Banking companies, along with other market participants, have been increasing their credit appetite for some time. Bankers have loosened underwriting standards and taken on new credit structures. At a time when many believe credit quality may start to worsen, analysts and regulators look at what has changed lending and how the changes could impact credit quality down the road.
Kevin J. St. Pierre, a senior analyst with AllianceBernstein LP's Sanford C. Bernstein & Co. LLC and a panelist at American Banker's latest roundtable discussion, said the continued erosion of underwriting standards and smaller loan-loss reserves could spell trouble, though Jeff K. Davis of First Horizon National Corp.'s FTN Midwest Securities Corp. said that credit underwriting skills have improved from the last credit cycle.
Kathryn E. Dick, the Office of the Comptroller of the Currency's deputy comptroller for credit and market risk, said that regulators are watching the size and growth of certain portfolios carefully, but that banks' capital is stronger now than it was during the last cycle.
David J. Konrad, an analyst with Keefe, Bruyette & Woods Inc., said he is worried about the covenant structures of syndicated loans. And Sharon Haas, a managing director of Fitch Inc., said the recourse of loans sold to third parties could be a concern.
Credit quality seems at the peak. What are the similarities and differences you see in the cycle so far?
KEVIN ST. PIERRE: Historically, the good, conservative banks that we all liked and that received higher multiples from the investment community were those banks that built reserves in good times and built them less in bad times.
Now ... as we've seen real improvement in credit, we've seen releases of reserves, and we've also seen some relaxation of underwriting standards, setting up potentially a difficult road over the next 12 to 24 months.
SHARON HAAS: The release of reserves is of concern to us for the exact same reason, and it's coming in conjunction with actually declining capital ratios as well.
Neither reserves nor capital is moving down so rapidly that it alone would be cause of concern. But the decline in reserves as a percentage of loans, and declines in pretty much all forms of capital ratios, in conjunction with weakening loan standards, suggests that at the next pivot point in the cycle, when these weaker loans start to go bad, then banks are going to be less well prepared than they were in the last cycle.
KATHRYN DICK: If you look at the structure of the banking system, it's changed dramatically.
The composition of bank portfolios is different than what we've seen in the past for some of the largest banks in the U.S. With respect to their underwriting standards ... you see a wide disparity across companies, because of this change in portfolio composition, as well as their loss history on these portfolios.
While capital levels, on average, may be declining, they're still at a level that we didn't see 10, 20 years ago.
With underwriting standards easing, that definitely attracts attention. The allowance is an issue that's very important to us. We spend a lot of time looking at individual firms, as well as horizontally across populations of firms looking for outliers.
So we are, I think, sharing your worries.
We also are spending a lot of time on the allowance issue, partly because, again, this is the time to do it. It doesn't do us any good to have heavy, hard discussions on the allowance when portfolios are sinking.
ST. PIERRE: One of the issues ... is the impact that provisioning practices and policies have had on earnings over the past five years and will have on earnings over the next five. The way I calculate it, about three-quarters of income growth over the past three years has been contributed by reserving policies.
And looking forward as we swing - and I think there will be a fairly dramatic swing in loss provisioning - how much of that volatility that has now been infused in the bank income statement, has been regulator-driven?
And I distinguish between safety-and-soundness regulators and accounting regulators. And in the wake of accounting scandals and concerns about cookie-jar accounting and managing earnings, we now seem to me to have an overemphasis on the matching principle where those good, conservative banks can no longer build reserves in good times.
I think industrywide we're coming out of the only three-consecutive-year period where provisions have lagged chargeoffs. I don't think that's ever happened, as far back as I can see. So I think something has changed. And until the safety-and-soundness regulators get a little bit of power back from the accounting regulators, I think we've got volatility in the bank income statement.
If there's volatility in credit, shouldn't that be reflected on income statements?
HAAS:If you force the banks into a situation that begs quarterly earnings volatility, and in fact increases that volatility rather dramatically when you go into a downturn, you compound the problem, because historically we've looked to the banks to help get us out of economic downturns by lending to the commercial industries as they start to need credit.
Banks won't be in a position to do that if they're shutting down at the same time that everyone else is looking for credit. So in a macro sense I think there's at least one argument to be made for why just-in-time reserving is not a good thing for the banking industry.
DICK: At the OCC, we are very concerned about earnings pressures.
If you look back to some of the statements that were released in 1999 through 2001 by banking regulators and the SEC, clearly at that time we had very public discussions about our different viewpoints.
