Credit Quality Indicators for a Unique Cycle

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“Bring back burn downs!”

This is a frequent request via phone or email since Silicon Valley Bank and Signature Bank failed in early March. Burn downs are statistical models generated during the 2007-08 financial crisis that recorded credit cycle losses on banks’ loan portfolios and determined what was left over after loans, reserves and capital were “burned down” for credit losses.

As a survivor of the financial crisis era, burn down models were not a pleasant experience for either the bank or the research analyst. Massive valuation deterioration and losses exceeded most banks’ capital and reserves, due to excess leverage from the credit extended on land and other construction properties. Weak earnings meant bank cash flows were little help to the credit recognition process. It was a terrible feedback loop that I prefer to forget. Perhaps forgetting is not realistic, since memory and learning from mistakes should be an analyst’s top skills.

Loan Loss Modeling
When the Covid-19 shutdown first unfolded in March 2020, Janney’s research team developed a new credit risk model to address how many loans could go bad and what losses should be assigned to these possible problem loans. We tried to be thoughtful: Not all loans would go bad. We argued that out of 100 loans, there were 10 to 15 that would have problems; many of those could be addressed in advance and often at small losses. Janney’s 2020 loss expectations were 2% to 3% across-the-cycle loss rates for banks. Fortunately, the Janney model proved fairly accurate, and actual losses were significantly less than we thought.

In 2023, we have a new credit cycle unfolding with three failed banks, a presumed recession starting soon and explosive predictions of commercial real estate loan losses galore. Hotel worries from 2020 have been replaced by office CRE in 2023 — credit mayhem is here! What should banks do to get ahead of the credit risk recognition cycle? How do banks ease investors’ fears of a charge-off surge and reduction in tangible book value per share? Bank management teams should take each issue seriously and address them immediately.

Updated Playbook
First, bank executives must speak clearly and plainly about their wide open disclosure on pass versus non-pass risk ratings that are standard in quarterly and episodic public filings, such as 8-Ks. The Federal Deposit Insurance Corp. still redacts these disclosures in call reports — public banks have a chance to provide investors with real data.

Given these disclosures, criticized loans are better understood in 2023 than in 2008. The 2.5% to 3% of non-pass rated loans at banks today are a fraction of criticized loans in 2009 and 2010. We encourage companies to disclose their criticized levels from 2009 and prior, which hit highs in the range of 10% to 12%. Investors may appreciate how bad it was then and how fortunate banks are today facing modest credit issues.

Next, we encourage bank managers to explain their long-run experience that loan defaults are limited, which can help combat investor negativity toward problem loans. Begin with statistical proof that supports how most loans are good and will repay as agreed. Then, share how your company mitigates potential problems in advance of a default or rating change to non-pass, including special mention or substandard rating.

Most investors have no idea how often loans encounter issues that are addressed by management long before becoming a charge-off. This leads to more reserves assigned to loans, broader loan categories and ultimately reduced loss exposure.

Finally — and perhaps most importantly — preach and shout about underwriting that features less leverage today compared to past cycles. Today’s loans have more equity, lower loan-to-value ratios and less dirt (little to no raw land) versus the similar loans made 15 years ago in the run up to the financial crisis. It is imperative that banks make explicit comparisons between a 2023 loan and a 2008 loan: how each could be resolved and what loss expectation occurs from each credit cycle. To analogize, investors and analysts tend to be from Missouri: “Show us!”

The bottom line is that credit issues in 2023-24 do exist. Banks must take ownership of current credit problems they may encounter and determine how they can be swiftly resolved and at what cost. Loss content should be far lower; providing specific data and examples will be critical to repairing the lost confidence from the recent bank failures.

Venture Capital Funds Remain Hungry for Fintechs

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Fintech investment isn’t drying up, so much as resetting from rabid to rational. That’s the assessment of several bank-backed fintech investment funds, where interest in striking deals remains high.

“Given the reset in valuations, more disciplined cash burn in the companies we are looking at and record deal flow, it’s a great environment for us and I expect us to step up our pace of investments in 2023,” says Adam Aspes, general partner at JAM Special Opportunity Ventures.

Over the past two years, its JAM FINTOP joint venture has raised about $312 million from a network of more than 90 bank investors to put into promising fintech and blockchain technology. It has two funds with a five-year investment period, “so we are still in the very early days of deploying capital,” Aspes says.

Regulators have signaled that they’ll be scrutinizing bank-fintech partnerships more closely and reviewing how well compliance issues are addressed. That might have unsettled some venture capitalists, especially those from outside the industry who are sometimes referred to as fintech “tourists.” But Aspes is unphased.

