Credit Woes Fuel Concern

Bank analysts are monitoring asset quality very closelyu00e2u20ac”credit deterioration is occurring throughout the industry, raising concerns from both regulators and the market. In times like these, directors must ensure they receive timely, accurate information about its portfolios to make prudent lending decisions, says David Hilder, financial services analyst, Morgan Stanley Dean Witter, Bank Director`s featured analyst in this issue. Hilder points out the pitfalls up ahead, but offers plenty of reason why the industry will remain on solid ground.

Bank Director: How bad is the credit downturn going to be this time?

David Hilder:

I`ve actually been surprised by the small number of negative surprises during the fourth quarter. There were certainly a number of negative pre-announcements, but the only real negative surprise was the $1 billion addition to reserves by Bank One. Going into this period, analysts and investors were expecting more negative surprises. But the fact is that nonperforming assets increased substantiallyu00e2u20ac”ranging as high as 75% on a sequential quarter basis, and nonperforming assets at a fair number of banks were 25% to 30% in the third quarter-to-fourth quarter period. So, how bad will it be? Well, it`s not good. But it does not bear the hallmarks of the credit quality decline that banks experienced between 1989 and 1991. That followed a shorter expansion, but it also followed what was a much greater period of overbuilding in the commercial real estate market. This time, the degree of real estate overlending and overbuilding is not nearly as large as it had been in the late `80s and early `90s. There is an argument, supported by data, which says lending to basic commercial and industrial loans increased by a rate exceeding both inflation and economic growth between 1995 and 2000, and the banks will have to pay for those excesses. The good news is that those excesses were not nearly as large as excess lending to commercial real estate in the late `80s. The potential negative is that the recoveries on nonperforming assets may not be as large. Most of the troubled loans in this cycle are basic, unsecured business loans, which may have a higher loss content than real estate loans because there is no security.

Is there an indication yet of the kind of recovery we are seeing?

It`s too early to know what the recovery rates will be on commercial and industrial problem loans. One thing we`ve done is look at trading prices in the junk bond market and recoveries on, or trading prices for, defaulted junk bonds. Those clearly suggest that loss rates are going up; recovery rates are coming down. The problem is that those averages encompass the last 10 years, including a very robust economic expansion, so it`s not easy to get meaningful comparable data. My guess is that this credit quality cycle will not generate the peak levels of losses that were seen in the late `80s, early `90s. We also looked at a group of 35 major banks, the 25 or 30 largest banks in the country plus a sampling of mid-cap and small-cap banks. Their peak loss year was 1991, when chargeoffs were about 145 basis points of average loans. Admittedly, there is a survivor bias in these numbers. They don`t include Bank of New England or some of the other banks or thrifts that failed. As a benchmark, the banks in the sample entered that period with chargeoffs in the 80 basis points range. In 1999, the chargeoff rate for a slightly smaller group of banksu00e2u20ac”basically 30 large banks that probably had 80% of all bank assets in the countryu00e2u20ac”was at about 80 basis points. Through the first three quarters of 2000, it was at about 75 basis points. I suspect when we throw in the fourth quarter, the year average will get up to 80 basis points. But I would not expect to see chargeoffs rise to 145 or 150 basis points of average loans.

So are we nearing a peak, or is it too soon to tell?

I don`t think the fourth quarter was a peak. We haven`t come up with an official forecast, but my own feeling is that we probably will not see a peak for at least another two quarters. I think that the earliest that nonperforming assets could peak is June 30, but it could be later in the year. Credit quality is generally a lagging economic indicator. If the economy starts to recover in the third quarter, I wouldn`t expect nonperforming assets to peak until after that.

Is it fair to say that no particular sector is to blame for this downturn?

What we are seeing is a movement away from sector-specific problems, which is what drove increases in nonperforming assets in the first half of 2000 and perhaps into the third quarter. What we clearly saw in the fourth quarter was a more generalized deterioration.

Some people might assume that this slowdown is a result of the collapse of dot-com businesses. Is that affecting the bank loan sector as well?

The short answer is “no.” The dot-com problems are really not having a big impact on bank credit quality. The interesting thing about the dot-com companies is that, in many cases, they went directly from venture capital financing to public equity financing through IPOs. They didn`t go through the intermediate stage of bank lending. The fact is that no banker in his right mind would lend money based on the financials of most dot-coms at the time that they took their companies public. In order to get a bank loan you generally have to have some sort of positive cash flow to service the debt. So, banks were not big lenders to dot-coms. But banks might be lenders to some of the more established companies that have indirect exposure to dot-coms.

What about the effect of the Fed lowering interest rates?

