While most bankers are familiar with the probability of default for various lines of business, many do not have a feel for the volatility of the lending category nor the correlation to the US economy.
Tag: Credit Monitoring
If a commercial real estate loan fails to pay on time, what is the probability of bringing the loan current?
There is an interesting separation between the recent drop in equity prices and credit products. Traditionally, a huge sell-off in equities reverberates through credit hitting corporate bonds first and then bank loan pricing. This time, it is barely happening. Back in late 2007, we saw this “sympathetic coordination” between equities and credit before there started to be legitimate credit concerns beginning with housing and capital markets liquidity. So what is different now?
Banks put loans on “Watch” in order to better monitor the changes with the borrower, tenant, and property. Whereas a “Special Mention” loan has a potential weakness that deserves management’s close attention, a “Watch” loan may be thought of as a pre-Special Mention and may just require management’s loose attention. While the “Special Mention” classification as a very clear regulatory definition, “Watch” can be more of an economic category.
Community banks have a distinct competitive advantage in identifying problem loans. While many bankers are taught to identify financial factors that portend problem credits, evidence suggests that for smaller commercial credits it is non-financial indicators that are better predictors of credit deterioration.
If you think the economy is going to muddle along, then you should skip this post as our analysis isn’t going to make a difference in your future - 2021 will be much the same as 2016. However, if you think the economy is going to pick up steam, or if you think the economy will get weaker, then today’s data could make a difference over the next couple of years. As can be seen by the graph below, commercial real estate risk continues to increase and the risk on new community bank loan production is up 6.5% during the first half of this year compared to last year.
Chances are if you are like most banks you might price a 3, 5 or 10-year loan at the same spread. If it is a fixed rate loan, maybe you price it off the appropriate Treasury, swap or FHLB index, but that only takes into account interest rate risk. As can be seen in the accompanying graph, based off community bank loan historic performance, credit risk starts off very low the first couple years of a loan, only to ramp sharply up before it starts to plateau around year seven.
If you listen to the news pundits, there is lots of talk about asset bubbles. To figure out if banks are lending into inflated asset prices we turn to the data for answers. Since valuation is a function of future cash flow, having a more accurate vision of the future is helpful when lending. Once predictive factor to alert commercial real estate lenders is when supply outstrips demand by more than a 2-to-1 ratio. When this occurs there is better than a 60% chance that cash flow remains flat or even goes down, thereby hurting property values.
As of the end of June, commercial real estate is the second largest credit risk on community bank’s balance sheets, composing almost 29% of the loan portfolio - just slightly behind residential real estate exposure. On a dollar basis, we are now approaching some of the highest levels in history and are on track to break the record in the next year, a record set back in Dec, of 2008.
Last week the RadioShack earnings announcement and restatement that it will close 1,100 locations sent bankers scrambling back to their credit files to see if the beleaguered electronics chain composed any part of their commercial real estate rent rolls. It turns out that that for about 100 loans, there is exposure with an estimate of 36 of these at community banks. Luckily, Radio Shack has been downsizing and has gone to smaller and smaller footprints so that on average, the stores now make up less than 10% of the rentable space at these retail centers.