And at the same time, I think if you go back and look at our interagency statement issued in 2001, we were clear that we hold very important to our charter and mission the responsibility to ensure that reserves are maintained at an adequate level.
What's maybe a little different today is I think we have a much more open dialogue with the accounting industry and with the SEC, hopefully to avoid finding ourselves in a position where we're having a public debate with a large financial institution about the adequacy of reserves.
And right now our large banks, on average, have three to four years of coverage for current period losses.
Recent loan officers' surveys showed easing lending standards. Are you concerned about this constant easing?
DAVID KONRAD: One place to look is the syndicated loan market. To me, where we're at right now feels a lot like where we were at in the late '90s, which was a time of fairly aggressive lending practices.
We are seeing an increase in the amount of transactions for equity sponsors and M&A financing, which typically has higher risk than a traditional middle-market loan. In terms of covenant structures, we're getting to five or six times funded debt to EBITDA [earnings before interest, taxes, depreciation, and amortization] as a pretty standard covenant, which is at or actually even a little looser than where we were in the late '90s. In addition, we've lost probably over 100 basis points in credit spread over the last couple years.
What's also interesting is the tenure of the deals has extended - 364-day deals used to be the norm. Now we're looking at multiyear facilities. So from that standpoint, lending standards have become more relaxed.
What's different in the current market is the participants of these credits. Nonbank institutions and hedge funds are becoming more and more active in this market. To some extent, it's a bit of a sweet spot for banks, as some of the larger banks are able to originate loans and collect an underwriting fee while shedding the credit risk to nonbank entities. That's actually a positive trend.
But over the long run I'm somewhat skeptical of the sustainability of this model. The institutional market is fickle, to say the least.
DICK: Some of the credit issues we've faced in the past with credit cycles and looking at commercial and industrial loan portfolios actually seem to be more of a liquidity concern today, from our standpoint, because what we see at the margin with these large syndicated facilities is that our banks don't originate and hold them. Their past business was to do that, but they're almost now in more of an intermediation capacity. They're holding very little of the credit risk.
And that means we have to worry about liquidity. We also worry about compliance and reputation risk.
We know from the securitization market that when you sell exposures, those exposures can work their way back into your balance sheet, whether it's protection of the name, the franchise value of your firm, or compliance issues where a 'T' was not crossed, an 'I' was not dotted.
So I think it does look very different, at least from our perspective, than what we've seen in the past.
ST. PIERRE: Industrywide, though, we have seen strong C&I [loan] growth on the bank balance sheet, and with the new Fed loan survey that's out, we saw again a further relaxation of credit standards on C&I loans. And there's a fascinating and somewhat counterintuitive correlation between the percentage of banks tightening credit standards and one-year lagged chargeoffs.
It tells me that the banks are always too late to tighten credit standards, and now we're still easing. It doesn't mean that a year from now we're going to have higher C&I chargeoffs, but what it does mean is that when credit does swing, the banks are likely to be too late.
JEFF DAVIS: From my coverage universe - at least the Southeast half - much of the risk in the system is systemic.
If we think about any type of real estate lending, the reduction in cap rates during the last 15 years has dramatically supported values. Cap rates in the early '90s were in the mid to upper teens. Today cap rates are decidedly single-digit.
Lenders and equity investors have to ask themselves what an unexpected increase in long-term rates of 100 basis points, 200 basis points, or more would mean. It probably would mean an immediate loss of equity in existing deals, slower lending activity, and ultimately, possibly, an increase in loss rates for an asset class which has had virtually no losses for a decade.
Commercial real estate and home equity lending have been tremendous earnings drivers for banks for over a decade. The cap-rate risk is real. There's nothing you can really do about it - we've had a 25-year one-way move in rates, and we could easily move part of the way back the other way.
KONRAD: Certainly on the small-cap bank side, commercial real estate and home equity loans have become such a big part of the balance sheet, more so than 10 years in the past.
So even if lending standards haven't changed, such as maintaining an 80% loan-to-value, there may be modestly lower risk management discipline owing to the increased concentration of loan types on banks' balance sheets.
DAVIS: Cycles come and go, but the larger banks have vastly better geographic diversity in their portfolios. ... [FleetBoston Financial Corp.] was our canary in a coal mine, but Fleet is gone. A lot of the weaker underwriters have been acquired.
I would assume net-net we'll have a lower volatility of losses over time, and barring a dramatic move in long-term rates. There is some sector risk, such as with private-equity sponsors who expect lenders to increase their financing multiples with the overall enterprise valuation to maintain leverage to generate targeted returns for the equity providers.
