The Credit Horizon: Are Banks Ready for a Downturn?

Banks have had a great run with credit quality in recent years, reaching historical lows in 2006 for net chargeoffs and riding a wave of loan growth. But now with delinquencies on the rise, problems in subprime lending, falling residential real estate prices, and worries about banksu00e2u20acu2122 exposure to commercial real estate lending, the party may be coming to an end. Just how well are banks and boards prepared for the inevitable downturn in the credit cycle? Whether the next big dip in the credit cycle happens soon or years from now, the manner in which a bank manages its underwriting and credit monitoring will make the difference between long-term survival and becoming road kill.

u00e2u20acu0153If you are going to have a successful banking organization that generates value for the shareholders, you have got to control the credit risk,u00e2u20ac says Mark Schroeder, president and chief executive officer of German American Bancorp, a $1.1 billion institution in Jasper, Indiana. u00e2u20acu0153We can misstep in a lot of places, but credit is not one of those places.u00e2u20ac

Recent trends should give directors pause. While credit losses are coming off rock-bottom lows, they are moving upward quickly. Loans 90 days or more past due rose 7% in the first quarter over fourth quarter 2006 to $60.5 billion, according to the Federal Deposit Insurance Corp. That represented 0.83% of all loans, the highest mark in two and a half years. Most of the growth in noncurrent loans was in real estate loan portfolios. Meanwhile, net chargeoffs of loans and leases reached $8.1 billion in the first quarter, a 48% increase over fourth quarter 2006.

u00e2u20acu0153The best days of credit are behind us,u00e2u20ac says Gerard Cassidy, managing director of bank equity research at the Portland, Maine office of RBC Capital Markets. u00e2u20acu0153We peaked in the third quarter of u00e2u20acu212206 and have been deteriorating ever since.u00e2u20ac

While FDIC data represents all banks, the community bank subset reflects the same pattern. Nonperforming assets at banks ranging from $500 million to $5 billion in assets increased to 0.49% in the first quarter, up from 0.32% a year earlier, according to BNK Advisory Group, a consulting firm based in Bethlehem, Pennsylvania. While the jump comes off a low base, Jay Brew, chief executive officer of BNK, characterizes the rise as gigantic. u00e2u20acu0153We are ripe for a credit cycle,u00e2u20ac he says. u00e2u20acu0153We have not seen a credit cycle since 1994. You have a whole generation of loan officers that have never done a workout.u00e2u20ac

Negotiating the terrain

In such a situation, the stakes are high. If banks go into a bad credit cycle, a few rotten eggs can create losses for five years, warns Brew, who also serves as an independent director for Embassy Bank for the Lehigh Valley, a $292 million institution in Bethlehem. For example, a bank whose nonperforming loans rise to just 2% of assets can be mired in workouts for five years, increasing noninterest expensesu00e2u20ac”such as legal and collection feesu00e2u20ac”and demanding much more of managementu00e2u20acu2122s and the boardu00e2u20acu2122s time. u00e2u20acu0153Itu00e2u20acu2122s not a short u00e2u20acu02dcTake your lumps and get out,u00e2u20acu2122u00e2u20ac Brew warns. u00e2u20acu0153The whole notion of workouts can take an enormous amount of time. Management must take an eye off growth [because] they are so busy dealing with the problems. They donu00e2u20acu2122t make more loans, [instead] they tend to clamp up. For healthy banks, the best thing to happen is to go into a credit cycle. You get to clean up.u00e2u20ac

Aside from risking going into the red, or tumbling into insolvency, troubled banks will also have a hard time finding a buyer. Because community bank stock is illiquid, many de novos are opened with a clear exit strategy of selling the bank down the road so that its investors can realize their gains. But selling the bank might become a tough proposition if things turn sour. u00e2u20acu0153No one wants to buy a problem,u00e2u20ac says Ron Robertson, president and chief executive officer of Centennial Bank, a $918 million commercial real estate lender based in Fountain Valley, California. u00e2u20acu0153If they do, they are going to buy it at a distressed price.u00e2u20ac

