Get Ready, Get Set, Go

Posted on March 5, 2020 Published by

Since we are now in March the days are getting longer and the weather a little warmer. It’s time to Get Ready, Get Set, Go! Spring training for Major League Baseball has started. If you’re the parent of student athletes and they (like me!) did not stay disciplined during the off-season, now is the time to get prepared. If not, we will find ourselves suffering with pulled muscles, shin splints and other more serious injuries.

Get Ready, Get Set, Go

The same is true for commercial loan portfolios. The relatively long period of economic growth and prosperity may have led many into a sense of complacency. But, based upon findings of some recent reports, it may be time to start getting things back into shape.

Last month’s blog examined some potential issues associated with multi-bank (financial institutions) transactions. Interestingly, the Board of Governors of the Federal Reserve, the FDIC, and the OCC jointly published their Shared National Credit (SNC) Report for the 1st and 3rd Quarters of 2019 in January 2020. This joint review program began in 1977 to review large loan commitments of $20 million or more and shared by two or more regulated institutions.

In 1998, they raised the number of regulated institutions to three or more. The minimum loan commitment was raised to $100 million effective January 1, 2018. This was done to adjust for the changes in the larger average loan sizes. While few readers of this blog participate in transactions of this size, the results of the review are very instructive for institutions of all sizes and not just multi-institution transactions.

Shared National Credit (SNC) Report Results

Total Special Mention and Classified loans rose slightly from 2018 to 2019. It remained elevated compared with loans during previous periods of strong economic performance. Leveraged loans (49% of all SNCs) were a significant portions of these transactions.

Leveraged lending is generally concentrated in merger-and-acquisition transactions. These would be characterized by total debt to Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) in excess of 4X. Also, with senior debt to EBITDA in excess of 3X. Finally, they would include total liabilities to total assets greater than 50%. Many of these loans were characterized by weak credit structures including high leverage (per above), aggressive repayment assumptions, weak covenants and/or permissive structures that would allow draws on incremental loan facilities.

While these factors are market-driven, they were not materially present during the last downturn. This raises the red flag as to potential increases in classified exposures and losses in the next (inevitable) downturn. As mentioned previously, these issues are not unique to SNCs. All markets are feeling the pressure to adjust to competitive pressure in this buoyant market.

Industry Performance

Other industry segments that showed weaker performance included Services with 7.1% of the loans noted as Classified and 4.2% as Special Mention. The Distribution segment had 5.7% of loans noted as Classified and 3% as Special Mention. While CRE was relatively low with 1.4% Classified and 3.8% Special Mention, there have been significant increases from 2018 to 2019 of 55% in Classified and 31% in Special Mention.

The OCC echoed similar sentiments in its Semi-Annual Risk Perspective for Fall 2019. The OCC noted strong traditional performance metrics in terms of Classified loans, Special Mention, Delinquencies, Non-Performing and Charge-Offs. However, they were quick to note that all these performance metrics are lagging indicators. They are traditionally at low points during good economic times.

Additional Concerns

Further, the current low interest rate environment masks risk in the portfolio. With the current volatility in interest rates, they urge caution that net interest margin could suffer. The OCC also cautioned that “good times” lead to lower quality in loan portfolios. Credit spreads tighten. Competition, in particular competition from non-deposit financial institutions (NDFI), is leading to weaker structures. The leveraged lending area and CRE where “seemingly everything is financeable” notes this in the SNC report.

The length of time of the current relaxed underwriting standards is another concern. Much of the future risk is already embedded in the portfolio, it’s just not identified. As this is occurring, some financial institutions are downsizing their risk management function to improve “efficiency.” This is certainly a recipe for short-term gain leading to long-term pain.

Risk Areas

The OCC Semi Annual Risk Perspective did single out CRE as a risk area, particularly for community banks due to high market valuations. They also noted a significant increase in delinquencies in the Ag sector. In a Forbes article from February 10, 2020, farm bankruptcies reached an 8-year high in 2019.

Even though the number of bankruptcies is well below historical highs, the number grew by 20% in 2019. Family farmers filed 595 bankruptcies in 2019. An increase has been shown every year since 2014. 361 bankruptcies were filed that year. (The recent all-time high was 723 bankruptcies in 2010).

Dairy is one of the sectors suffering the most from farm closures, particularly in Wisconsin. Wisconsin was the state with the highest number of farm bankruptcies in 2019 with 57. Over the past 15 years, the number of dairy farms across the state has fallen 49%. The trade war with China (however a phase 1 trade deal was recently signed), relatively low commodity prices, and growing farm debt are reasons for the Ag Sector weakness.

When Will It End?

Many of us have been around long enough to know that good times do not last forever. The real question is how much longer or when does the music stop? The “experts” all seem to agree that we are enjoying good performance in the financial services sector by historical standards. But due to the length of the performance, it is difficult to predict how our current portfolios will perform when things inevitably slow down.

That said, I think there are some questions we need to ask ourselves now to be ready.

  1. How fast can the cycle stop? It may not necessarily be slow allowing for time to adjust.
  2. How resilient are your borrowers to stress? The time is now to identify the most vulnerable credits in your portfolios.
  3. Are the credit control units of your organization working and prepared?

It may also be a good time to examine how risk may have changed in your portfolio. A question for every lending and risk management professional is: How far are you willing to “bend” to meet the competition? A race to the bottom is not really one I want to win! Finally, how much have you already given up through previous underwriting?

Thoughtful consideration of the above questions (and plenty more) can certainly help uncover what may be losses lurking in plain sight. As for when the current positive economic cycle will change, we don’t know. The best we can do is “Get Ready, Get Set, Go.” Be prepared!


Richard Rudolph is Senior Consultant at Enlighten Financial, a specialized consulting firm that focuses on loan review and risk management services to community banks and credit unions. Enlighten Financial has made it our business to shed light on the complex financial landscape, and lead clients in the right direction. We work with financial institutions and other providers to mitigate risk. To talk to Rick directly, please call: 920.445.8133

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