Commercial banks grew loan balances by 2.11% in the second quarter of this year compared to the first. This growth belies that some banks increased their commercial loan portfolios more than the industry average and other banks experienced shrinking loan volumes. While the industry is experiencing much needed total growth, that growth is not evenly distributed among banks.
This past December, the regulatory community telegraphed their intentions of focusing bank examinations on commercial real estate (CRE) concentrations in 2016: “During 2016, supervisors from the banking agencies will continue to pay particular attention to potential risks associated with CRE lending” (SR 15 17, Dec 2015).
If you think the economy is going to muddle along, then you should skip this post as our analysis isn’t going to make a difference in your future - 2021 will be much the same as 2016. However, if you think the economy is going to pick up steam, or if you think the economy will get weaker, then today’s data could make a difference over the next couple of years. As can be seen by the graph below, commercial real estate risk continues to increase and the risk on new community bank loan production is up 6.5% during the first half of this year compared to last year.
We analyzed default rates through 2015 for banks between $300mm and $3B in asset size. Historical default rates were measured and analyzed for various loan categories for this bank set. We also reviewed Moody’s Investor Services corporate default and recovery rates through 2015 and considered which industries may present opportunities for community banks from a yield/risk perspective and as a way to diversify from real estate concentrations.
We always like to look back and see where underwriting and credit accuracy can be improved. Recently, we looked at almost 5,000 commercial real estate (CRE) loans from across the country that was underwritten in 2012. We looked at the property level cash flow projections to include revenue, expenses and net operating income (NOI) and then compared that to what has actually happened over the last 3 years. Our findings should give you some comfort to the conservative nature of your average underwriter.
Introduced in 1937 in an Oklahoma Humpty Dumpty supermarket, the shopping cart has proven to increase per person sales and extend shopping time. A boost to many retail establishments, it is often said to be a predictor of retail health. More shopping cart sales equals more store openings. The problem is that sales are slowing. This is germane to banks as commercial real estate exposure related to retail property financing composes an estimated 22% of community bank commercial real estate (to also include mixed use).
Having more bankers to throw at a borrower or more assets to flaunt does not make a bank more effective. Strategy beats size every time, but bankers need to be smart how to position themselves against large banks. When it comes to loan mix, community banks need to be careful to assemble their assets with enterprise risk in mind. In particular, the increase in commercial real estate (CRE) and specifically, High Volatility Commercial Real Estate (HVCRE) is starting to be a concern.
Last week, we broke down how a quantitative bank may look at credit in order to get more accurate on their credit grades. Most banks do this to make sure they have their loan loss reserve levels correct. However, the better reason to invest in your credit model is to win more loans from the competition, while not being adversely selected. Today, we look at one of those two strategies that a bank might employ to drive out their competition from the marketplace or at least protect themselves from being driven out of business.
One problem with commercial loan portfolio due diligence is that there is no common underwriting standard between community banks. Mortgages, autos, consumer and other retail-type of loans tend to be more standardized since liquidity is greater. However, when it comes to commercial lending, the difference between banks can be wide. One bank’s “3” rated credit can be another bank’s “6.” While this is understandable between banks, this credit gap can even be found within one bank as different regions, branches and even lenders can propagate these systemic differences.
Few banking school classes teach the finer points of loan structuring these days. This is a mistake as loan production is so competitive and spreads so thin that inexperienced lenders are at a distinct disadvantage. Last week, for example, we were discussing a loan here at CenterState and we determined the downside (stressed) case in a particular commercial real estate loan’s cash flows was a 0.8x debt service coverage ratio (DSCR). The question came up how much risk is that compared to a loan that cash flows at 1.25x stressed case?