Let’s lose the balloon
Balloon maturities have historically been used by commercial banks to manage interest rate risk and to maintain control over the loan. The balloon is a hard due date that forces the borrower to either pay the balance of the note in full or negotiate new terms. Most regional and national banks moved away from the short term (3-5) balloon years ago.
It is a very rare occurrence that a lender will actually non-renew a balloon mortgage in business banking. Usually the balance is re-negotiated for a new 3-5 year fixed rate and renewed. This cycle of re-negotiation and re-documentation is repeated until the underlying collateral (usually real estate) is sold or the loan fully amortizes (15-25 years).
Consider an alternate way of managing interest rate risk by using adjustable rate notes. NCUA regulations allow for maturities on real estate up to 15 years for federally chartered CU’s and 20 years for state chartered CU’s. Structure your note to adjust every 3-5 years with a balloon at 15. The advantages of adjustment over balloon:
- Less cost to the lender and borrower. A rate adjustment, if not automated, involves 15 – 30 minutes of loan operations time and no loan officer or legal resources. Would you rather your staff concentrate on originating new loans or managing paperwork on an existing loan?
- Less opportunity for lender to lose the loan to a competitor. A balloon notice forces the borrower to take some action on the loan, one of those actions may involve shopping competitors.
- The balloon puts you in an un-competitive situation, most banks moved to a 10-15-year term years ago. In addition there is usually someone in the market with a 10-15 year fixed rate. Your balloon structure might be a negative risk selector.
- Less chance of triggering (re) appraisal issues.
What about the credit control issue? Do you lose needed leverage in case something goes wrong with the relationship? I don’t think so. Most commercial loan forms contain default triggers with an acceleration clause that gives the lender the ability to call the note for a host of reasons. Here are the standard triggers of acceleration in our Wolters Kluwers documents:
Payments, Insolvency or Bankruptcy, Business Termination, Failure to Perform, Default on Other Debt, Misrepresentation, Judgment, Name Change, Property Transfer, Property Value, Material Change or Insecurity
Most accelerated notes are due to payment default. Chances are that a payment default will not happen 30-90 days prior to a 5-year balloon, so even in loans structured with a balloon, the acceleration could be triggered by a performance clause rather than the balloon feature. For other non- compliance issues (think- failure to provide timely financials) a rate increase clause may be a more appropriate tool than an acceleration clause.
I have experienced 2 major real estate turndowns in my career, the first was the S&L crisis mid 80’s. Regulations were tightened and new MAI commercial appraisals were required on all new and renewed commercial loans. It was brutal, I had to call good customers that had never missed a payment nor intended to miss a payment and tell them I had to order a new appraisal at considerable expense (to the borrower) in order to renew the note. If the appraisal did not support the loan we had to demand a pay down or classify the loan as substandard.
During the recent Great Recession, most of our Partner credit unions fared well with the valuation issue because they used rate adjustments rather than balloons. Other credit unions were not so lucky. Performing ballooned notes required a new appraisal and subsequent pay downs on loans with deteriorated collateral values.
As a young aggressive lender trying to build a book of business I loved balloon notes at competitors, it was a great opening for me to revisit a prospect 90 day ahead of a balloon and move the loan to my bank. Getting a notice in the mail from your lender that says $X,XXX,XXX.XX is now due and payable in full creates angst and uncertainty, excellent motivation for a borrower to consider competing lenders.