Boards should also take note of the hidden costs of nonperforming loans. Centennial only focuses on commercial real estate lending, mainly in California and Arizona. It hasnu00e2u20acu2122t written off a loan in 15 years, allowing it to avoid the cost of having a collections department and keeping its efficiency ratio in the 20% range. So while it pays more for quality people to run the bank, it more than makes up for it with a solid portfolio. u00e2u20acu0153You require less staff,u00e2u20ac Robertson notes. u00e2u20acu0153Our people have been with us for a long time. They are well trained and well paid.u00e2u20ac

To be sure, while a banku00e2u20acu2122s management may make poor moves in its lending practices, the directors are the last stop. u00e2u20acu0153The board [members are] responsible for approving and setting policy and hiring management and holding them accountable to run the bank,u00e2u20ac says Dan Stevens, chairman and chief executive officer of Home Federal Bank, a $726 million thrift in Nampa, Idaho. u00e2u20acu0153To the extent they are not successful, they are liable for what might happen to the bank [as a result] of being derelict in their duties. So it is definitely in their best interest to be very interested in credit risks. Of all the risks, credit risk is the one that can take a bank down faster than any other.u00e2u20ac

In some cases, board members can be subjected to enforcement actions by regulatory agencies if they are found not to have acted in the best interests of the bank. u00e2u20acu0153The board [members have] to be involved,u00e2u20ac Robertson says. u00e2u20acu0153If they are not, they are very foolish because they are sticking their necks out to the extreme.u00e2u20ac

Still, some banks have not heeded the advice and engaged their boards enough. Young & Associates, an advisory firm based in Kent, Ohio, recently has worked with two banks that have received FDIC memorandums of understanding

Red flags

Board members should be concerned given todayu00e2u20acu2122s changing macroeconomic climate. Several factors have created warning signs. While many banks have avoided subprime, the fallout is still being felt as banks take earnings hits. Analysts and investors are hard-pressed to know the extent of the damage since banks generally do not break down subprime lending from traditional mortgages on the balance sheet. u00e2u20acu0153Weu00e2u20acu2122ll probably see more of those one-off situations coming out of the industry where people kind of have to admit that they do have some of that on paper,u00e2u20ac says Mark Fitzgibbon, director of research at Sandler Ou00e2u20acu2122Neill & Partners, an investment bank in New York.

The mortgage market is also causing concern. Many banks have in recent years doled out mortgages with teasers, such as interest-only loans, mortgages with LTVs greater than 100%, and loans with negative amortization. Those mortgages are now readjusting. Meanwhile rising long-term rates have caused adjustable rates to go up, also crimping homeowner budgets. And some banks have further extended themselves by issuing home equity loans to the very borrowers who are now teetering on the edge. Those loans would offer banks little to recoup if they are tied to troubled mortgages.

The housing slump itself is giving bankers the jitters. Over the past several years banks made loans freely to homebuilders; now many of the smaller shops are closing their doors, leaving lenders holding the bag. Markets such as Florida, Northern Virginia, Southern California, Las Vegas, and Phoenix are greatly overbuilt, notes Cassidy of RBC. Even the commercial lending market, considered healthy, might be in store for regional problems. For instance, Cassidy sees weakness in business lending to businesses related to General Motors Corp., Ford Motor Co., and Chrysler, which he foresees giving banks in the Midwest potential trouble.

Another consideration for boards has been the trend in recent years for banks to increase concentrations in commercial lending. Banks have faced stiff competition for traditional one-to-four family mortgages and suffered the margin-eroding effects of the inverted yield curve. As a result, they have been bumping up exposure to commercial real estate, business lending, and industrial lending in search of higher margins. u00e2u20acu0153We are seeing growth in the commercial realm,u00e2u20ac says Grope of Young & Associates. u00e2u20acu0153Because the mortgage industry has dried up for community bankers, they are turning more to the commercial segment.u00e2u20ac

In commercial real estate, for example, concentrations have ramped up quickly. u00e2u20acu0153Commercial real estate has fueled so much of the growth over the past several years,u00e2u20ac says Randy Dennis, president of DD&F Consulting Group, based in Little Rock, Arkansas. u00e2u20acu0153But it has resulted in overconcentration.u00e2u20ac The boom in loans prompted the FDIC, the Federal Reserve Board, and the Office of the Comptroller of the Currency to issue new guidelines last December, defining high concentrations in a commercial real estate portfolio as 300% or more of total capital. Also, loans for land, land development, and construction are considered a high concentration if they surpass more than 100% of total capital. (The Office of Thrift Supervision also issued guidelines, but without the limits.)