DICK: That's a great point, because the management of risk certainly in the larger companies has focused so much more on a portfolio concept, using things like the selling of credit facilities and credit derivatives to help manage those exposures.
We talked a little bit about concentrations. That is another hot button for regulators. We issued guidance at the beginning of the year about commercial real estate, because we were seeing, especially in some of the midsize and smaller companies, concentration levels that in and of themselves weren't necessarily troubling but had to be married with a stronger capability of risk management.
We received a lot of industry response on that one, which is healthy.
I think actually there's a misinterpretation of what we laid out there. We laid out some concentration thresholds, not to say those were limits on banks, but to say that from our supervisory standpoint, crossing some of those thresholds, approaching them, meant examiners are going to look for a higher level of risk management than what we would see in an average bank.
Of course, commercial real estate's a tough one, because all commercial real estate is not the same, and getting through that portfolio and understanding the real exposure that exists within a bank's portfolio is difficult.
I think the industry is much better today at underwriting risk, but it doesn't mean mistakes won't be made.
Are there portfolios that worry you more than others - C&I, CRE, consumer?
DICK: I think it might be tough to try to compare the underwriting standards you see in the C&I world versus residential or consumer.
If you look at the commercial underwriting standards as a whole and level of easing, it actually improved slightly with the numbers we had in the first quarter 2006. But let's call it stable, because that's to me what it looks like.
There are three portfolios that I think stand out, and we've touched on, I think, all three of them. One is commercial real estate, one is large corporates or syndicated credits, and the other is leveraged financing.
A black eye has sort of surfaced in the industry because of those portfolios. That, naturally, as those paid to worry, draws our attention.
DAVIS: I started my career over 20 years ago at AmSouth, and the key message then was, we can lose the bank on the commercial platform, but not retail lending, where the bank could not make enough bad mortgage or car loans to break the institution.
Poor retail lending could hurt earnings for a year or two, but not badly enough to lose the bank.
The same is true today. It's the large commercial borrower that always is the risk, especially nonrecourse and enterprise value-based lending in an environment of rising valuations.
Can we assume that the banks that have the strongest C&I growth are the most willing to compromise in underwriting?
ST. PIERRE: Yes. I think there are banks that do it well, but if a bank is growing C&I loans at 30% to 40% annualized rates, there's a red flag, and I think you have to watch that.
There are banks that have historically done it well. North Fork ... [was] a bank that did it effectively.
DICK: Loan growth is one of the key indicators that we use to tell us about the level of risk that's being embedded in credit portfolios.
HAAS: We've all been focusing on traditional measures of credit quality - net chargeoffs, reserve to loans, loan growth. And I would agree with all those.
But one of the things above and beyond that that we worry about - and, frankly, we're not quite sure that we have all the best tools to measure it quite yet - is what I call the background risk.
So, for example, we think about all of those institutions that are underwriting huge portfolios of loans and selling them into either structures or the secondary market, recognizing most of this is actually sold without recourse but also recognizing that there are business reasons why an institute would take back a problem under certain circumstances and what the ramifications might be if you had a sudden turn in a certain industry.
This is what we spend a lot of our time worrying about with respect to the next turn in credit quality, because so much of today's market is driven by the changes in asset origination for distribution.
We have credit derivatives to help mitigate risk, but we also have credit derivatives to help banks take risks. The ... [collateralized debt obligation] market and CLO market, which have grown exponentially, are outlets for a lot of the loan origination that we don't see hit the portfolio.
I wonder about the second-dimension or third-dimension risks that may come back to haunt us in the next cycle turn.
It seems there's a lot of excess liquidity from nonbank sources in the credit market. If that dries up, what impact will it have on this credit cycle? How do the third-party providers and the nonbank providers impact the credit underwriting?
KONRAD: It certainly runs the risk for added volatility. If I were the agent bank and 30% of the syndicate is a nonbank, it seems to me that it may be more problematic to get the group together and come to a decision regarding the credit structure should the borrower trigger a covenant violation. Should we waive the covenant? Should we amend the deal? Should we provide a different type of financing?
To some extent, the makeup of the syndicate puts us in uncharted waters regarding how transactions get restructured and the timing of any resolution.
HAAS: One of the areas in which the third-party nonbank buyers of credit have had a huge impact is in the area of loan covenants. Fitch recently did a study on comparing the number of loan covenants, and across the board in both investment-grade loans as well as non-investment-grade loans, we've seen a reduction in the number of loan covenants being used.
