In the March 2020 Bank Watch, we provided our first impressions of the “reshaping landscape” created by the COVID-19 pandemic and its unfolding economic consequences. This month, we expand upon the potential asset quality implications of the current environment.
One word that aptly describes the credit risk environment is inchoate, which is defined as “imperfectly formed or formulated” or “undeveloped.” We can satiate our analytical curiosity daily by observing trends in positive COVID-19 cases, but credit quality concerns created by the pandemic and its economic shocks lurk, barely perceptible in March 31, 2020 asset quality metrics such as delinquencies or criticized loans. However, the pandemic’s effect on bank stock prices has been quite perceptible, with publicly-traded bank stocks underperforming broad-market benchmarks due to concerns arising from both asset quality issues and an indefinite low interest rate environment. Bridging this gap between market perceptions and current asset quality metrics is the focus of this article.
At the outset, we should recognize the limitations on our oracular abilities. Forward-looking credit quality estimates now involve too many variables than can comfortably fit within an Excel spreadsheet—case rates, future waves of positive diagnoses, treatment and vaccine development, and governmental responses. The duration of the downturn, however, likely will have the most significant implications for banks’ credit quality.
We neither wish to overstate our forecasting capacity nor exaggerate the ultimate loss exposure. We recognize that transactions are occurring in the debt capital markets involving issuers highly exposed to the pandemic’s effects on travel and consumption—airlines, cruise operators, hotel companies, and automobile manufacturers. Investors in these offerings exhibit an ability to peer beyond the next one or two quarters or perhaps have faith that the Fed may purchase the issue too.
To assess the nascent credit risk, our loan portfolio analyses augment traditional asset quality metrics with the following:
A Farewell to Arms (1929) by Ernest Hemingway, which provides the preceding quotation, speaks to a longing for normality as the protagonist escapes the front lines of World War I. While perhaps a metaphor for our time, the quotation—with apologies to Hemingway—also fits the 2008 to 2009 financial crisis (“the world breaks everyone”) and uncertainties regarding banks’ preparedness for the current crisis (will the industry prove “strong in the [formerly] broken places”?).
To simulate credit losses in an environment marked by a rapid increase in unemployment and an abrupt drop in GDP, analysts are using the Great Financial Crisis as a reference point. Is this reasonable? Guardedly, yes; in part because no preferable alternatives exist. But how may the current crisis develop differently, though, in terms of future loan losses?
Table 1 presents aggregate loan balances for community banks at June 30, 2002 and June 30, 2007, the final period prior to the Great Financial Crisis’ onset. One evident trend during this five year period is the grossly unbalanced growth in construction and development lending, which led to outsized losses in subsequent years. Have similar imbalances emerged more recently?
We can observe in Table 2 that loans have not increased as quickly over the past five years as over the period leading up to the Global Financial Crisis (67% for the most recent five year period, versus 90% for the historical period). Further, the growth rates between the various loan categories remained relatively consistent, unlike in the 2002 to 2007 period. The needle looking to pop the proverbial bubble has no obvious target.
Using the same data set, we also calculated in Table 3 the cumulative loss rates realized between June 30, 2008 and June 30, 2012 relative to loans existing at June 30, 2008.
This analysis indicates that banks realized cumulative charge-offs of 5.1% of June 30, 2008 loans, although this calculation may be understated by the survivorship bias created by failed banks. The misplaced optimism regarding construction loans resulted in losses that significantly exceeded other real estate loan categories. Consumer loan losses are exaggerated by certain niche consumer lenders targeting a lower credit score clientele.
Are these historical loss rates applicable to the current environment? Table 4 compares charge-off rates for banks in Uniform Bank Performance Report peer group 4 (banks with assets between $1 and $3 billion). Loss rates entering the Great Financial Crisis and the COVID-19 pandemic are remarkably similar.
We would not expect the disparity in loss rates between construction and development lending versus other real estate loan categories to arise again (or at least to the same degree). Community banks generally eschew consumer lending; thus, consumer loan losses likely will not comprise a substantial share of charge-offs for most community banks. For consumer lending, the credit union industry likely will experience greater fall-out if unemployment rates reach the teens.
Regarding community banks, we have greater concern regarding the following:
In the Great Financial Crisis, banks located in more rural areas often outperformed, from a credit standpoint, their metropolitan peers, especially if they avoided purchasing out-of-market loan participations. This often reflected a tailwind from the agricultural sector. It would not be surprising if this occurs again. Agriculture has struggled for several years, weeding out weaker, overleveraged borrowers.
Additionally, to the extent that the inherent geographic dispersion of more rural areas limits the spread of the coronavirus, along with less dependence on the hospitality and tourism sectors, rural banks may again experience better credit performance.
The Plague (1947) by Albert Camus describes an epidemic sweeping an Algerian city but often is read as an allegorical tale regarding the French resistance in World War II. Sales of The Plague reportedly have tripled in Italy since the COVID-19 pandemic began, while its English publisher is rushing a reprint as quarantined readers seek perspective from Camus’ account of a village quarantined due to the ravaging bubonic plague.
As Camus observed for his Algerian city, we also suspect that banks will not be free of asset quality concerns so long as COVID-19 persists. Another source of perspective regarding the credit quality outlook comes from the rating agencies and SEC filings by publicly-traded banks:
Banks tend to be senior lenders in borrowers’ capital structure; thus, the rating agency data has somewhat limited applicability. Shadow lenders like business development companies and private credit lenders likely are more exposed than banks. Nevertheless, the data indicate that the rating agencies are expecting default and delinquency rates similar to the Great Financial Crisis. As for Camus’ narrator, the ultimate duration of the pandemic will determine when normality resumes. Lingering credit issues may persist, though, until well after the threat from COVID-19 recedes.
Community banks rightfully pride themselves as the lenders to America’s small business sector. These small businesses, though, often are more exposed to COVID-19 countermeasures and possess smaller buffers to absorb unexpected deterioration in business conditions relative to larger companies. Permanent changes in how businesses conduct operations and consumers behave will occur as new habits congeal. This leaves the community bank sector at risk. However, other factors support the industry’s ability to survive the turmoil:
Nonetheless, credit losses tend to be episodic for the industry, occurring between long stretches of low credit losses. The immediate issue remains how high this cycle’s losses go before returning to the normality that ensues in Hemingway and Camus’ work after war and pestilence.
1 Emmanuel Louis Bacani, “US Speculative-Grade Default Rate to Jump Toward Financial Crisis Peak – Moody’s,” S&P Global Market Intelligence, April 24, 2020
2 Fitch Ratings, U.S. LF/CLO Weekly, April 24, 2020.
3 Fitch Ratings, North American CMBS Market Trends, April 24, 2020.
4 Fitch Ratings, U.S. CMBS Delinquencies Projected to Approach Great Recession Peak Due to Coronavirus, April 9, 2020.
5 Fitch Ratings, Update on Response on Coronavirus Related Reviews for North American CMBS, April 13, 2020.
6 Jake Mooney and Robert Clark, “US Banks Detail Exposure to Reeling Hotel Industry in Q1 Filings,” S&P Global Market Intelligence, April 24, 2020
7 Tom Yeatts and Robert Clark, “First Financial, Pinnacle Rank Among Banks with Most Retail Exposure,” S&P Global Market Intelligence, April 27, 2020
Originally published in Bank Watch, April 2020.