As Good As It Gets

By Kenneth Cline

Banks continue to enjoy a favorable lending environment and sterling credit quality. But chief credit officers say these halcyon days can't last forever.

Midway through 1997, loan volumes remain strong and credit quality coasts along comfortably. While credit card delinquencies are beginning to take a toll on consumer portfolios, household financial stress has not yet spilled over into other retail lending products. And commercial loans still show no signs of trouble. Flush with capital and reserves, banks in any case seem well prepared to handle whatever credit problems do arise.

Enjoy it for now. Chief credit officers and other industry observers agree that this is as good as it gets. While the credit card problem is driven by excessive consumer debt and liberal bankruptcy laws, an economic recession would eventually spread trouble into other areas, such as auto loans, mortgages and home equity lines. Commercial credits would feel the impact as well. Already there are signs of lax underwriting in commercial lending.

"It's as good as it's ever been and I don't expect further improvement," says Dorothy M. Horvath, chairwoman of Robert Morris Associates, the industry's credit quality watchdog group. "If anything, we're going to start seeing some increases in problem indicators."

A Banking Strategies statistical study, compiled from data provided by SNL Securities LP, shows that credit quality at the top 50 U.S. banks--a proxy for the industry--actually peaked in 1994. Net chargeoffs fell to roughly 0.5% of average total loans, compared with roughly 1.8% in 1991, when banks were hammered by commercial real estate defaults. The chargeoff ratio has risen slightly from its nadir, inching above 0.6% in the first quarter of 1997.

In other respects, however, the party continues. The top 50 banks together achieved robust annualized returns of 16.74% on equity and 1.27% on assets in the first quarter. Nonperforming assets fell to 0.95% of gross loans, compared with 4.85% in 1991. And reserve coverage is strong, standing at 270% of nonperforming loans at March 31, compared with 70% at yearend 1991.

"In a pure credit sense, things look pretty good right now. It's tough to pick an area that will keep you up late at night," says Jack Meyers, vice chairman and chief credit officer of BankAmerica Corp.

Related Charts

Problem Assets Fall, Coverage Rises Some Problem Indicators Rise Modestly Narrowing Spreads on Syndicated Loans Profitability Keeps Climbing

Fortified by this secure credit environment, lenders feel they still have some room to run. Top lending executives cite computer technology, communications, energy, gaming, and health care as growing industries that continue to generate robust loan demand. Meyers says BankAmerica, buoyed by a rebounding California economy, still sees plenty of opportunity in retail, small business and middle market lending.

The wild card in everybody's lending/credit quality scenario remains the economy. "Usually, the peak in credit quality does not occur until the economy slows down significantly or even goes into recession," says Norwest Corp. economist Sun Won Sohn. "If we are heading into a recession--say, in the next year or so--then we are looking at the tip of the iceberg right now."

But Sohn himself doesn't expect a recession soon. So long as economic growth remains in its "Goldlilocks" state of "not too hot and not too cold"--about 3.25% annualized--and interest rates don't rise dramatically, banks likely will enjoy another year or two of good times. Sohn, for one, judges the economic outlook to be "reasonably good" through 1998. His one concern is a major rise in interest rates triggered by the Federal Reserve Board, which would impact interest rate-sensitive sectors of the economy such as housing and automobiles.

Credit Card Woes

Problems, when they occur, will likely show up first in the consumer sector because household spending has fueled the current economic expansion. And the proliferation of adjustable-rate mortgages, credit cards and home equity lines has made consumers more vulnerable to rising rates.

Rising delinquencies in credit card portfolios already suggest many consumers are overburdened with debt, a situation exacerbated by liberal bankruptcy laws. Personal bankruptcies surged above one million filings last year, an annual record. The percentage of bank card accounts more than 30 days past due has been rising steadily for the last two years, reaching 3.75% at yearend 1996, according to the American Bankers Association. The Federal Deposit Insurance Corp. reports that bank card chargeoffs accounted for 61% of the industry's $15.5 billion in net loan losses last year.

Paul W. McGloin, chief risk policy officer at CoreStates Financial Corp., attributes half of his bank's card losses to bankruptcy filings, which move a credit from performing to chargeoff status in one fell swoop. McGloin and other credit quality guardians expect these card delinquencies to worsen and are taking action now to gird themselves against further deterioration. Philadelphia-based CoreStates recently instituted a policy of carrying reserves sufficient to cover four full quarters' worth of anticipated credit card losses, extrapolating from past trends. CoreStates also reduced its time frame for charging off bad credits, from 180 days to 150 days.

Nicholas J. Ketcha Jr., director of bank supervision at the Federal Deposit Insurance Corp., points out that card issuers have more than $1 trillion of untapped credit lines outstanding, paving the way for immense additional consumer borrowing. He says the FDIC's "greatest concern" is that households and small businesses will fall back on this credit in a recession, piling on additional debt at a time when they--and the banks--are least able to carry it.

Bankers are watching nervously to see when credit card problems spill over into other areas of consumer lending. For now, the phenomenon mostly is confined to the "subprime" category, or loans made to individuals with blemished credit history. The FDIC recently warned banks about the dangers of carrying additional subprime auto and credit card loans directly on balance sheets, and it also cautioned against providing financing to specialized subprime lenders.

The well-publicized crackup of several subprime auto lenders has alerted bankers to weakness in the low end of the auto paper market. McGloin says he's "relatively comfortable" with the quality of standard, bank grade auto paper CoreStates is seeing right now. But McGloin, like other chief credit officers, wonders what will happen in an economic slowdown. The leasing craze introduced a new risk factor to auto lending in the 1990s. How will lease lenders cope if a flood of slightly used cars hits the market at the same time manufacturers are piling on incentives to push new vehicles?

