What Industries Should Banks Avoid and Target Plus Tax Reform Pricing Change Projections

Bank Credit RIsk Projections

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. It is important to note that these projections were done prior to the tax law changes and thus we look for them to further improve. In this article, we discuss a summary of credit trends for new loans, highlight pricing changes taking into account both credit and tax reform plus provide the top ten industries where credit is improving and deteriorating. 


What Is Happening To Bank Credit


The average forward-looking probability of default for bank credit came in at 2.3% or 14 basis points above where it was last year at this time. This is a 6% worsening of credit, but we quickly point out that the 14 bps of movement are well within the standard deviation of 21 bps. It is too early to know that the deterioration is a trend, as statistically credit spreads remained within their normal bands.


The volatility of credit which we measure by one standard deviation of POD movement came in at 2.1%, which is just slightly lower than the 2.2% credit volatility of last year. To put this in a practical context, while the average loan has a 2.3% probability of going into default on any given year, 68% of the time, that probability of default can range between 1.15% and 3.25%.


Industry probabilities of default - bank credit


All told, 23% of the industries we track improved their annual probabilities of default, 75% got worse, and the remaining 2% were unchanged. The average credit that improved decreased their probability of default by an average of 12 bps, while the average credit that deteriorated increased their probability of default by 22 bps.


Deteriorating Industries


Largely, the deterioration of credit was driven by negative changes in healthcare payments (healthcare PODs are up 52 bps), lower energy prices (energy company PODs are up 60 bps), and changes as a result of technology shifts. Within technology shifts, traditional retail struggled, demand for electronic hardware weakened due to app/smartphone development, and the “Uberization” of transportation continued. In 2016, we saw this rise in on-demand rideshare usage impact taxis and limousine companies (+50 bps). Now, we see credit being impacted by such things as rail transportation (+ 43 bps), shuttle transportation (+63 bps) and car rental companies (up +41 bps).


The other major negative shift that is forecasted to continue is media as radio/TV broadcasters increased 51 bps in credit risk. The good news is that the deterioration of credit in print has largely stabilized from several years ago and the PODs were up only seven bps year over year.


Finally, with regard to technology, education continues to get hit (+37 bps) as more education moves online and prices continue to go up hurting demand.


Improving Industries


On the positive side, credit improved in some agricultural lines such as dairy (PODs down 30 bps), hogs (-11 bps), and grain milling (-21 bps). Commercial construction trades and products such as lighting (-40 bps), steel (-36 bps), aluminum (-31 bps) and metal wholesale (-22 bps) saw the most improvement.


Industries related to tourism improved (+14 bps) due to a better improving economy as did securities/investment firms (-18), courier services (-19) and apparel manufacturing (-15 bps).




In line with forward-looking higher probabilities of default, loan spreads increased four basis points in December to an average of + 2.48% for commercial real estate and + 2.61% for commercial non-real estate secured. Some probabilities of default shifted 132 basis points, while the average credit shifted 14 for the quarter. Both of those are material moves as it constitutes 35% and 6% changes respectively. Banks that are not paying attention could find their return on equity over time is substantially lower than expected.


To give banks a feel for this impact of credit and taxes we first price a typical 20-year amortizing loan due in five years at the average spread of + 2.48%. The change in the forecasted credit drops this $1.5mm loan from a 15% risk-adjusted ROE loan to a 14.3% risk-adjusted ROE loan.  Note that this is under the old corporate tax structure. 


Loan Pricing with the Tax Cut Jobs Act - Tax Reform


We then hold everything else constant and just adjust for Federal taxes bring the top marginal rate down to 21%. If we recalculate, this gives us a 17.6% risk-adjusted return on equity and an increase in profitability by some $21k.


Loan Pricing with the Tax Cut Jobs Act - Tax Reform


This, of course, can’t last as competition will serve to further tighten spreads. In both examples above, we used an average manufacturing company. We then apply their new tax rate take into account the new cap on interest deductibility, depreciation, and other reform changes (as we outlined HERE) and adjusted credit accordingly. 


Loan Pricing with the Tax Cut Jobs Act - Tax Reform


As can be seen above, there is plenty of new room for commercial loan price compression. What was a Libor + 2.48% spread for the fourth quarter, we project will tighten to Libor + 2.17% over the next year. This won’t happen overnight, but we believe that the bulk of this change will occur in the next 60 days as banks proactively adjust their loan pricing to compensate for their own lower tax liability. Also, the next major change in loan pricing will occur during the summer months when bankers get a feel for how tax reform is impacting their borrowers. Higher free cash flow level should serve to improve credit thereby warranting tighter pricing.


Putting This Into Action


Banks that track industry credit changes have a clear advantage as they can proactively select certain industries and more efficiently construct a credit portfolio. Banks that are still trying to target a non-risk-adjusted net interest margin will find themselves losing more quality transactions and likely gaining lower credit quality borrowers. Tax law changes, potentially deteriorating credit and higher rates will create some clear industries that are winners and losers. Banks need the ability to create a loan portfolio with intent and proactively go after those credits that they desire.