When is it too much of a good thing?
The third quarter results of many banks are showing growth in loan portfolios, even at a time when there are multiple factors at risk in the US economy. Interest rates continue to be a 'question mark', with an increase ever on the horizon, but unknown. Oil prices are impacting a wide sector of the economy in states that are heavily engaged in oil and gas production and related industries that make up much of their employment base. The upcoming election and the impact that the winner might have on the direction of government policy represent more unknowns looming in the relatively near term future. Uncertainty and struggles in foreign economies to which we are tied, whether we want to be or not, may sideswipe any progress we make on our own.
Yet the US economy overall is seeing continued growth, and banks are seeing reduced charge-off levels and healthy increases in loan portfolios. But are they healthy? Are the higher levels of interest income blinding bankers to the 'disease' that we just recovered from? Are the improved LTV's as artificial today as they were in 2006? Is the reported easing of underwriting standards allowing borrowings which will not be supportable when the economy experiences the inevitable decline, however temporary?
In a speech last week the OCC's Thomas Curry reminded banks that this is a typical point in the economic cycle where banks become focused on growth numbers and drop their guard a bit when it comes to protective covenants, practical maturities, and underwriting standards in general. The competition for the 'good' loans is tougher and the market is still rewarding the banks that report growth and related profit increases. The OCC on the other hand, insists that it has not forgotten. "While I have no intention of letting up in our emphasis on operational risk, we are reaching that point in the cycle where credit risk is moving to the forefront," said Curry on Wednesday, October 21st.1
One major difference between the current situation at many banks and where they were in 2006 is that frequently banks have more of their capital tied up in troubled assets than they did back then. According to a recent analysis of FDIC reports from June 30, there are three times as many dollars in noncurrent loans as there were in mid-2006.2 The reason for that is multi-faceted. While many loans are underperforming, the interest rates associated with them are higher than what the bank could earn if it had to redeploy that capital today. And to sell those assets, banks would possibly have to incur a loss due to the write-down required for the sale which would be an immediate hit to income as well. Low funding costs have somewhat 'enabled' banks to hold on to these troubled assets for longer than they might have in a different interest rate environment, and this could bode ill for the time when managing these assets and funding them becomes more expensive, which could be the case relatively soon.
While 'recapture' was a positive topic in many annual reports earlier this decade, the tide there has turned as well. Many banks are reporting that they are in fact increasing their loan-loss reserves this quarter to reflect concerns about slowdowns in the economy continuing. Some of those are also the banks with hefty exposures to the oil and gas industries, so it was not a result of overwhelming caution by any means.3 These bankers are also ones publicly discussing concerns about portfolio health and earnings pressure leading to aggressive lending strategies.4
While concerns about the oil and gas industry have been widely recognized, another area of concern that Curry addressed is the increased levels of auto lending. Outstandings in these portfolios were significantly higher in the 2015 second quarter results, and the specifics of the loans being made here is cause for concern as well. The term of average auto loans has increased in recent years, and standards for credit scores are reportedly lower.5 As if on cue, on October 27th the OCC released new guidance for exams of floor plan lending as part of the Comptroller's Handbook on Asset Quality in Safety and Soundness exams.6
None of these issues should come as a real surprise to anyone who has been in lending since before the 2006 peak. When will we learn? We know better but we can't help ourselves - is that it? Hopefully we have learned, and the OCC won't be the only one pulling in the reins next year. There have been quite a few years to shore up weakened balance sheets and clean up poor performing portions of the loan portfolio. This business is cyclical and that should come as no surprise, but Mr. Curry is right to start sounding a warning now, so that smart bankers can make whatever last preparations they need to, as we enter what could be another part of the cycle that includes more 'downward' movement.