The number of FDIC-insured institutions with construction loans exceeding 100% of capital totaled 2,239 at the end of the first quarter, a 32% increase over two years ago. Similarly, 2,709 institutions exceeded the 300% threshold for CRE loans, a 10% jump. Meanwhile, originations have risen for all property types in the first quarter over the same period a year ago, according to the Mortgage Bankers Association of America. Originations are up 64% for loans for health care properties, 62% for office properties, 37% for hotels, 26% for multifamily, 25% for retail, and 14% for industrial.

To be sure, the boom across all loan categories might put some banks in a precarious spot down the road. u00e2u20acu0153Competition is fierce out there,u00e2u20ac says Steven Fritts, associate director for risk management policy and examination oversight at the FDIC. u00e2u20acu0153At the end of the day, if banks arenu00e2u20acu2122t letting some business walk away, then they are probably packing along some losses they are going to have to deal with in the next few months and years.u00e2u20ac

As banks have ramped up their commercial lending, they have simultaneously loosened underwriting standards. Lenders are also accepting a lower average credit score, typically 620 and up, compared with a range of 680 to 720 about 18 months ago, according to Young & Associates. LTV ratios on commercial credits have also risen to the 75 to 80 range, up from 65 to 70 over the same period. And banks have lowered minimum net-worth requirements of borrowers.

In its work with clients, Young & Associates reviews portfolios and ranks them on a one to eight scale, with one to four translating to different levels of a passing grade, five meaning u00e2u20acu0153on watch,u00e2u20ac six u00e2u20acu0153substandard,u00e2u20ac seven u00e2u20acu0153doubtful,u00e2u20ac and eight u00e2u20acu0153loss.u00e2u20ac Among a group of banks representing $2.3 billion in loans, the average grade slipped to 3.28 at the end of 2006, down from 3.15 a year earlier. u00e2u20acu0153It tells us banks are putting on more riskier loans than in the past,u00e2u20ac Grope says.

u00e2u20acu0153Banks might be OK with their peers, but they are going in the wrong direction,u00e2u20ac Grope adds. u00e2u20acu0153Unfortunately, everybody is heading in the same direction, with a slight to average increase in delinquency. We are seeing lower credit scores, debt ratios, and cash flows. Things are going to get worse before they get better.u00e2u20ac

Safe navigation

Given all the clouds on the horizon, boards need to be asking the right questions (see sidebar above). The liability is the same for all boards, but the type of tasks they conduct depends on the banku00e2u20acu2122s size, notes David Danielson, president of Danielson Capital, a consulting firm in Vienna, Virginia. u00e2u20acu0153The bigger the bank, the more it will rely on policies and procedures,u00e2u20ac he says. u00e2u20acu0153Smaller bank board committees are more likely to see the credit.u00e2u20ac

At First Horizon National Corp., a $38.8 billion bank based in Memphis, Tennessee, the job of its credit policy and executive committee is to set and monitor policy at the highest level, leaving the minutiae for management. For example, it sets portfolio limits such as the percentage of commercial real estate it has on the books relative to capital. u00e2u20acu0153We ask them to approve those high-level limits,u00e2u20ac says Greg Olivier, credit risk manager for First Horizon. u00e2u20acu0153The committee is saying, u00e2u20acu02dcOperate within that band.u00e2u20acu2122 Weu00e2u20acu2122re saying, u00e2u20acu02dcWeu00e2u20acu2122re operating within that band, and we are managing it this way and at this level of detail.u00e2u20acu2122u00e2u20ac

