Sunshine, Rainbows & Emerging Credit Risk

Thoughtware Article Published: Oct 04, 2019
A banker looking at charts

We made it! As of July 1, we’re now in the longest economic expansion in American history. Great news, right? Maybe so, maybe not. Despite being the longest, this expansion isn’t the strongest. According to the U.S. Bureau of Economic Analysis, the gross domestic product (GDP) in the U.S. grew by 2.1 percent for the second quarter of 2019 when compared to the same quarter of 2018. This 2.1 percent annualized growth in GDP is one of the slowest observed annualized, non-negative GDP growth rates since the end of World War II. Further, by comparison, annualized GDP growth rates for 2017 and 2018 were 2.4 and 2.9 percent, respectively. Although these last two years enjoyed economic prosperity due in large part to the short-term stimuli of federal tax relief and increases in government spending, there are other conflicting economic indicators. While U.S. unemployment rates have improved from 9.9 percent in 2009 to 3.9 percent in 2018, The Associated Press (AP) reports the Institute for Supply Management stated that its manufacturing index declined to 51.2 in July from 51.7 in June. Per the AP, “U.S. factory activity expanded at a slower rate in July for the fourth consecutive month.”

As financial institution professionals consider the contradictory comments and data noted above, they should 1) be relieved the expansion has continued for so long, producing low unemployment, strong corporate earnings, low credit losses, etc., and 2) be concerned about the inevitable course reversal due to natural economic cycles.

BKD’s Loan Review Services division can view certain aspects of the current expansion in specific relief. Our team tracks two important metrics—classified loans to total loans and classified loans to total equity (Ratios). We track these Ratios, which comprise nonpublic and public data, for each of the financial institutions we’ve performed loan review services for in the most recent 12-month period. As you might expect, the average, mean and range of these Ratios have improved significantly in recent periods. Furthermore, these Ratios are actually better than they were prior to the Great Recession.

Despite strong performance in terms of credit quality, we’ve recently observed several credit market trends that may be viewed as alarming:

1.    Cash-out refinance transactions for investment real estate, particularly one- to four-family properties:

  • Prior to the 2008 recession, we observed a great number of these transactions, particularly in the 12 months leading up to the recession.
  • Many then became problem credits due to high leverage and tight cash flows.

2.    Capitalization (cap) rates:

  • In general, cap rates are rising in several real estate market segments (multifamily, office, retail and industrial properties).
  • These rising cap rates will ultimately result in lower overall values for investment real estate, ceteris paribus.
  • Despite the recent increases in cap rates overall, many of these rates are still below seven- and 10-year average rates for certain property segments.
  • Lower values that have resulted from rising cap rates will most likely have the greatest effect, in terms of credit losses, on troubled credits; that is, lenders must remain keenly aware of the aforementioned trend when considering current values of collateral properties under all current market conditions.
  • For example, Green Street Advisors estimated that “cap rates for power centers in tertiary markets are up over 200 basis points over the past 18 months.” 1

3.    Structurally weak credit facilities:

  • The prime rate benchmark was artificially low, holding at 3.25 percent from December 2008 to December 2015; in the 43 months since the rate began its upward arc (first change date was December 17, 2015), the prime rate has increased to 5.5 percent and was reduced to 5.25 percent on August 1, 2019.
  • As most bankers are all too aware, pressure to grow earning assets has continued to intensify in recent periods (months and years).
  • Rising interest rates have had two conflicting effects: 1) a material improvement in overall gross and net interest margins, while 2) competition for good-quality credit relationships in recent activity has led to underwriting and/or loan structure decisions that otherwise may not have been made.
  • We’ve observed an increasing number of loans where the lender has made financing concessions such as limited guarantees (or no guarantees required), loan-to-value regulatory exceptions, extended financing terms (beyond the economic life of the collateral asset), 100 percent financing of the project or collateral cost and others.
  • These concessions, when combined as two or more, often lead to regulators referring to this practice as “layering of credit risk” and should be avoided for all but the most creditworthy of borrowers.

4.    Interest rates and layering of credit risk:

  • We’ve observed loan structures where the lender mismatched the loan purpose and loan terms, mismatched loan collateral and loan terms or structured both of these as the same credit relationship.

As financial institution professionals navigate the coming periods where uncertainty appears likely, we should remain ever-mindful of the mistakes and poor decisions made leading up to the Great Recession. In the words of the Spanish-American poet, author and philosopher George Santayana, “Those who cannot remember the past are condemned to repeat it.” 

For more information, reach out to your BKD trusted advisor or use the Contact Us form below.


Mar, Joi, Commercial Real Estate Outlook: Are Cap Rates Heading Up?, April 23, 2018. Green Street Advisors.  https://www.greenstreetadvisors.com1

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