Lesson 17 of 25 · 7 min
How the spread is set: size, collateral, and relationship
The same institution will price two identical portfolios differently, and the difference comes out of a grid nobody outside sees.
A spread is not quoted from judgement either. Like the advance rate, it comes from a table — a pricing grid with a base spread and a set of adjustments, applied in order.
The adjustments encode what the institution wants. Size reduces the spread, because the fixed operating cost of a facility is spread over more dollars and because a larger relationship is worth more. Collateral quality reduces it, because a portfolio of broad funds is cheaper to monitor and cheaper to liquidate than a concentrated one. Concentration adds to it, for the reasons lesson 8 set out. Other balances held with the institution reduce it, because the spread is priced against a relationship rather than against a loan.
That last input is the one that looks least like arithmetic and is nevertheless the most mechanical. A relationship-based reduction is a cross-subsidy: the institution accepts a thinner margin on the lending because it earns elsewhere. The grid states the terms of that trade in basis points, which is a precise way of saying which business it wants.
The result is that two borrowers with identically sized portfolios and identical balances can carry spreads a hundred basis points apart without either price being wrong. Neither figure is a judgement about the person. Both are the same grid, read down different rows. None of the adjustments is arrived at in the conversation where the price is quoted, either; that conversation reports an output the grid produced beforehand.
Key terms
- Pricing grid
- The internal table of a base spread plus adjustments for size, collateral and relationship. The spread equivalent of an advance-rate schedule.
- Size band
- A range of facility sizes sharing one spread adjustment. Bands rather than a smooth curve, which creates the effects of the next lesson but three.
- Cross-subsidy
- A thinner spread accepted on one product because the institution earns on another part of the same relationship.
Worked example
One grid, two borrowers
Base spread 300 basis points. Adjustments: minus 45 for a facility between $1m and $3m, minus 35 for collateral entirely in broad funds, plus 60 where one position exceeds 40 percent of the portfolio.
- Borrower A, $2,400,000, all broad funds
- 220 bp
- Borrower B, $2,400,000, 52% in one name
- 315 bp
- Difference in spread
- 95 bp
- Annual difference on a $2,400,000 balance
- $22,800
- Difference in portfolio size
- $0
300 - 45 - 35.
300 - 45 + 60.
$2,400,000 × 0.0095.
Same institution, same week, same amount of money. The $22,800 came from two rows of a table describing what the lender prefers to hold.
Check yourself
A grid has a base spread of 285 basis points, minus 95 for facilities above $5m, plus 60 where a single position exceeds 40 percent of the collateral, and minus 40 where other balances with the institution exceed $10m. A borrower has a $6,300,000 facility, 46 percent in one name, and $12,000,000 of other balances. What is the spread, and what does it cost on a full draw?
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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.