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by Blair Svendsen, Commercial, Consumer & Real Estate Lending Supervisor, Doeren Mayhew
For the last few years, commercial loan growth was non-existent, and the opportunities hard to come by. The lack of quality opportunities and nervousness on the part of senior management and loan committees contributed to eroding loan portfolios and shrinking margins. Flushed with liquidity, many entities chose to stay liquid, with short-term investments yielding far lower returns. Now that the economic recovery has finally taken hold, commercial loan trends are recovering nicely. What does it mean for your financial institution, and how can you best manage risk during today’s environment? Our Financial Institutions Group explains.
Credit conditions in the commercial lending sector have recovered to pre-recession levels. As published in the March 2015 issue of The RMA Journal, the Risk Management Association’s “Weighted Average Probability of Default” (WAPD) for C&I portfolios was noted at just below 2.5 percent for all loans for the third quarter of 2014. As a point of comparison, the last time the WAPD was that low was the second quarter of 2008. Rounding out 2008 at 3 percent, the WAPD then soared above 5 percent by the end of 2009. The peak percentage was almost 5.5 percent in the third quarter of 2010. Recently, the last four years saw a positive trend, with the WAPD dropping relatively consistently year after year, proving the economic rebound.
In a similar fashion, the percentage of non-current commercial loans leveled off at around 1 percent as of the third quarter of 2014. The journal also presented data on non-current loans segregated by region of the country, which was roughly equivalent to third quarter 2008 levels. The recovery is spread broadly across the country, with all regions showing declines in non-current loans. Regarding region-specific data, the Southwest fared the best at just under 1 percent, while the South was less fortunate, going over the 1 percent mark. The remaining parts of the United States hovered closely near the 1 percent threshold.
Commercial loan portfolios are now as strong and performing as well as they were in 2008, immediately preceding the recession. That is both encouraging and slightly foreboding. No one deliberately originates a bad loan. In harsh economic environments, lenders are on guard. However, in low-rate environments with minimal delinquencies and pressures to increase yield and market share, relaxing of lending standards can allow flawed assets to creep onto the books. Loans that looked great in 2007 did not look so good in 2010. What can lenders do to ensure the loans that look good in 2015 continue to perform well in 2018?
The safest way to avoid loan losses is to lock the money up and never make any loans, but all financial institutions are in the business of risk. Smart lenders are also in the business of evaluating and accurately pricing risk. These lenders use pricing models to measure credit risks and link them to the interest rate charged. With improving loan-to-asset ratios, less liquidity and interest rate increases likely in 2016, are you appropriately pricing loans?
Being able to anticipate market changes is also important. Interest rates are at historic lows. There are many different opinions on when rates will rise, but no significant debate on whether they will rise. As part of prudent underwriting, loans should be rate-shocked, and debt-service ratios tested under varying interest rate scenarios to determine if borrowers will be able to service the increased payments, regardless of whether loans are fixed or variable rate. Fixed-rate loans with balloon or short-term amortizations can quickly become a lender’s problem when they mature and interest rates have moved significantly higher.
Everyone is running interest rate risk models, but what is management doing about it? Borrowers are also aware rate increases are coming and are increasingly pushing for longer fixed-rate terms. Lending institutions can resist these pressures if the local competitive environment allows it or can mitigate the risk by:
If your portfolio has grown and changed over the past few years, closely monitoring it can reduce where your risks lie today. A rigorous loan grading system, coupled with periodic reviews validating the loan grading process, can provide a realistic picture of the loan portfolio. As loan grades migrate up or down, management can assess whether the risk inherent in the portfolio is increasing or decreasing. Identifying credits beginning to struggle can allow early interventions that both assist the borrower and reduce the lender’s exposure to potential losses resulting from a loan default.
Finally, sector or industry concentration led to many failures in the recession. Whether it was highly volatile commercial real estate or just too many non-owner-occupied credits, concentrations exposed institutions to catastrophic risks. According to the Risk Management Association, even today’s concentrations within certain industries are something to be cautious of. The RMA Journal looked at the percentage of exposure and expected loss for more than 20 industries. Topping the list from an exposure standpoint was wholesale trade, manufacturing, finance and insurance, health care and retail trade. Each industry varied in regards to its expected loss and the total exposure. For example, manufacturing is almost 9 percent of total exposure and less than 8 percent of the expected loss.
The industries with the best ratio of low expected loss to total exposure include mining, wholesale trade, and finance and insurance. Industries with more unfavorable ratios included agriculture, health care and other services. The agriculture data was about a 2 percent expected loss on 1 percent of exposure, health care data was 9 percent loss on 8 percent concentration, and other services had a 5 percent loss on a 3 percent exposure.
Given the recent downturn and the reduction of jobs involving manufacturing and skilled trades, the expectation might have been that this sector would be worse than relatively stable sectors, such as health care. However, The RMA Journal indicates something different. Who would have thought manufacturing is safer than health care? That wasn’t the case in 2008, but it is now.
Based on this observation, it is clearly an indication that trends change. What is “safer” today may become saturated in a few years and become “unsafe.” Construction loans are a great example of this. Arguably the most profitable type of secured loan right before the downturn, these loans became a large source of charge-offs for many institutions. Now, construction loans are gaining momentum again as the economy recovers.
Concentrations should be monitored internally with a careful eye on the economic environment. Hard and fast concentration limits in a policy may be acceptable, but that is only the start. What is reasonable in one part of an economic cycle may not be reasonable a few years later. When was the last time your institution did an analysis of 20-plus industries? Even if an analysis was done, did anyone explore the trends in the industries to determine if lending should be slowed down or stopped for that section? Obvious concentrations are one thing, but the third, fourth and fifth-largest sectors may be the ones posing the greatest risk. There weren’t too many institutions with a large portfolio in construction loans in 2007, but those with even small portfolios generally felt some pain in the downturn.
Monitoring trends and avoiding future issues is the smartest way to operate. Rely on Doeren Mayhew’s Financial Institutions Group advisors in Michigan, Houston and Ft. Lauderdale to help you put the proper monitoring in place to minimize your institution’s future lending risks.
Source: The RMA Journal, March 2015
This publication is distributed for informational purposes only, with the understanding that Doeren Mayhew is not rendering legal, accounting, or other professional opinions on specific facts for matters, and, accordingly, assumes no liability whatsoever in connection with its use. Should the reader have any questions regarding any of the news articles, it is recommended that a Doeren Mayhew representative be contacted.
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