Reduction in deferrals a promising sign for credit

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South State in Winter Haven, Fla., had two powerful levers to pull to help clients weather the coronavirus storm: Paycheck Protection Program loans for small businesses and a regulator-backed approach to loan deferrals.

The PPP helped many small businesses survive the summer, and millions of consumers and commercial clients were able to suspend loan payments for at least three months. But worries mounted this summer that deferrals would only delay the pain and that lenders would need to keep postponing most payments or start looking at charge-offs.

For most banks, including South State, neither scenario has materialized.

Despite a festering pandemic that has restrained recovery in a number of markets and industries, the overall economy appears to be slowly healing, the job market is improving, and many once-vulnerable borrowers are again making loan payments.

So there is some hope that a coronavirus-imposed credit meltdown was averted.

“We still have companies hurt by this thing, particularly hotels and some restaurants, but we also have many that are finding ways to adapt and even increase revenue,” said Chris Nichols, a strategist and head of capital markets at the $37.7 billion-asset South State. “I’m optimistic. I really am. The picture is a lot brighter than what people feared back in May.”

At South State, deferrals as a percentage of total loans fell from 17% on June 30 to about 11% at the end of August. The ratio is expected to keep declining as existing 90-day deferrals expire and more borrowers resume payments.

“There’s still reason for concern, but it’s headed in the right direction,” Nichols said.

Other banks are reporting similar results.

Janney Montgomery Scott analyst Will Curtiss noted in a report that, among banks his firm covers that have given updated guidance, deferrals are half what there were in the second quarter, declining from 15% of all loans to 7%.

Deferrals are declining across nearly every sector, including retail, with hotels and restaurants that rely on on-site dining remaining the exceptions, said Brad Milsaps, an analyst at Piper Sandler.

Piper Sandler estimates a deferral rate closer to 10% of total loans for the companies it covers.

“By the deferral measure, and it is an important measure, things are improving,” Milsaps said.

Other disclosures show that more borrowers are regaining their footing.

The $3.2 billion-asset SmartFinancial in Knoxville, Tenn., said modified loans, which totaled 14.9% of its portfolio on Aug. 31, will likely fall to 1.6% by the end of October. The $6.2 billion-asset Hanmi Financial in Los Angeles said it expects borrowers representing about half of its deferred loans to start making interest payments.

Recent data suggest that a majority of borrowers who sought deferrals did so to safeguard themselves from the unknown fallout of a pandemic as opposed to a need to avoid defaulting on their loans, said Robert Bolton, president of Iron Bay Capital.

“The reality now is that most are able to make their payments — or soon start making payments,” Bolton said. “That’s encouraging.”

But banks aren’t in the clear yet.

Bank stocks remain under pressure, suggesting “skepticism that lower deferrals will translate into lower problem loans down the road,” Curtiss wrote in his note. Rather, investors believe criticized and classified loans will move “significantly higher by yearend.”

The continued existence of deferrals, even at lower levels, will mask underlying credit weakness at most banks, industry observers said. And the impact of expired stimulus programs, including enhanced unemployment benefits and the PPP, remains unclear.

Many lenders have argued that more stimulus is needed to help consumers and businesses reach 2021, when a vaccine is expected and the worst of the pandemic’s impacts could subside. But legislation to provide more support remains in limbo.

“Bankers are pleased with the trends over the summer, but they know they are by no means out of the woods,” said Eric Corrigan, a senior managing director at Commerce Street Capital.

“If there is no additional stimulus this year, we’re going to see more cracks in credit quality and more weakness for banks,” Corrigan said. “I think by the fourth quarter, again without more stimulus, you would start to see some real pain.”

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Credit quality Community banks Loan modifications Coronavirus