While most bankers are familiar with the probability of default for various lines of business, many do not have a feel for the volatility of the lending category nor the correlation to the US economy.
Tag: Probabilities of Default
If a commercial real estate loan fails to pay on time, what is the probability of bringing the loan current?
Credit is always changing and we watch a variety of markers such as corporate bond credit spreads, vacancy rates, net effective rents and many others in order to help us understand credit. Three of those important credit metrics are the probability of default (POD) by industry, the rate of change of that POD and the volatility of credit of each industry. We just got fourth-quarter forward-looking, through cycle probabilities of default in driven by PayNet and have run our analytics.
Given the rise of CECL, the term “probability of default” (POD) and “probability of survival” gets thrown around a lot these days. Ten years ago, these were terms that only credit analysis or portfolio managers truly understood. Now, we see them misused a lot, and more importantly, the concepts are getting muddled. Using PODs are one of the most important tools for understanding credit and all bankers, including those not in loans, should have a basic understanding of how to use these metrics.
When it comes to underwriting, it is not so much the risk that causes banks concern, but the volatility around the risk that is the problem. The major industry with the highest probability of default for banks is trucking at a 4.7% annual probability of default, but if you price and reserve for 1.4% of the loan, you have mitigated that risk. That is, lending to a trucking company is no more risky as lending to a pig farmer, which incidentally has the lowest probability of default as of June of 2017 at 0.95% and would require pricing and a reserve of about 0.29%.
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).
The 20’s and 30’s were known as the Golden Age Of Aviation and today is a particularly special day in aviation history as it marks the 88th anniversary of Charles Lindbergh becoming the first person to fly across the Atlantic and the 83rd anniversary of Amelia Earhart doing the same in the first female solo transatlantic crossing. In similar fashion, we are in the Golden Age Of Commercial Credit and today marks the day when commercial credit has never been better in the history of banking.
Chances are if you are like most banks you might price a 3, 5 or 10-year loan at the same spread. If it is a fixed rate loan, maybe you price it off the appropriate Treasury, swap or FHLB index, but that only takes into account interest rate risk. As can be seen in the accompanying graph, based off community bank loan historic performance, credit risk starts off very low the first couple years of a loan, only to ramp sharply up before it starts to plateau around year seven.
Do you treat all cash flow the same? That is, does a property with a 1.25x debt service coverage get a “3” rating no matter what type of property it is? If so, your bank is most likely mispricing risk which will hurt performance over time. Every waking business day, bankers have to make decisions and the ones with the best information will have superior performance over time.
If you drive a fair bit, you probably agree with us that gridlock is bad, but it is starting to get better. It used to be we used to drive to work only to use the bathroom and then start to commute home. Now, with many of the major Stimulus Package projects coming to an end, we can make it to work and discuss the latest episode of Homeland before having to turn around - And this is a problem.