The dramatic reduction in the U.S. budget deficit is good for the nation generally but may have a sharply negative impact on financial institutions - particularly community banks and thrifts - that rely on Treasury bonds as a pricing index for commercial and residential loans.

This development has significant ramifications for many lenders, but I have found through my discussions with community bankers around the country that relatively few are aware of the problem.

Recent estimates by the Office of Management and Budget indicate that continued budget surpluses and the planned repurchase of Treasury bonds could eliminate all publicly traded Treasuries in 10 years.

We are facing a world in which the supply of U.S. government debt could be sharply reduced, and financial institutions that rely on Treasury yields to price many of their loans may be in for a shock when these loans reprice. Banks and thrifts that fail to prepare for this change may be placing income at risk.

Historically, the Treasury yield curve has been a benchmark for loan pricing because it was always assumed that yields would move in concert with other market interest rates. But as the government begins to curtail bond issuance and buy back outstanding issues, yields should move lower and diverge from market rates.

Clearly the day is coming when a five-year Treasury note will no longer be an appropriate pricing benchmark for a commercial loan.

The situation is actually somewhat different for commercial and residential loans. Both tend to price off the Treasury yield curve, but the problem is more immediate for the commercial sector.

Though commercial banks have increasingly turned to balloon loans, on which most of the principal is paid in a lump sum when the loan matures, term loans with reset mechanisms - in which the rate is reset at specified intervals, usually three or five years - are still quite common.

The initial rate is almost always determined by competitive market conditions, but the reset price is often driven by the five-year Constant Maturity Treasury index - the average yield of all actively traded five-year Treasuries - plus a spread.

If projections of budget surpluses hold true, a bank that writes a term loan with, say, a five-year reset tied to the five-year Treasury note may find a few years later that the yield no longer approximates other five-year assets.

The obvious remedy is to switch to a new index, but this is easier said than done.

The most viable alternatives include the rate curve for Federal Home Loan Bank advances; the U.S. dollar swap curve; the U.S. agency yield curve; and yields on AAA-rated securities, corporates, or, of course, the prime rate or Libor. But each alternative is less desirable than Treasuries.

An important consideration is customer acceptance, and the business customers of most banks are probably too unfamiliar with many of these indexes to feel comfortable with them. One great thing about the Treasury index is that yields on various maturities are printed every day in the business sections of most major newspapers. Staying abreast of some of the more sophisticated indexes would be difficult.

The alternative index with the most borrower acceptance would probably be the prime rate, which is 300 basis points over the fed funds rate. But prime does not always reflect what's going on in all the credit markets and can be influenced by national monetary policy. Nor is it a term funding rate, and many commercial loans are written for specific terms.

The U.S. dollar swap curve is probably more reflective of what's happening in other markets than any other alternative, but few small-business or middle-market borrowers are likely to be familiar with it. Moreover, the lender would have to give most customers a basic primer on swaps.

The best compromise may be the Home Loan bank advance rate, since a growing number of banks are borrowing from the Federal Home Loan Bank System to fund their lending. The banking industry has a growing liquidity problem that will force many institutions to rely even more on Home Loan bank borrowings, and it makes sense to match loan rates with the cost of funds as much as possible.

Two disadvantages of this index are that it's not as well known as the prime rate and that different Home Loan banks post somewhat different advance rates, which can confuse borrowers.

Other suggestions include reducing all reset intervals to one year or, if the borrower insists on using a Treasury index, stating in the loan document that an additional spread will be built in to the reset price to give some protection should there be a disconnect between the Treasury index and other market rates.

It might take longer for the ramifications of losing Treasury bonds as a pricing index to appear in the residential mortgage market. Most adjustable-rate mortgages are repriced off the one-year CMT index, the average yield of all actively traded one-year Treasuries.

Though there may always be a supply of one-year bills available, depending on how the government finances its operations, it is conceivable that the demand for shorter maturities will rise as the pool of longer-term maturities diminishes. This, in turn, would distort the one-year bill's historic relationship with other credit markets and reduce its effectiveness as a repricing benchmark.

The greatest concern exists for those lenders that hold their adjustable-rate loans in portfolio. What benchmark will they use if the one-year, three-year, or five-year CMT indexes are no longer meaningful?

Again, the best alternative may come from the Federal Home Loan banks' one-year advance rate for adjustable loans that reset at three- or five-year intervals. Banks may find that homebuyers are driven primarily by the initial mortgage rate and care less about the reset index, especially since mortgage holders are so quick to refinance when rates head down.

The thornier problem by far is all those adjustable loans currently in portfolio that used CMT indexes as their reset benchmark. Should the yields on Treasuries drift downward as the supply dwindles, institutions may find it difficult to align pricing at the reset with other market rates.

When it comes to finding new commercial and mortgage reset indexes, timing is crucial. The first lender in its market to switch to a new index, particularly one that engenders stiff borrower resistance, may find itself at a competitive disadvantage. And yet to do nothing in the face of this secular market change could have drastic long-term effects.


Mr. Darling is chief executive officer of Darling Consulting Group, a Newburyport, Mass., balance sheet management consulting firm.

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