In just a couple of months, the current economic expansion will be the longest in US history. Since the mid-19th century, the country has experienced 33 business cycles in all, with the average economic expansion lasting a little over three years, and the average recession lasting just under 1.5 years. The current expansion will, without a doubt, outlive the previous longest period of economic growth that occurred from 1991 to 2001. However, no one has yet repealed the business cycle in the United States, and we believe that the next loan your bank funds will very likely to be required to withstand a recession (except short-term bridge financing or evergreen revolvers or the like).
We also believe that community banks now have an excellent opportunity to maximize profits by selectively migrating their loan quality to take advantage of the high probability of a recession within the life of the next loan. Community banks have opportunities to maximize loan performance in both downturns and upturns. However, now an opportunity is screaming out for banks to position their loan portfolio to maximize performance in a downturn.
How to Position Your Loan Portfolio for a Downturn
First, we are not forecasting a recession imminently. However, in the next one to three years the probability of no marked economic slowdown is exceedingly low. An expanding economy will lead to a recession because of overheating or the creation of asset bubbles that will eventually burst. The probability of a soft landing for an extended period is exceedingly low. Second, we are not forecasting the severity of length of the next downturn. We contend that banks must rotate the kind of loans they target based on the anticipated path of the economy.
We believe that to optimize long-term loan portfolio performance, community banks must migrate up the credit spectrum and originate better credit quality loans. The reasons for doing this are as follows:
- During longer periods of expansion, banks misprice credit risk more severely. Therefore, to avoid mistakes during an aged expansion cycle banks are better off competing for better credit quality on a risk/return spectrum.
- In a recession, better credit quality loans have a higher risk-adjusted ROE. While this is not a self-evident truth in banking, anyone that has spent time in SAM can attest to the high cost of managing failed credits and the drain on capital these credits may cause.
- Top performing banks want to be ahead of the competition in selecting their loan portfolios (proactively migrating credit quality). When the economy slows, many banks want to capture the better credit quality loans (reactively migrating credit quality), but by that time the forward-thinking banks have already started rotating their credit quality in anticipation of the change in the business cycle, thereby crowding out the reactive banks.
- By selecting the correct credit quality in anticipation of the change in the economy, banks can avoid negative selection bias. For example, if a bank is not anticipating changing economic conditions and generates credit quality across the spectrum, in a downturn the competition will scramble to steal high credit quality loans and avoid the lower credit quality loans, naturally decreasing the average credit quality of the portfolio. Banks that plan can start migrating their loan portfolio to avoid this negative selection bias – especially by demanding the correct prepayment provisions.
We believe that the correct way to select loan quality is to increase credit quality in anticipation of the downturn and decrease credit quality in anticipation of an upturn. The graph below demonstrates the concept.
At the end of an expansion, banks should start favoring higher credit quality loans, while at the end of a recession banks should start favoring lower credit quality loans. We are not quixotic and understand that the tradeoff for higher credit quality is lower yield – and as we near the end of an expansion, that is precisely the correct tradeoff for banks to make. Banks can never tell with certainty when an expansion will turn into a recession and vice versa. However, that decision also does need not be abrupt. Community banks do not need to turn the ship 180 degrees – decision to migrate the loan portfolio credit quality can be incremental and take months or even years.
Unfortunately, we do not see much sign of community banks turning the ship even slightly. We look at thousands of loans every month booked by community banks, and we do not see increased underwriting standards – just the opposite is occurring. More importantly, very few community banks are pricing credit to selectively migrate their credit quality. We analyzed two hundred of loans from a little over a dozen community banks across the country over the last 12 months and measured the standard deviation of the credit spread (controlling the credit spread by the bank). We found that the average bank’s one standard deviation for credit spread is only 20.8 basis points. That means that 66% of loans are priced within 41 basis points of each other, and 95% of loans are priced about 82 basis points of each other. Coupled with the loosening underwriting standards, we feel that this is evidence that banks are not differentiating loans based on credit quality. Just the opposite is occurring – credit quality is decreasing to maintain margin.
Finally, we need to underscore the importance of meaningful and marketable prepayment provisions. Generating better credit quality loans is an excellent idea at this point of the credit cycle, but keeping them at the bank is even more critical. The easiest way to prevent your best credits from being poached is to require a prepayment provision in the loan document. However, community banks have struggled with this, and we will share our ideas on the subject in a future blog.
We do not know when this business cycle may turn, but given that it will soon be the longest on record we can assume that we are closer to the end than the middle of the expansion. Banks that increase credit quality near the end of the business cycle fare much better in the downturn than banks that do not migrate their loan portfolio. The migrating the loan portfolio need not be abrupt or drastic but should shift the credit quality in a meaningful way. To achieve this strategy, banks need to give up yield, but in return can gain long-term ROE.
Submitted by Chris Nichols on April 24, 2019