"The assumptions made about residual values of leased vehicles will most likely turn out to be overoptimistic," says Mickey Dry, chief credit officer of Wachovia Corp. in Winston-Salem, N.C. "From a historical perspective, there will be less equity in cars. If you've been heavy in leasing and, on top of that, aggressive in your residual assumptions, you could be in for trouble."

Slipping Standards?

Commercial portfolios remain healthy. According to the FDIC, only 0.26% of average commercial and industrial loans had to be charged off in the fourth quarter of 1996, compared with 4.73% of average credit card loans. Few major banks reported significant blips in commercial delinquencies in the first quarter.

However, concerns about pricing and margins are mounting. Margins have become so thin in syndicated loans, for example, that lenders have been complaining they are not getting paid for the risk they take.

Spreads on top-rated syndicated loans contracted by 48% over the last three years, from 31.3 basis points in the first quarter of 1994 to 16.4 basis points in this year's first quarter, according to New York-based Loan Pricing Corp., which tracks lending trends. "In the investment-grade loan market, you can almost say there's no profitability," says Loan Pricing market analyst Babak Varzandeh. "The spreads and fees have been compressed to the point where anything that's getting done in that market is purely for the purpose of maintaining relationships."

The riskier, leveraged market is the most profitable corporate lending avenue right now, adds Varzandeh, citing wider credit spreads and higher fees. But even in leveraged credits, intensifying competition between commercial banks and investment banks is squeezing margins.

The Office of the Comptroller of the Currency, in its annual survey of credit underwriting practices at the nation's largest banks, reported last September "a moderate but discernible trend of increasing credit risk within the national banking system, despite a stable economy and generally favorable leading economic indicators." The agency's report focused mainly on pricing pressures and thin margins in national loan syndications. But Comptroller Eugene A. Ludwig subsequently gave speeches warning about declining underwriting standards seen at some banks over the last two years.

"Most troubling to us is the liberalization of some underwriting structures and terms," says Scott Calhoun, the OCC's deputy comptroller for risk evaluation. While pricing pressures are mostly market-driven, banks should exercise more control over their own underwriting standards, in the agency's view. The OCC examiners are disturbed by relaxed loan covenants, lengthened maturities and increased leverage in deals across the entire spectrum of commercial and industrial loans, according to Calhoun.

"We don't see enormous exposure to default risk today," Calhoun adds. "But we see much more structural risk today than in the recent past, which gets to the relaxation of some of the terms, covenants and protections built into typical agreements between lender and borrower."

Because of these concerns, the OCC is now recommending that banks take a closer look at their reserve levels. Calhoun says the agency wants banks to front-load loan-loss provisions, diverting earnings into reserves now, when times are good, rather than waiting until a recession forces their hand. Some banks have taken the opposite tack in recent quarters by failing to match chargeoffs with commensurate reserve-building.

But the OCC, according to Calhoun, has not taken as critical a stance on the reserve question as certain analysts. Richard X. Bove of Raymond James & Associates and Raphael Soifer of Brown Brothers Harriman & Co., for example, have raised red flags about banks' propensity to grow loans faster than loss reserves. Between 1992 and 1996, for example, annual loan growth of 10% dwarfed a 2.1% annual growth in loss reserves at the top 50 banks, according to Bove, who in early May advised the sale of all but a few select bank stocks.

By one stringent measure employed by Banking Strategies, however, aggregate reserve coverage among the top 50 banks has not weakened in recent years.

Shock Absorbers

Overall, the OCC seems to believe banks are better positioned to handle a credit downturn than they were in the late '80s. Calhoun ticks off the reasons: healthy levels of capital and reserves, improved diversification and risk management techniques, and the increased use of securitization, which shifts risk off bank balance sheets. In addition, the market has not been ruinously polluted by the antics of countless insolvent savings and loans, as was the case a decade ago. Nor has it been roiled by runaway inflation. "That's not to say there couldn't be a casualty or two," Calhoun says. "It's just that, because the industry is better prepared, the overall pattern in a downturn should be one of slowing earnings growth (as opposed to widespread failures)."

While underwriting standards have slipped recently, safeguards still are improved from the 1980s. Commercial lenders today usually base their deals on strong cash flow with a clearly identified source of repayment, as opposed to, say, relying on future asset sales, a feature of the highly leveraged transactions of the late 1980s. Varzandeh at Loan Pricing Corp. says another difference is that major term loans are now structured so that the largest repayments come due later in the loan's cycle, giving the companies more cash flow up front and therefore more financial flexibility. Companies are also better able to refinance their loans in today's low interest rate environment.

The industry has made great strides in risk management, moreover, strengthening controls and emphasizing diversification, both by geography and by industry category. Says Varzandeh, "Bankers tell me that even if they hit a few isolated defaults, they're not holding big positions on a lot of deals."

So perhaps this credit cycle truly is different. But history suggests the need for caution. Banks always suffer when the economy turns down, and the worst credit hits often come from unexpected quarters. And some protections banks are relying on now may not prove to be fail-safe. Securitization, for example, theoretically shifts risks off bank balance sheets. But what happens when securitized portfolios turn sour? Banks can't afford to turn their backs on investors, since they risk damaging their own credibility in the asset-backed market. Rather tellingly, both Banc One Corp. and First Union Corp. have felt compelled to come to the rescue of their troubled credit card pools by cutting fees and contributing new receivables.

Complacency now--when times are good--could be misguided. Says the FDIC's Ketcha, "We've always said the business cycle doesn't last forever. Some place along the line, there's going to be a blip."

Mr. Cline is senior editor of Banking Strategies.

Copyright © 2003 by Banking Strategies, published by BAI.

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