Real-Time Lessons from the Final Stages of COVID Surge

Now Is the Time to Do Our Homework on Deposits

Five Years Later, We Are Not Done Talking About “COVID Surge”

We all know the story of “Deposit Surge” associated with the pandemic. Much has been written about the resulting trouble some banks had because of the spike in the cash supply, rapid increase in deposit balances, overextension of cash into longer duration assets, and (on a lag) the resulting rapid rise in interest rates.

Not nearly as much has been written about the “Loan Refinancing Surge.” It began in earnest in June of 2020 when rates had plummeted due to government market intervention (e.g., The Federal Reserve’s Quantitative Easing program / bond purchases) and uncertainties over how quickly the economy would rebound after the pandemic failed to drain the money supply influx quickly. It eased when the word “transitory” was stricken from the Fed’s vocabulary at the end of 2021. And it ended in the second half of 2022 when the FOMC was midstream with its tightening policy.

Unlike the deposit surge, the impact of the loan origination surge is still at hand. Understanding the issues and how the next 18 months may impact your institution is critical when looking at longer-term success with your balance sheet.

From the Editor

We received two inches of snow here north of Boston this morning. It’s April 12th and it feels like mid-January. The longest winter in recent years hasn’t relented and has kept a firm grip on the region.

Although intuitively I know better weather is ahead, it just doesn’t feel like it!

In a way, perhaps that’s exactly how bankers feel about all those loans they put on their balance sheet during the COVID era period of low rates. With every passing quarter we look to better days ahead, but those low-rate loans have kept their grip on asset yields for what feels like an eternity.

However, for some institutions, relief is finally approaching.

In this month’s Bulletin, DCG Managing Director Jeff Reynolds writes about the oft-overlooked COVID-related loan surge that will surely be in sharp focus for many financial institutions over the next several quarters. He implores management teams to define what “cashflow” really means, to understand loan modifications and their impact on modeling, and to reconsider how to think about pricing in volatile markets.

As we await “better weather,” I hope Jeff’s article will help bankers understand how a large portion of their asset base might react when the sun finally comes out to shine!

Vin Clevenger, Managing Director

How Much Loan Refinancing Are We Talking About?

According to the Philadelphia Fed, residential mortgage refinancing in the United States more than doubled from $1 trillion in 2019 to $2.6 trillion in 2020 when interest rates fell. It continued at a similar pace in 2022. The following shows the dramatic change in balance and the coupon range of mortgage-backed securities held by the Federal Reserve (as disclosed on the System Open Market Account (SOMA) Holdings of Domestic Securities webpage).

Source: FRB of New York

While this is only one sector of the lending universe, it provides a clear example of what many banks experienced in a year and a half in a historically low-rate environment. Although residential mortgages will take time to pay down, commercial loans are a different animal. While terms can vary, I feel it is common that a fixed rate C&I and CRE portfolio turns over every 5 years or so. Looking back at CRE origination trends for a sample of my clients, the following is an example of what I saw as a common experience.

Source: Loans360°®, DCG client data

Why Focus on This Now?

This past quarter, I routinely saw projected balance sheet spread expansion for the “current rates” (rates sideway) scenario that ranged from 5% to 15% over the next 12 months.

Source: DCG client data

In the example above: With no change in rates and without growth or material changes in balance sheet mix, spread is modeled to improve 16.9% by just standing still. This is largely due to the asset side of the balance sheet and, more specifically, loan yields.

Many ALCOs looked at these results with a level of discomfort or perhaps disbelief. This is understandable given the magnitude of issues the rapid rise in rates and inverted yield curve caused some balance sheets.

Pessimism leads to questions, and those questions will help shape our understanding of and comfort level with what margin projections are suggesting.

Rising Loan Yields Are THE Story

Forward projections for loan yields for most of my clients are eye popping. I did a back of the envelope test on each client and found that, based on the coupons that are rolling off versus current origination rates, most could shrink their loan portfolio by 3-5% and remain loan interest revenue neutral. So just standing still and rolling over what is coming in could lead to much more favorable margin results.

Knowing how key this variable is, it might be worthwhile looking more granularly at your loan cashflow projections. You might be surprised at what you find.

First: “Loan Cashflow” Means Different Things to Different People at Your Institution

When bankers think about “cashflow,” they usually think of the accounting definition and what shows up on a statement of cashflows. Fair enough.

But let’s think about this a little more as it relates to common events in the life of loan portfolio, and terminology used to describe what is happening. Consider the following:

If a floating rate Line of Credit has a maturity date, is it going to result in principal cashflow or simply a review of credit worthiness and terms?

A large CRE loan on a property held by a long-tenured and valued client is set to reprice in 6 months from a rate of 4.00% to 8.00% (based on current index and spread). Will it result in a balloon payment from that customer or a negotiated modification of the terms of that loan?

Unless the LOC customer has had a material change in credit conditions, the loan will simply be rolled and likely without a change in terms other than the next maturity / review date. In this case, there is no impact on liquidity, interest income projections, or interest rate sensitivity. But does it show up consistently as “cashflow” in your risk models?

The CRE example is a little more nuanced. At some point, the loan officer and borrower will likely start talking before the upcoming reset and negotiate new terms on the loan. No cash changes hands except on paper if the transaction is reflected in a new loan document. If handled as a modification, the change in terms has the same effect for budget and interest rate risk modeling as if a completely new note were written.

