Commercial Loans: A Bubble About to Burst?

Morningstar

Commercial and industrial loans have provided a safe haven for banks in the aftermath of the financial crisis. Burned by real estate in all its forms--residential mortgages, land and construction loans, and commercial real estate--banks turned to business lending to find growth, egged on by politicians eager to aid the economic recovery. Over the past two years, banks have lowered lending standards and prices in an attempt to build their books. Only time will reveal the extent of the building bubble, but we think at least a few large banks have already accumulated dicey levels of exposure to C&I loans. We would be wary of holding these banks at high prices, and think investors in the rest should keep a close eye on regional economies.

Why Worry?
Commercial and industrial loans are made to businesses for a variety of purposes and to nearly any industry. They include both working capital and term loans and can be made on a secured or unsecured basis with widely varying contractual terms and maturities. Seasonal and working capital loans finance current assets like inventories and receivables and are often structured as revolving lines of credit. Term loans are usually associated with a fixed repayment schedule and used to finance assets including plants, equipment, and long-term working capital.

In the aftermath of the financial crisis, banks turned to C&I loans for a variety of reasons. Recently burned by residential mortgages and other types of real estate, and suffering from low demand for (and increased regulation of) consumer loans, bankers across the country have been finding the growth and yield they are looking for in the form of C&I loans. As bankers are wont to do, they rushed en masse into the field in 2010, encouraged by political pressure to continue lending and aid the economic recovery as repayment for the assistance they received in 2008-09.

Since then, commercial lending has experienced both exceptional growth and a decline in lending standards. Growth in C&I loan balances at commercial banks accelerated coming out of the Great Recession, reaching double-digit annual rates by 2012 before slowing to a still-healthy 8% by October 2013. Balances at the nation's banks now total $1.6 trillion--equivalent to the peak levels reached by late 2008.

According to the Federal Reserve's most recent Senior Loan Officer Opinion Survey on Bank Lending Practices, commercial lending standards began a sizable decline in early 2010 and have been easing fairly consistently ever since. In fact, the proportion of large banks easing lending standards reached levels around 20% (comparable with the easing that occurred in 2004 and 1993) on several occasions since that time. At the same time, banks are competing more aggressively on pricing. In the October 2013 Beige Book, several Federal Reserve Districts (Philadelphia, Cleveland, Richmond, Chicago, and Dallas) reported "intense competition on pricing and terms." Much like underwriting standards, commercial loan spreads have been loosening considerably for several years. The larger banks we cover may be even more prone to underpricing than smaller competitors, as regional and company-specific risk factors may be ignored by large-scale risk models.

Furthermore, the relaxation of lending standards is not due to improvement in the economic outlook. Instead, respondents to the loan officer survey are citing aggressive competition and heightened risk tolerance as the major causes for their banks' actions. The combination of heady growth rates, loosening standards, aggressive competition, and increased tolerance for risk seems like a familiar recipe for disaster. But do commercial and industrial loans pose the same risks to bank investors that subprime mortgages did before 2007?

Some banks have exposures large enough to cause problems in the event of a commercial lending bust. Of banks we examined with more than $10 billion in assets, 14 maintain more than 300% of tangible common equity tied up in C&I loans, and six of these have more than 400% of tangible common equity in exposure to C&I. In addition to total balance sheet C&I lending, rapid growth--especially as underwriting standards have fallen--is a concern. Banks with significant exposure to commercial lending, and that have aggressively added commercial loan balances over the past two years, bear the most risk related to this category.

Elevated delinquencies in a benign environment can be an early sign of future credit problems. As part of our global credit rating methodology, we examine the relative credit performance of a bank versus all publicly traded peers. In studying troubled banks, we have learned that banks experience deteriorating credit performance (relative to the industry average) up to three years before failure. We applied these findings to banks with high C&I exposures, looking for those with relatively high rates of delinquent commercial loans, on the assumption that exceptionally high rates of delinquent loans now could be a harbinger of even higher losses later. Large banks are experiencing commercial delinquencies at an average rate of about 0.40%, but customers at a handful of institutions are making late payments at more than twice those rates.

How Bad Could It Be?
Having established that a potentially dangerous combination of C&I concentration, lax underwriting, and price competition exists, we set out to examine the potential for investor losses in the event of a downturn.

Bad C&I loans at U.S banks exceeded 6% of balances on more than one occasion in the past 30 years, according to the Federal Reserve. Our global credit rating methodology is somewhat harsher, assuming that loss rates could reach 8% on these loans in a stressed scenario, on par with the "more adverse scenario" loss rates assumed by regulators in the initial Supervisory Capital Assessment Program. To determine a bank's vulnerability to a C&I lending bust, we examined potential losses--using our 8% stress-case rate--relative to its tangible common equity and earnings.

