On Monday, March 15th, The Wall Street Journal ran a very upbeat article entitled, “U.S. Banks Will Turn Last Year’s Fear Into This Year’s Profits”.
The article opines that the tens of billions of dollars that were set aside by our nation’s banks to cover pandemic-related loan losses were not needed. Therefore, they will be able to come back out of reserves and added to the bottom line.
The very next day, the American Banker printed a Bloomberg article with a very different idea of what is happening. The title of this article: “U.S. small businesses are holding off the debt apocalypse. For Now.” Yes, “apocalypse”. You can’t get much more ominous than that.
The Bloomberg article warns that at some point, government help and lender forbearance will come to an end. When it does, many small businesses may lack the cash and income they will need to keep going at all, let alone pay back loans that are a year or more in arrears.
If this “apocalypse” comes to pass, the banks that made the small business loans will need their loan loss reserves handy.
So we have two very different projections from two well respected sources. They can’t both be right ...or can they?
Here at Bauer, we are cautiously optimistic about the condition of our nation’s banks and credit unions. Yes, net income was down in 2020 as financial institutions put away provisions for potential loan losses. And yes, those losses are largely theoretical at this point. However, the majority of federally-insured banks and credit unions have prepared themselves for a worst case scenario.
A new stimulus package and the opening up of the economy will help keep most loan categories in the black. We also believe that lenders will continue to work with small businesses. Community Banks will rework loan terms if/when possible. It makes good business sense—if the small business has a fighting chance—to give it a boost so it can pay another day. A loan paid late is better than a loan paid never. It’s good for the bank, good for the business and good for the community.
There is one loan category that we are concerned about: Commercial real estate (CRE). These loans cover shopping malls, movie theaters, office buildings, and other buildings that could be relatively empty for the foreseeable future.
We know that as vaccines become more readily available, people will gain the confidence to go back out in groups and things will get better. At this point, though, we don’t know how long that will take.
Time is ultimately what will determine whether bank reserves will turn into profits (as we hope and as the Wall Street Journal suggests) or into losses (apocalypse notwithstanding). In the majority of cases that do not involve CRE, Bauer believes it will be the former. Banks heavily loaded with CRE, we imagine will be dipping into those reserves.
The 50 community banks listed on page 7 each have more than 35% of total loans tied up in CRE. They also each lack the necessary reserves to cover all losses if 90% of current delinquent CRE has to be written off.
Interestingly, as we were writing this article, the Office of the Comptroller of the Currency (OCC) made public its February enforcement actions. It included a Formal Action against 4-Star Southwestern NB in Houston, which has over 80% of its loan portfolio invested in CRE.
Southwestern has had its struggles with loan quality as well. But by the end of 2020, its delinquency to asset ratio was far lower than its peers (likely a result of the regulatory scrutiny). That’s why you don’t see it listed here on page 7. It has abundant reserves (over $14 million) to cover all delinquent loans (which are a little over $1 million at present... and declining). We suspect it was the 80% concentration that flagged it, rather than a problem with loose underwriting.
We do see this as a foreshadow of things to come, however. Regulators will be taking a harder look both at CRE loans and the banks that are highly leveraged in CRE. We will likely see more actions like this coming down the pike. That’s the regulatory way to stave off “the apocalypse”.