One explanation anecdotally is that it's to standardize the covenants that are embedded in the loans. So you definitely have an influence coming from this new group of investors in commercial loans. But I don't think it was nearly as prevalent one or two cycles ago.
A full 25% of high-yield bond issuance in the first quarter was in the triple-C category. That speaks volumes about what the appetite for investors is right now. The real issue is, did we become complacent as an industry, the banking industry, in thinking that we can always sell sub-investment-grade product off to third-party buyers?
Right now investors are hungry for yield.
So the risk appetite among bankers is just as large as among other nonbank lenders?
HAAS: I think because they know there's a third-party market out there, they're willing to originate that credit, because they don't have to hold it within their loan portfolio forever. They're anticipating a higher expected loss, but only on a sliver of the portfolio, and are willing to devote a part of the portfolio to higher-risk credit.
The industry participants are larger and more diversified. And as a result, they do have capacity to take on higher-risk credits in some portion of their portfolio. And today that absolute number is a lot larger than it was 10 years ago.
DICK: Some of the chief credit officers in these companies are worried about a change in the credit landscape and what that means if they find themselves at the workout table, not with 10 of their counterparts who all have sort of the same objective, but now half or more of those counterparts in the syndication may not have the same objective as the bankers do and, in fact, may drive the agent bank into a position that was not where they intended to be or where they would have been having the same conversation five, 10 years ago.
These are the very questions that we ask ourselves, and, quite frankly, we've had very healthy discussions internally about, is there something we need to do differently by way of our supervisory model? We clearly, post-Enron, had to think about risk outside the parameters of just financial risk.
It's awfully nice to feel better about precisely measuring your risk, but certainly we're well aware that you're precisely measuring based on what's happened in the past. And if your worry is, "I'm not real sure what the future looks like," a prudent banker is going to take that message and avoid exactly what Sharon's talking about, this complacency, and recognize good information.
Do you see any differences in underwriting between the smaller and the larger banks?
DAVIS: The smaller ones are heavier into commercial real estate, although that does not necessarily mean underwriting structures are dramatically different.
Most of the Southeast banks are well versed in the risk in that sector, because the Southeast as an in-migration market for three decades has had related lending demand. The longtime players have seen all facets of the cycle, but with a backdrop of steady demand for real estate.
The Midwest banks tend to be heavier in C&I, simply because of the region's manufacturing base. It should argue that the Midwest banks are better versed in the volatility of C&I.
So to you, it's less a question of size and more a question of portfolio concentration?
DAVIS: And in the quality of management and their ability to underwrite. I would point to someone like Alabama National. It's a small-cap but has had nominal loss rates the entire life the risk management team has been there, when others had loss-rates multiples of theirs with the same asset categories.
DICK: I'd have to agree. It's very difficult to make a lot of generalizations, because when you get into banks of different sizes or you start to take into consideration some of the judgmental factors such as management of the institution, that can have a material impact, really, on the quality of the company.
Nobody mentioned first mortgages as an area of concern. It would seem like that would make at least the top three.
ST. PIERRE: Well, the driver of my concern with the banks that have concentrations in non-first-lien consumer loans is the repricing of the first mortgage debt. We've had over the past quarter-century a boom in floating-rate mortgages, adjustable-rate mortgages, and, even over the past two years, a boom in short-term hybrids and interest-only loans, which we'll be repricing over the next one to three years.
To trigger a mortgage chargeoff at a bank or at a portfolio lender, you need a default, and you need a decline in the home value below the loan-to-value where you're protected. If that default never occurs because I'm still employed and I'm still paying my mortgage, then that first-lien lender is in pretty good shape.
DICK: One of the reasons we've maybe worried less about residential real estate is it takes a whole lot of those loans to cause a real financial problem in the banking industry.
And if you look on the spectrum of lending, you start with the residential real estate with some collateral versus what we're going to see when we get into some of the C&I portfolios.
So I think from a supervisory standpoint, less of a worry directly by way of credit risk, but I think it does introduce other exposures into the institution. A lot of banks selling off mortgages, especially as some of the underwriting standards are eased, can put them in a position where putbacks may become a problem.
HAAS: Whether it's IO or payment option ARM or a first mortgage with a piggyback on it, … we have ... entered into uncharted territory to the extent that we really don't know the behavior of that particular product down the road.
We're not thinking it's a huge disaster, but … provisioning needs for residential mortgages may be very different in the future than they were in the past.
So starting from very modest levels, losses could easily be triple what they were in the past. If you're looking to historical performance of only traditional conforming mortgages to determine future provisioning, that is a concern.
