Powerball And The Reason Why Banks Need To Tighten Underwriting Standards

Tightening Bank Underwriting

Tomorrow night’s Powerball lottery will be the world’s richest at an estimated $1.4B. Bankers, despite the odds, are even buying tickets both individually and in syndicates. The ironic part is that with such a big pot, the odds of you winning don’t change (still 1 in 292 million, or about the same as a quarter coming up heads 28 times in a row), but the expected winnings actually go down with a larger jackpot, not up. The higher number of players increases the odds of you splitting the jackpot. This is why bankers would be wise letting the computer pick your numbers, as you have whole segments of society playing birthdays (numbers below 31), consecutive numbers, numbers that form shapes on the ticket and the number 69 (the highest number you can pick). The good news is that bankers are familiar with this concept of expected winnings, as it is the same for understanding expected losses in their lending portfolio. That knowledge is particularly germane these days as it points to why you should also be tightening underwriting standards along with buying Powerball tickets.

 

Warning Signs

 

Lost in the all the Powerball hysteria on Friday just as the jackpot was setting new records,the Baltic Dry Index hit a record low of 429. This index reflects the cost of shipping raw materials by sea and is thought to be a forward indicator of future manufacturing production. Fewer raw materials means companies are ordering less - less orders mean slower future growth. While the Baltic Dry isn’t that great of a predictor, it is one of many that should concern bankers – lower commodity prices, falling equities, lower commercial construction, wider credit spreads and more global weakness all are sending signs that our growth could be slowing.

Now, we are not here to tell you that we are heading into recession, as there are many bright spots such as employment, consumer spending and corporate earnings. However, our point today is that the odds are increasingly growing that we could be within a couple years of the top of the asset quality market. If you think like us, then there are some clear steps you might want to consider for your own bank’s performance.

 

Is It 2004?

 

The fatal flaw in many bankers thinking has always been the inability to look ahead and forecast into the future. Only about a dozen banks started to curtail lending back in 2004 anticipating the top of the market. Sure they missed two great preceding years, but what they gave up in profits in 2005 and 2006, they made up for during the 4th quarter of 2007 when the bottom dropped out of the credit markets and loan values reset down by an average of 10% (to be followed by another 20% by 2008). Unfortunately, many banks failed to make adjustments, most waiting to mid-2008 to reduce the credit risk on their balance sheets.

 

Putting It Into Action - Playing More Defense

 

There are a number of ways that banks can get more defensive. While the situation isn’t as drastic as selling loans and shutting off lending, there are three things that you should consider. We have already written extensively as we laid out our quantitative case for why banks should be increasing their allowance for loan loss provisions (HERE). This we believe is mandatory for most banks.

 

The second step that your bank should consider is moving up in credit quality. Here, what you should consider is going after higher quality borrowers at tighter spreads. If you did this one tactic two years before each bank trouble spots over the last 25-years (1989, 2000 and 2004), your bank would have been significantly better off.

 

Better Returns

 

If you think that moving from a 3.5% credit spread to a 2.0% credit spread will hurt your bank’s performance, you could be right. Then again, you could be very wrong and you could be one of those bankers that are not looking forward enough. 

 

For example, if you are managing lending off net interest margin, then you are at a distinct disadvantage as you are not measuring the expected risk-adjusted return. If you do have a loan pricing model and/or a credit model that measures risk-adjusted return and takes into account expected probabilities of default, then you could see how given the forward probabilities of default, returns are better.

  

To see this, consider the two loans below. The first is for a quality manufacturer of healthcare equipment that has a solid track record of financial performance and is purchasing their industrial building. As you can see below, pricing is Libor + 2.35%, far too thin for many community banks. However, after adjusting for risk, this comes out to an 18% return on equity. 

 

Loan Pricining

 

Now compare the above loan to the one below. All the terms are identical except this loan is for a retail center, an asset class that is expected to have higher future probabilities of defaults. Despite the margin being Libor + 2.85%, or 21% better, the risk is higher so the expected risk-adjusted return is lower at 14% instead of 18%.

 

Loan Pricing 

Unfortunately, many community banks would choose the second loan, yet give up the first loan to a larger national bank. This could be a mistake if the economy runs into trouble over the next six years (these were both 10-year loans).

 

More Capital

 

Finally, the third thing we might suggest is that to the extent you project a need for capital in the next three years, 2016 would be a good time to get it while debt rates are low and the cost of equity is still relatively inexpensive.

 

Conclusion

  

In addition to increasing loan loss allowance, banks should consider going up in credit quality in order to protect the downside. If some of those economic signs regain strength, then these banks can resume putting riskier assets on. However, we think the time to put riskier assets on was back in 2010 to 2014. Now, as risk increases, we believe banks should look ahead and take some steps to play better defense. Otherwise, you just might need to use some of your expected Powerball winnings to offset some future loan losses.