Regulators made us do it.
That, in a nutshell, is how many banks in the energy-lending business explained why they downgraded scores of loans to oil, gas and coal firms and substantially boosted their loss reserves during the first quarter.
Though banks have been increasing reserves on energy loans for several quarters as oil and gas prices have plummeted, increased regulatory scrutiny forced them to take even more aggressive action in the three-month period that ended March 31, bankers said on recent earnings calls.
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Banks reassess the borrowing capacity of oil exploration and production companies twice a year. The spring round of energy loan redeterminations is scheduled to begin in April. Will banks successfully use this process to de-risk?
March 9 -
Lenders repeatedly reassured skeptics that their credit risks from the energy slump were under control. But more oil and gas companies are filing for bankruptcy, and more of them are said to be drawing down their credit lines signaling that the worst may be yet to come.
March 2 -
Bankers in the Bakken Shale region of Montana and North Dakota are keeping an eye on exposure to hotels, apartments and retail space as economic slowdowns occur in energy-producing markets. Bankers in the Marcellus Shale region are also on alert, though there might be less exposure since that region had not yet had a development boom.
February 29 -
Bank earnings season is just getting underway, but a consistent theme around energy lending is already emerging credit quality is going to get worse and weigh on profits the rest of the year.
April 14
That increased scrutiny includes a new, two-step process for reviewing shared national credits and a shift in how regulators want banks to account for loans to exploration and production companies that are collateralized by oil and gas reserves.
Many bankers said that they are shifting loans to "criticized" status even if they are still performing.
At Hancock Holding in Gulfport, Miss., three-fourths of assets downgraded during the quarter were tied to reserve-based loans that were flagged during the exam or by new regulatory guidance, John Hairston, the $22.8 billion-asset company's chief executive, said during a conference call. Hancock's total nonperforming loans at March 31 were up 73% from just three months earlier.
"Several credits, totaling about $80 million in outstanding balances, were moved to nonaccrual status by way of the exam, none of which are past due," Hairston said, noting that Hancock received its exam results on March 15.
Other banks that reported sharp increases in problem energy credits during the quarter included Fifth Third Bancorp, PNC Financial Services Group, Comerica, BB&T, Texas Capital Bancshares and LegacyTexas Financial.
Fifth Third's nonperforming assets increased 26% from three months earlier, to $830 million, and most were reserve-based loans identified by regulators, Chief Risk Officer Frank Forrest said during the Cincinnati company's earnings call Thursday. "The regulators … have taken a much stricter view of how they're classifying these loans from an accounting perspective," he said. "They're looking to cover both the first and the second-lien positions."
Regulators are reportedly focusing on reserve-based loans because of an increase in second liens that have the same payment priority as first-lien positions. The decision was made to require banks to subject second liens to a payment capacity test like they already do for first liens.
Those three- to five-year loans typically consist of revolving facilities backed by the value of a borrower's oil and gas reserves. Concerns exist that the value of those reserves could decline if energy prices remain depressed.
It's significant too, that regulators, for the first time, split up their annual shared-national credit exam into two stages. Typically it's an annual review that takes place later in the year, but regulators conducted part of the exam sooner this year. The methodology for handling reserve-based loans came up during exams that recently wrapped up, bankers said.
Some bankers said that the exam incorporated recent regulatory direction. The Office of the Comptroller of the Currency, for instance, released an 83-page
Regulators are watching the leverage involved with reserve-based loans, bankers said. The OCC, for instance, noted in its handbook that examiners should consider a downgrade if total funding debt is more than 3.5 times higher than a borrower's earnings before interest, taxes, depreciation, depletion, amortization and exploration expenses.
The OCC and Federal Reserve Board declined to comment.
That was the case at LegacyTexas Financial in Plano, said Kevin Hanigan, the $7.6 billion-asset company's chief executive. Regulators "are looking hard at leverage and they're looking hard at deals that have total leverage of over four times," he said. "That's both senior and junior forms of debt in the cap structure."
Three LegacyTexas credits were downgraded and another loan – a troubled-debt restructuring where payments are being made – was moved to nonaccrual status. With the exception of one borrower in bankruptcy, all of LegacyTexas' other energy clients are making payments on a regular basis, Hanigan said.
Other issues could have been at work, too.
BOK Financial in Tulsa, Okla., warned in its
For many banks, the changes are creating situations where they are setting aside significant reserves, often for loans that for now are showing no signs of stress.
"During the quarter, we fully implemented the regulatory guidance from the SNC exam," Daryl Bible, chief financial officer at BB&T in Winston-Salem, N.C., said during the $212 billion-asset company's quarterly call. "The allocated reserves totaled 8.5% and 44% of the energy portfolio was criticized and classified. It's important to note, today, all borrowers are paying consistent with their agreements."
Some institutions, such as Comerica, applied the OCC's guidance even though they aren't national banks, while others, including KeyCorp, decided to apply the recommendations across their energy portfolios rather than limit it to just exploration and production credits.
"It sounds like all these banks learned something in the SNC exam in terms of how to look at" the issue, said Kevin Fitzimmons, an analyst at Hovde Group. Judging from differing approaches discussed during quarterly calls, "it obviously wasn't crystal clear" what banks are supposed to do in terms of grading all of their energy credits.
The moves, while taking a bite out of first-quarter profits, could benefit banks over the long run, some industry experts said. Many institutions are in the midst of
"The regulators don't want to be surprised, even if that means taking a tough stance," said Chris Marinac, an analyst at FIG Partners. "That may not be bad and could actually be healthy and therapeutic. It is painful in the short term, but the chances of seeing future deterioration are reduced."
For now, bankers said they believe the guidance only applies to a limited amount of energy loans. Regulators are expected to complete a second phase of SNC exams later this year with plans to still release just one annual report.
"At this point, we're not hearing any sort of chatter like what we had heard with the exam around energy," Clarke Starnes, BB&T's chief risk officer, said when asked during the company's call about the potential for changes being applied to other industries.