Conversely, boards at community banks should be involved with approvals above a certain size loan. At North Jersey Community Bank, a $203 million business lender in Englewood Cliffs, New Jersey, executives work with members on the loan committee daily. u00e2u20acu0153We want them to be that involved,u00e2u20ac says Frank Sorrentino, chairman and chief executive officer. u00e2u20acu0153Itu00e2u20acu2122s not that we need them to be. But they are very engaged and active, which is the way it is supposed to be. They know the loans. They know the credits. They know the borrowers. And it helps because they bring a certain insight that one individual may not have.u00e2u20ac The strategy has helped the bank maintain a solid portfolio, with no chargeoffs in the first quarter and nonperforming loans at 0.07%.

Boards often can monitor credit more effectively by having a subcommittee deal with certain issues. Two years ago, German American, which does mainly commercial lending, created a credit risk management committee made up of three independent directors and chief executive Schroeder. The committeeu00e2u20acu2122s responsibility is to review and approve large loansu00e2u20ac”those 66% and greater of the banku00e2u20acu2122s overall limitu00e2u20ac”and make recommendations to the full board for approval.

The advantage of using a subcommittee is that credit tasks can be concentrated, rather than flooding the entire board with the responsibility. At German American, for example, each quarter the credit risk management committee reviews various credit quality reports, the allowance for loan losses, classified credits, and the approval process itself. It also reviews the largest credits in the company. Two years ago, Schroeder and the board saw there was a need for a stand-alone credit risk management committee. u00e2u20acu0153We did not have a committee on the credit risk component, and that is the most significant risk factor in a banking organization,u00e2u20ac Schroeder says. u00e2u20acu0153There was nothing [requiring us to do so] from a regulatory or credit quality perspective, it was just good governance.u00e2u20ac

Subcommittees reviewing credit should have a mix of directors with different backgrounds. u00e2u20acu0153You donu00e2u20acu2122t want database types that are going to pick every number apart,u00e2u20ac says Peyton Patterson, chairman, president, and chief executive officer of NewAlliance Bank, a New Haven, Connecticut thrift with $8 billion in assets. u00e2u20acu0153You want people that are making their own business decisions and are accountable for results.u00e2u20ac Seven of the 15 members on her board are on the loan committee.

When Patterson started at NewAlliance in 2002, its head of lending had presented large loans for approval before the entire board. Patterson established a subcommittee to streamline things. u00e2u20acu0153Itu00e2u20acu2122s not efficient if you have too many people making credit decisions who donu00e2u20acu2122t have the right skills,u00e2u20ac Patterson says. u00e2u20acu0153Now we have a group of people who have worked together consistently and are very experienced. Thereu00e2u20acu2122s an open dialogue, which I think is the most important thing because lending is an art, not a science.u00e2u20ac

Testing the currents

How can a board spot potential problems? There are a variety of ways to assess risks, using analyses that can be routinely reported to the board. The consulting firm BNK Advisory, for example, examines 15 metrics on a banku00e2u20acu2122s balance sheet, comprising three different areas: credit risk, interest rate risk, and liquidity risk. With credit risk, for example, BNK looks at adjustable reserves to adjustable loans, change in portfolio mix, net loan growth, net loans to assets, total loans to equity, and yield on loans and leases. Each metric has a limit that serves as a warning sign. Brew dubs them u00e2u20acu0153canaries.u00e2u20ac For example, a bank would receive a canary if its change in portfolio mix is greater than 7% year over year and its net loan growth is greater than 20%. If a bank receives seven or more canaries, there is a likelihood that the bank will run up against regulatory pressure, either informal actions or formal mandates, Brew says. About 13% of banks with less that $3 billion in assets at the end of 2005 had seven canaries or more, according to analysis by BNK.

Having a policy in place to quickly deal with delinquent borrowers is also critical, bankers say. Overdrafts are another warning sign, as are customers who are late in delivering their most current tax returns and financial data. u00e2u20acu0153Often there is a reason: They donu00e2u20acu2122t want us to see them,u00e2u20ac says Bill Kelly, executive vice president and chief credit risk officer at Georgian Bank, a $1.7 billion bank in Atlanta.