“We have always had a thesis [that] there would be greater emphasis on fintechs being compliant with a bank’s regulated rails,” he says. “So, I don’t think our investment thesis has changed, but I think the market is definitely moving in our direction,” especially in the areas of blockchain technology and banking as a service, or BaaS.

Activity at the venture capital divisions of the largest U.S. banks has not cooled off significantly either, says Grant Easterbrook, a fintech consultant.

“While the total dollars involved may be down relative to 2021 — as firms retrench in a down market and valuations fall — I am not seeing any signs of a major pullback from fintech,” Easterbook says. “Banks know that technology continues to be both a weakness and an opportunity, and they are looking for deals.”

Carey Ransom, managing director of the BankTech Ventures fund, is on the hunt for “real solutions to real problems,” and thinks the fintech shakeout will benefit investors like him. His goal is to find fintechs that can be of value to the more than 100 community banks in his fund by advancing their digital transformation efforts in some way. So the fund isn’t just injecting capital, but helping the fintechs grow.

“We have increasing relevance in a market shift like this,” Ransom says. “We have a very clear value proposition.”

In his view, the market had gotten out of whack with all the free-flowing money over the last year. Now the focus is on more sensible valuation metrics. “Some of it is just returning back to the right valuations and fundamentals,” he says.

David Francione, managing director and head of fintech at Capstone Partners in Boston, has a similar take, pointing out that 2021 skewed perceptions in more ways than one. With the pent-up demand following the Covid-19 pandemic, “2021 was a record year by anybody’s imagination for any metric.”

He notes that investment in fintechs for this year is up compared to the years prior to 2021, so he thinks the dramatic drop-off needs to be put into perspective. “If you strip out 2021, and you look at the prior three or so years before that, this year is still a record year, relatively speaking,” Francione says.

Still, he would not be surprised if there is a lull in activity, given factors like the geopolitical environment and the threat of a recession.

“I think this year is sort of a transition year. Things are probably taking a little bit longer to finance. At least that’s what we’re seeing in some of the transactions that we’re in,” says Francione, whose firm was recently acquired by the $179 billion Huntington Bancshares in Columbus, Ohio. “I would call it more of a pause than anything.”

Like Ransom, Francione thinks the pause could benefit banks that want to partner with fintechs. Francione’s advice to fintechs is to reflect on what they can do to solve a problem that banks — or more importantly, the bank’s customers — have.

“A lot of these fintechs that we’re talking to, they think, ‘Oh, this bank could be interesting.’ But sometimes they don’t really understand why and what they can really do for them. So they really have to peel back the onion and figure out: Who are their customers? Is it a similar target market? What are some of their needs? Does our technology solution address those needs? Can they integrate easily? What is the real value that they’re going to bring to this potential bank partnership, whether the partnership is in the form of an investment or is strictly a partnership to resell some of its products?”

Ransom says he has been in meetings where fintech executives come in saying they are out to disrupt banks. Then they find out that Ransom works with banks and because they need to raise money, “mid-conversation they shift their tone to, ‘Maybe I can help banks,’” he says.

His top recommendation to fintech executives that want to work with BankTech Ventures is to understand the value their technology can provide to community banks. “If we have to explain it, they’ll lack credibility,” Ransom says.

The fintech founders who tend to be a fit for his fund — which is backed by banks ranging in size from $200 million to $20 billion in assets — are less flashy and more pragmatic. The ideal founders also have taken care to capitalize the fintech properly.

“Don’t raise $100 million for a business that’ll sell for $200 million,” Ransom says. “That’s a change we have seen — which I see as healthy.”

Those that take on too much money create a situation where the risk is no longer worth the potential return for investors. But the total amount raised is not the only concern; the types of investments can also be an issue.

He believes some fintechs take on too much “preference capital,” the outside money that gets priority for returns over common shares, which the founding executives tend to own. If the executives think they are unlikely to get paid, it misaligns incentives and creates a risk that they could decide to leave the fintech, Ransom says.

If some fintechs are in a sudden scramble to cut expenses, slow the cash burn and move from growth to profitability faster, fintech analyst Alex Johnson suggests that it is to be expected after the heady cash free-for-all that prevailed last year.

“Between 2019 and 2021, money was just too readily available. A lot of tourists — founders looking to get rich quickly and generalist VC firms sitting on massive piles of cash — wandered into fintech and screwed stuff up,” Johnson writes in a recent edition of his Fintech Takes newsletter.

A growth-over-everything mindset prevailed and a lot of bad behavior got overlooked. “One example: the alarming amount of first-party fraud that has been tolerated by neobanks in recent years,” he writes. “And now we are all suffering through the hangover.”