We initially tested potential effects on solvency by assuming an immediate reduction in tangible common equity equal to 8% of each bank's C&I loan balance. While only six of the banks tested now have tangible common equity ratios less than 6%, 21 banks would fall short of the 6% level assuming an instantaneous 8% reduction in the value of their C&I loans. Furthermore, while only two banks maintained tangible common equity ratios of less than 5% as of Sept. 30, an 8% C&I loss rate would result in 10 banks breaching the arguably critical tangible leverage ratio of 20:1.

Earnings, of course, provide an offset to credit losses. Additionally, the income of a well-capitalized bank could be significantly affected by unexpected C&I losses. Therefore, we also compared stress-case C&I losses (again assuming an 8% loss rate) against pretax, preprovision earnings. Since Morningstar does not cover every bank we analyzed, we used an annualized average of quarterly pretax, preprovision earnings over the past three years as a proxy for earnings power, rather than the analyst forecasts used to generate fair value estimates and credit ratings. Of the banks we examined, 26 would have at least a year of pretax, preprovision earnings wiped out by stress-case C&I losses, while seven would lose more than two years of earnings.

Which Banks Are Most Vulnerable?
With all that as background, we set out to identify the most vulnerable banks in our coverage list. We assume a C&I lending bust would primarily affect banks with the following qualities.

Outsize exposure to C&I loans: More than 300% of tangible common equity tied up in commercial lending.

Recent growth in C&I balances: More than 10% average annual growth in C&I balances since December 2010

Earnings vulnerability: Stress-case losses (8% C&I loss rate) greater than one year of average pretax, preprovision earnings power.

Only eight large banks fit all of these criteria.

What Should Investors Do?
The risks alone are not necessarily reason to short--or even sell--most of these stocks. A few considerations serve to temper our bearishness despite the obvious risk factors.

Past problems in C&I lending have been related to problems in various industries, often on a regional basis. The 2001 "business recession" following the tech crash produced a brief but significant increase in commercial loan losses. Defense industry cutbacks contributed to West Coast bank losses in the early 1990s, while a real estate crash in the Northeast hurt associated industries. The energy bust in the mid-1980s was a major factor in C&I losses during that period. With few industries booming in the current economic environment, we think the possibility of a bust is lessened.

Postcrisis capital increases provide a buffer against insolvency. In our opinion, bank failures and dilutive capital raises are usually related to a combination of excess exposure and insufficient capital. Washington Mutual, for instance, had subprime and option adjustable-rate mortgage exposure equal to 751% of tangible common equity at the end of 2006, while no banks we examined have more than 500% of tangible common equity exposure to C&I loans.

C&I loans are less vulnerable to a drop in the value of collateral. Losses in the residential mortgage, land acquisition and development, and commercial real estate markets can be exacerbated by falling collateral values. Business loans, on the other hand, are arguably less subject to volatility in the value of underlying assets.

Loss rates in diversified C&I books are unlikely to match those experienced by the most aggressive mortgage lenders. We note that loss rates of 20%-plus in C&I lending would be necessary to wipe out tangible common equity at even the most exposed banks, with reasonable stress-case loss rates of 5%-10% equivalent to only about one fourth of tangible common equity balances at these banks.

That said, we think investors would be wise to keep a close eye on the valuations, balance sheet growth, and credit performance of the riskiest banks, and be ready to sell their stocks if any of the following occur:

The Morningstar credit rating is lowered. We think the quantitative factors that affect our credit rating--the Morningstar Bank Solvency Score, Stress Test Score, and Distance to Default--often reflect changes in credit quality well in advance of changes in earnings, let alone capital deficiencies.

C&I delinquencies continue to rise above the industry average. We have found that relative deterioration of credit quality at individual banks in benign overall environments can be predictive of severe problems later.

Valuations rise to a level inconsistent with C&I risk to earnings and/or capital. We would be reluctant to hold any of these stocks at a 2-star price.

Industry-specific problems arise. Widespread declines in the profitability of a particular industry (automotive, health care, high technology, and so on) or a slump in a regional economy are likely to cause problems at banks with outsize exposures.

At the moment, we're especially wary of Regions Financial (RF), which increased its C&I loan book considerably after similarly aggressive expansion in construction loans resulted in shareholder losses from 2008 to 2011. We don't think investors in this no-moat stock, which is trading at a premium to our fair value estimate, have much to lose by lightening up exposure.

The case is less clear for City National (CYN) and SVB Financial Group (SIVB). Both have a history of fairly conservative underwriting, and neither is new to the C&I game. In fact, SVB specializes in loans to high-tech and life science companies, a niche few other lenders have the expertise--or nerve--to enter. City National's business model is also commercially focused--the bank provides a variety of trust and other services to business owners in addition to lending, and its commercial customers typically provide the bank with an exceptionally low cost of funds. Investors focused only on valuation may want to reduce exposures to these higher-quality companies, but we would consider waiting for signs of increasing troubles in the California economy before aggressively selling these names.

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