Take care in understanding the term “loan cashflow” and how it can change if focusing on credit, liquidity projections, or budget / interest rate risk considerations. It can mean different things in different management applications. Being more deliberate in communication on this subject can lead to a better understanding of issues and reduced frustration managing the balance sheet.

Modifications Matter (a LOT!)

As we have been developing DCG’s loan analytics platform Loans 360°®, I have been blown away at the granularity that our data science and development teams have been able to break down “loan cashflow.” One thing that granularity brought into focus was the issue of modifications. In several client instances, the level of actual cash prepayment was half the total if we included loan modifications.

A modification is defined as an unexpected change in terms prior to the contractual maturity of the note. It could be a short extension of the balloon date of a note with no change in rate. It could be a change in the rate without a change in maturity. It could be an extension of the reprice date and the rate until that time.

Why does it matter? Not picking up modifications in your prepayment analyses will likely impact how accurately your model expresses loan interest income trends (good or bad). Given the level of modification I have seen in customer data sets, it is a much more material factor than I would have imagined.

The Loan Origination Surge

With the pandemic in its early stages, interest rates had cratered in response to the incredible economic uncertainties and unprecedented relief response from both Congress and the Federal Reserve to soothe economic fallout from the COVID lockdowns.

The 5 Year Treasury rate, a key benchmark in community banking, hit a low of approximately 20bps in the summer of 2020. It averaged 67bps from July of 2020 until December of 2021 when the market threw the penalty flag at the Treasury Secretary and Fed Chair for their assertion that inflation was “transitory.” It steadily rose thereafter as a behind the curve FOMC tightened at a rapid pace.

How much of your loan portfolio turned over in that low-rate period? If most of your fixed rate loan production has a 5 Year reset or maturity, that large spike in origination (and modification volume) is very likely poised to “cashflow” over the next 2 years.

Sometimes looking back (at historical originations and modifications in this case) can give you a better understanding of what lies ahead. In the earlier example, the delta between origination rates 5 Years ago (3.66%) and more recent times (6.73%) suggests that good times are coming and appears to validate what a lot of NII simulations are suggesting.

What could get in the way of seeing that come to fruition? Lending rates would have to fall at least 3% in this example for us not to see yield lift. That can bring comfort if you think that better times lie around the corner. It can create a level of unhealthy complacency in this day and age.

Tariffs and Whatnot

Dating back to the beginning of the 2000s, market volatility (as measured by the VIX index) in April of 2025 hit a level only surpassed by the outbreaks of COVID and the Great Recession. And when we look at the 5 Year Treasury (a key benchmark in fixed rate loan pricing) just over the past month, the volatility has been disconcerting as the market reacted to tariff policies without well-defined end games or durability.

While “Liberation Day” and tariff talk has received a lot of press (with some even calling it the “end of Globalization”), the impact on treasury rates was not as impactful as the string of bad employment data in Q3 of 2024 leading up to the FOMC meeting. With all this volatility, what should bankers do?

Source: Bloomberg LLP

Loan Pricing in Volatile Times

While wanting to steer clear of politics, it is difficult not to acknowledge that these are (at the very least) interesting times, and it is hard to argue that the recent volatility will dissipate in the foreseeable future.

If you agree with that, do you take it into consideration in your loan pricing process? This is an even more critical question given the deluge of loan volume that will be repositioned over the next couple of years.

Should we run with a loan pricing model/strategy that simply suggests “the 5 Year Treasury + a spread” is the going rate for a 5-year fixed rate term? If you make the commitment during one of those lulls in rates, your bank might not be happy with that decision in the long term. When you see a peak, do you actually capture all that market rate lift on loan pricing? Playing a trailing average may produce more reasonable results if you are not using loan swaps (which effectively match funds the origination and puts the burden of prepayments risk on the borrower).

In Closing: The Heightened Need for Forward-Thinking Risk Management

This last stage of the “loan origination surge” is about to play out, and hopefully this article provides some thoughts on how data, analysis, and diligence can help make the most of what should be a favorable period for most community banks. But remain diligent.

Think of that large block of refinancing that is going to take place over the next 18 months. As it rolls in, it will roll back out and likely lengthen the duration of the asset base significantly. The fact that it is happening in a much higher rate cycle will make it more susceptible to prepayment or modification if rates fall from here. And for certain, the probability of falling rates now is a lot greater than it was 5 years ago.

The importance of better understanding your loan cashflow activity is only increasing from here.

Contact DCG to speak with a balance sheet expert, schedule a Loans360°® demo, or discuss your institution’s needs and goals.

ABOUT THE AUTHOR

Jeff Reynolds is a Managing Director at Darling Consulting Group. After serving as an auditor in the insurance and banking industries, Jeff joined DCG in 1996. In this capacity, Jeff’s primary responsibility is advising clients on ways to enhance earnings while more effectively managing their risk positions. He regularly assists clients with strategic and capital planning projects and has also served on numerous due diligence teams for client acquisitions. Jeff is a frequent author and speaker on a variety of balance sheet management topics and has served as a guest faculty member for the ABA’s Stonier Graduate School of Banking.

An Eagle Scout, Jeff volunteers in his community as a Boy Scout leader and assists with leadership development programs. He received a B.S. degree in business administration from Salem State University in Massachusetts.

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