I would say the Fed`s move to lower short-term interest rates is an almost unambiguous positive for banks. Clearly the Fed is trying to have an impact on the capital markets, and if it can get the capital markets to reopen that will lead to greater business spending and investment and, ultimately, to a rebound in consumer confidence.

Is there anything boards of directors should be doing to boost earnings or create a positive investment picture in this climate?

I think credit quality continues to be the most important issue that bank directors can focus on. They should make sure they are getting accurate, timely information and that the information that is being passed on to both equity and bond investors and to the rating agencies is truly accurate and timely and fairly presents the credit quality situation of the bank. After that, they should look at the information carefully and ask management what they are doing to manage credit risk, both what the underwriting standards are going forward and, perhaps more importantly, what steps are being taken to identify and work out the credits that are going to get into trouble.

Is there a danger that a board could become scared by credit quality problems and tighten too much, restricting a bank`s growth?

That is a danger. I think analysts and directors have to remember that banks are in the business of taking credit risk. That is the skill that commercial banks have, underwriting and managing and pricing credit risk, as well as working out the problems when they arise or deciding, perhaps, that they should be worked out by someone else and then selling the loan. That said, I think most bank directors realize they are in the business of providing credit and that management`s job is to manage that process and the directors` job is to oversee it.

Is it possible that there a bright side to this picture? Could there be an increase in M&A activity as a result of this downturn?

I`m sure that M&A will return. It hasn`t exactly been dead. There has been a lower level of transaction volume than in 1998 and even in early 1999, but I think that the new accounting rules will be quite positive for thoughtfully struck, strategically driven transactions. The new accounting rules will be much more flexible in that they will do away with poolings, but will not require the automatic amortization of goodwill over a set number of years. Goodwill will be put up as an asset on the balance sheet, and it will be written down whenever there are events that suggest that the value might have declined. But if there are no events that suggest the value declined, then there is no requirement for amortization. That will also allow banks to accomplish strategic mergers flexibly, using not just the stock swap required for pooling, but either stock or cash or any mixture of stock or cash. There will effectively be no restrictions on the size or timing of subsequent divestitures, and there will be no prohibition against continuing to manage one`s capital account by buying back stock. It looks like those rules will take effect on July 1, 2001. Whenever they take effect, I would think that shortly thereafter you should see an increase in strategic mergers and acquisitions among banks. However, during a period of rising nonperforming assets and rising chargeoffs and digestion of credit quality problems, banks are very cautious about striking mergers. And they do an enormous amount of due diligence on their counterparty`s commercial loan book and their consumer loan book. During the heady days of 1997, `98, and `99, credit-quality due diligence, in many cases, was done over a weekend because there were no obvious credit quality problems. Today, the picture is totally different. I don`t know that we would go back to the early `90s when due diligence went on for months, but we are in a situation where a thorough credit due diligence would certainly take more than a couple of days.

Because of what happened to the dot-coms, do you think that some banks might shy away from Internet banking?

I think we are past the first phase of banks` investment in their own Internet-enabled operations. Virtually all of the major banks in the nation have at least some fashion of Internet banking. Most of the large banks are well on their way to Internet-enabling virtually all of their product services and internal processes, which is really the second phase. We are now at a point where the banks are trying to decide what their next step on the Internet will be. Having put up a product, they are now reviewing that product: who uses it, how often they use it, is there a way to make it profitable? I think many banks are deciding, appropriately, that there is no particular need for the Internet channel to be a profit center unto itself. I don`t think any delivery channel is a profit center unto itself. Customer relationships are profitable or not profitable. And it appears that the truly Internet-only bank does have a very limited appeal. As a business proposition, the standalone Internet bank doesn`t seem to have much of a future.

It would seem to be hard to gain consumers` trust.

In effect, as a purely Internet-only bank you become sort of a high-cost payer for deposits, and there are very few, if any, models for asset generation over the Internet that work. Even though Internet banks enjoy a substantial advantage in processing costs and in general and administrative expenses, they have a very high level of marketing costs and funding costs.

Is Internet banking more of a distribution avenue than a profit center?

The Internet offers capabilities beyond what the phone or the fax or the ATM offers. Account aggregation is a great and potentially highly valued service that really can`t be done over the phone or by mail. In effect, the family office for very high-net-worth individuals or a variety of private banking services were account aggregators, but it was a very expensive proposition. The Internet allows you to get a level of information that is more detailed and more timely than was available to the Rockefellers under the old family office system.

It wouldn`t necessarily generate profit from that customer, but it would certainly generate stickiness.

The Internet is not simply another means of communication with the customer. By the nature of its technology, it allows a type of service at a much lower cost that would not have been practical at a reasonable cost under previous technologies. The Internet ultimately will be viewed as one of many means financial institutions and their customers use to communicate. But, as each of the previous technologies did, it will add a different level of service.