Today's difficulties in the subprime credit markets are the canary in the coal mine. Weaknesses — perhaps not so serious, but material nonetheless — also will be felt in the housing, commercial real estate, and C&I loan markets in the months ahead. This choppiness in the U.S. credit markets ultimately will prove a worldwide phenomenon.
This will be partly because of the ripple effects from the subprime mortgage market. For example, a bank may not have even one direct subprime loan, but it may be lending to a developer who has a sizable portion of his revenue coming from subprime housing. Accordingly, the bank's loan to the developer may be in serious jeopardy.
Furthermore, as American Banker has reported, not only is classically subprime lending in trouble, but the alt-A market as well. Quite a number of these loans are not actually to low- and moderate-income Americans, but rather to middle- and upper-income ones who have been speculating on real estate, partly because more flexible mortgage instruments are available. With real estate values leveling off or dropping in many areas of the country, these speculators are finding themselves in economic trouble and have begun defaulting on their loans.
We are only in the early innings of the loan repricing that is at the heart of subprime woes. Substantial numbers of loans will reprice over the next 12 months. If 20% or more of the borrowers on these repriced loans continue to default, the number of Americans who will not be buying new cars, refrigerators, and smaller-ticket consumer goods will be in the millions. This will affect sales and manufacturing in this country and abroad.
Additional troubles are coming not from subprime lending per se, nor even from the ripple effects, but from the increasingly aggressive lending that is encouraged by the flat yield curve. With the yield curve compressing margins, banks can either suffer with lower profitability or try to increase lending. But this is just the environment where the yield curve does not sufficiently price risk into dodgier transactions, so increased lending too often means lower credit quality that is not offset by adequate income.
Moreover, increased lending in this kind of environment often means a weakening of credit standards in general — and this is the case today.
Mispriced loans with weaker standards always mean trouble down the road. In this case, I would expect to see the chickens increasingly coming home to roost over the next 18 to 24 months.
Happily, a number of banks are taking action now to brace for this softness in credit. These banks may have less robust earnings now, but they are positioning themselves for important successes down the road.
Here are some steps you can take now to minimize troubles in the future:
- Carefully re-examine your credit portfolio for weaknesses.
- Explore sales of the weaker credits. In the current environment, they are not likely to look better in six months, nor are they likely to be looked on more favorably by your supervisor when the next credit examination comes around.
- Review your credit standards and make sure their terms are strong. Now is the time to strengthen, not weaken, standards.
- Review lending practices, policies, and follow-through. Future problems from weak credit practices will not come solely from an inability to repay. Many will come from claims involving suitability, disclosure, and other compliance-related issues.
- Look skeptically at plans by loan officers to expand lending by moving down the credit spectrum.
Credit markets are going to be a great deal more challenging in the months ahead. Many banks that perform better over the next several years will heed the athlete's rule: short-term pain for long-term gain.
