for such things as ratings from Standard & Poor's Corp. and Moody's Investors Service.
Finally, companies using the program must pay ongoing fees for the rating agencies, remarketing, and letter of credit draws. These fees add about 30 basis points to the effective interest rate for each borrower. A fee for the letter of credit can add 100 basis points or more to the cost of borrowing.
Because of these expenses, the bank originating the transaction must obtain approval from the borrowers up-front in the form of a commitment letter. The letter spells out the costs negotiated between the bank and the borrower.
Despite the obvious hassles, Mr. Paras said borrowers using this program receive several benefits. Besides getting the lower interest rate afforded by tapping the capital markets, the fee schedules for the program are similar to those paid by large companies with frequent commercial paper offerings.
"Because the rating agencies and the market see only one issuer, it lowers the cost of the transaction," he said.
And it is these savings that induced David Schipper, owner of Tell- Schipper Properties Inc. of Akron, to give the program a try in 1988. One of the first companies to use the mechanism, the firm worked with Bank One Akron to combine about three commercial real estate projects worth about $6 million into one loan using the new program.
Mr. Schipper said the company was able to set up a 15-year amortization schedule with an interest rate that changes weekly. By using this reset feature, he estimates he has kept his borrowing costs more than 100 basis points below prime.
"Between 1989 to 1994, we were able to capture a lot of interest savings as rates came down," he said. "I've thought about converting to a fixed rate on a few occasions, but I think for the long run, it's best to use the seven-day rate."
While the mechanism holds obvious advantages for borrowers, Mr. Paras said it may hold even more advantages for banks. By earning fee income without booking an asset at the same time, he said, the boost to return on assets is infinite.
"Our banks will use this when they are confronted with a situation where booking the asset wouldn't meet the ROA or net interest margin hurdles of the bank," said Mr. Paras. "This allows them to provide the funding while booking fee income."
