By Jackson Takach, Economist, Farmer Mac
For community banks, good income is hard to find. Today, we live in a low interest rate environment with tight credit spreads. Thirty-year treasury yields sit at just over 2.5 percent, a far cry from the 6.9 percent averaged in 1995. Competition for borrowing relationships is at an all-time high. Given these conditions, it is no wonder the average asset yield at commercial banks has fallen from over eight percent in 1995 to around four percent today. Traditional noninterest income such as trading, investments, fiduciary services, and account fees used to serve as a way to enhance earnings, but regulatory pressure and compliance have hampered the economics. But the good news is there still exists one income source that offers little risk, high returns to capital, and best of all, little compliance: the sale of farmland loans into the secondary market through companies like Federal Agricultural Mortgage Corporation, more commonly known as Farmer Mac. Let’s take a closer look.
The Changing Role of Noninterest Income
The basics of banking are loan making and deposit taking. But beginning in the mid-1980s, the proportion of noninterest income on a typical bank’s income statement grew from 25 percent to approximately 45 percent by 2000. But these sources of income proved to be volatile and during the recessions of 2001 and 2008, bank noninterest income plummeted and with it bank earnings. Enter Dodd-Frank: the new world of consumer financial protection and, along with it, an increase in regulatory compliance that disproportionately burdens small and community banks. In 2014, large commercial banks still found it pretty easy to generate large swaths of noninterest income through low-margin, high volume wealth management services. For example, the median return on equity for banks with more than one billion in assets for fourth quarter 2014 was 8.8 percent compared to banks with less than 150 million in assets with a median ROE of 6.8 percent. A big driver of that difference is the relative amount of noninterest income; for large banks the median percentage of noninterest income to total net income was 90 percent but, for smaller banks the percentage was only 49 percent.
Fee Income That Enhances Returns to Capital, Not Volatility
Fortunately, there still exists a way for a bank to increase noninterest income without increasing compliance or earnings volatility, regardless of its size or scale – by selling existing and newly originated farmland and USDA guaranteed loans into the secondary market through companies like Farmer Mac. In return for these loans, selling banks can be rewarded with two sources of noninterest income:
- Origination fees – Typically, players in the secondary market do not charge an origination or underwriting fee, so any fees generated by a selling institution are retained in whole.
- Servicing strip – The bank selling into a secondary market has the opportunity to add a recurring servicing fee into the borrower’s note rate. Every time the borrower makes a payment, that servicing strip is paid back to the seller in return for managing the relationship with the end borrower.
The benefits of the transaction for the bank are notable and go beyond becoming a reliable source of noninterest income. For example, selling into a secondary market offers higher return on equity, and unlike a consumer and residential lending, there are few if any regulatory compliance costs. Plus, while many noninterest income generators like wealth management services, prepaid cards, and account fees are subject to swings in consumer demand that can add to earnings volatility, a servicing strip is predictable, declining only with the amortization or prepayment of the loan.
Noninterest income is an important aspect of any bank’s bottom line. Small and community banks are increasingly challenged by regulation and compliance to generate this type of income. The sale of farmland loans into the secondary market decreases bank risk and increases income without increasing capital requirements or compliance costs, all while increasing options to the end customer. That is a win-win at little to no cost for the bank.