Simply put, boards and managements should have a solid lending policy in place, bankers and consultants say. A bank should have procedures for identifying trouble among borrowers and what to do to prevent losses. Georgian Bank had no chargeoffs or nonperforming loans in the first quarter of 2007. The bank follows the philosophy of many community banks: u00e2u20acu0153Know your customer.u00e2u20ac Georgian focuses on locally owned businesses with annual sales of $1 million to $50 million and up. It also targets affluent individuals with assets of $100,000 or more to become investors. The bank hires only experienced lenders, and relies mainly on word of mouth for its marketing. That helps the bank keep tabs on its borrowers. u00e2u20acu0153We stay in touch with those customers on a very regular basis,u00e2u20ac Kelly says. u00e2u20acu0153If we see red flags, we deal with them very swiftly. Our experience is, if there is a problem loan, it is not going to get better with age.u00e2u20ac

Banks also need to have the right personnel and systems in place to sustain growth. u00e2u20acu0153Banks have found the lending to come fast and furious,u00e2u20ac says Dennis of DD&F Consulting. u00e2u20acu0153And their provision for building back-office risk systems and adding risk managers has not kept up with demand.u00e2u20ac Banks, he says, should plan for fast growth first by hiring the right people.

NewAlliance Bank hired Don Chaffee to be its chief credit officer four years ago. It was an unusual move at the time for a community bank of its size, about $2.4 billion in assets. Chaffee, an industry veteran, came from J.P. Morgan Chase. & Co. But NewAlliance was ramping up for anticipated expansion through acquisitions and organic growthu00e2u20ac”much of it in commercial real estate and business lending. The bank followed up by hiring a statistician from Fair Isaac Corp., a credit scoring software provider based in Minneapolis. It then built a credit data warehouse that linked all of the systems in order to keep an eye on key indicators such as delinquencies, nonperforming loans, concentrations, loan-to-value ratios, and FICO scores. The system has helped NewAlliance evaluate the portfolios of the five banks it has bought since 2002.

u00e2u20acu0153Knowing we were going to grow a fair amount, we put in place a credit team that not only provided the underwriting expertise but also a well-oiled database and credit monitoring program,u00e2u20ac says CEO Patterson. In all of its top credit and lending positions, New Alliance has made sure it has executives who have been through one or two downturns in the credit cycle. u00e2u20acu0153They are the ones in the key jobs because they have seen what a bad loan can do to profitability,u00e2u20ac Chaffee says. u00e2u20acu0153It takes 100 good loans to pay for one bad one.u00e2u20ac

Watching the horizon line

Board loan or credit committees may want to consider hiring outside firms to review their portfolios on a periodic basis. Companies such as Young & Associates and Plante & Moranu00e2u20ac”based in Southfield, Michiganu00e2u20ac”perform portfolio reviews. NewAlliance uses Bennington Partners, a firm in Southbury, Connecticut, to analyze its portfolios twice a year. The firm looks at the types of loans the bank is making and the level of credit quality, with a heavy emphasis on updated financial information on the borrowers. The bank also hired Bennington to scrutinize portfolios of banks NewAlliance acquires. The firm reports directly to the boardu00e2u20acu2122s credit committee, rather than to management, giving directors an independent review of the banku00e2u20acu2122s performance.

All told, the boardu00e2u20acu2122s job of monitoring credit risk is ongoing. With the changing credit landscape, and increased responsibility for boards, observers note that directors must constantly keep abreast of developments through continual training. Directors must be more involved, a far cry from the old days. u00e2u20acu0153You donu00e2u20acu2122t just get trained once,u00e2u20ac says Dennis. u00e2u20acu0153You have to constantly be aware of how banking is changing. Boards need to be active. The age of directors who just come and collect a check should be gone. These rural banks that have had directors there for 25 yearsu00e2u20ac”where all they do is collect a check and chat with their buddiesu00e2u20ac”that is a very dangerous thing to do in todayu00e2u20acu2122s environment. From their own personal standpoint, it is just too risky.u00e2u20ac

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