CEO Jon Winick on Slow Growth in Wealth Management Forcing Small Banks to Make Tough Choices
There is something for everyone looking for lending pitfalls in the coming months.
Mortgages, subprime auto lending, commercial-and-industrial loans and student lending are ripe for setbacks and, in some cases, crises.
Here is a breakdown of each of those risk factors, the reasons behind them and the possible upsides or alternative strategies.
The refinance market has largely carried the mortgage industry over the past few years because consumers took advantage of historically low rates. Now that the Federal Open Market Committee has raised rates twice in the past year, and the benchmark 10-year Treasury has spiked upward since the presidential election, many expect the refinancing market to nosedive.
“We’ll see refinancing all but dry up, and the mortgage business is going to really suffer” in 2017, said Donald Musso, CEO of FinPro Capital Advisors, a bank consulting firm in Gladstone, N.J.
The question becomes whether an improvement in the overall health of the housing market can take up the slack.
“It’s going to be sales that drive your mortgage lending now,” said Jay Pelham, president of the $3 billion-asset TotalBank in Miami.
That may be easier said than done. The incoming Trump administration and the Republican-led Congress have signaled they may reduce the mortgage interest deduction, a move that the National Association of Realtors and other housing industry groups have warned will wallop the housing market.
Banks’ mortgage fortunes could vary among geographic markets, too. The South Florida market, especially downtown Miami, appears to be set for a high level of purchase activity, Pelham said.
“If you look at our downtown market, it’s full of restaurants, jobs and apartments that both professionals and young people want,” he said. “When I look at prices per square foot here, we are still cheap compared to New York, London and Chicago.”
For months, regulators have forcefully warned about soaring balances of subprime auto loans and the risks associated with them. The data seemed to back them up.
In March, Fitch Ratings reported that more than 5% of securitized subprime auto loans were at least 60 days late, the highest delinquency rate in 20 years.
And the 90-day delinquency rate for subprime auto loans was 2% in the third quarter, versus 1.9% a year earlier and 1.4% in the third quarter of 2012, according to a Federal Reserve Bank of New York report. Over the same period, delinquency rates for borrowers with higher credit scores were relatively flat. Meanwhile, about 3.6% of overall auto loan balances were 90 days behind in payments.
Lenders have downplayed those concerns, saying that they have applied strict underwriting standards.
Yet some banks have begun to take precautions. The $143 billion-asset Fifth Third Bancorp in Cincinnati and the $147 billion-asset Citizens Financial Group in Providence, R.I., this fall announced plans to scale back indirect auto lending.
At the same time, some community banks have shown greater interest in auto lending as consumer demand for car loans continues to soar. The $4 billion-asset Fidelity Southern in Atlanta and the $9 billion-asset First Interstate BancSystem in Billings, Mont., each posted double-digit increases in auto loans in the third quarter.
Lenders have recently made improvements in how they underwrite subprime auto loans, and that may prevent a big meltdown, said Jon Winick, CEO of Clark Street Capital, a bank consulting firm in Chicago.
“There have been real innovations in the subprime auto space that are unique to that asset class,” he said. “You can prevent someone from using their own car if they’re 30 days delinquent and you don’t have that level of control with a real estate deal.”
Tough competition for commercial-and-industrial loans has created one of the riskiest situations as many banks are said to have cut pricing to win business.
Banks have crowded into the C&I space for plenty of reasons. One is that regulators have placed a great deal of emphasis on commercial real estate loan concentrations, and banks have responded by improving risk management and bolstering capital levels. Those steps may help limit CRE losses, but they have encouraged more banks to risk expansion in C&I loans as they hunt for places to deploy their capital.
There is so much competition in the C&I market that many players have caved to borrowers’ demands for lower rates and better terms, Winick said.
“Underwriting standards have collapsed the most in C&I,” he said.
At the same time, C&I loans present significant challenges when they default as they are typically not collateralized by tangible assets.
“If a C&I project defaults, you don’t have an automobile you can repossess or a house you can foreclose on,” Winick said.
But there are some potential bright spots for C&I. One is that the presidential election is over, which should remove the anxiety that had led many businesses to hold back on capital spending for months because of political uncertainties, Musso said. Talk of tax cuts and regulatory relief has played well in commercial sectors.
“I actually think we may see a modest uptick there because the business community believes we’ll see some relief from the Trump administration,” Musso said.
Another is that banks may have already suffered through the worst part in two subcategories of C&I lending, energy and taxi medallion loans. A rebound in oil prices dampened the losses at energy lenders, while some banks like the $72 billion-asset Comerica in Dallas reduced their exposure to the sector. And executives at the $38 billion-asset Signature Bank in New York recently said that they have restructured troubled taxi loans.
“I think the new normal has come out in taxi loans,” said Dave Etter, managing director of loan review services at Sheshunoff Consulting. “To try to sell taxi loans now is just impossible. You’re just looking to generate some cash flow.”
Finally, some banks have attempted to carve out specialties within the C&I category to diversify loan portfolios and improve yields. The $28 billion-asset First Horizon National in Memphis, Tenn., for example, has expanded in franchise finance and health care finance to help dilute its C&I exposure.
The massive pile of student loan debt threatens to send scores of consumers into financial ruin. The Congress and the incoming Trump administration may try to address the situation by getting the U.S. government out of the student loan business. That could create an opportunity for banks to re-enter the private student loan market.
Investors are betting that will happen. Shares of SLM Corp., the Newark, Del., company known as Sallie Mae, rose 54% from Nov. 8 to Dec. 28, to $10.95. Sallie Mae is the largest private student lender.
Only a few banks remain active in student loans, including Citizens Financial. Those banks stand to benefit from the new political environment, KBW analysts wrote in a December report, and other banks may want a piece of the action.
What most analysts agree on is that the amount of student-loan debt that consumers are carrying is unsustainable.
“It’s my biggest concern in the consumer space, hands down,” Winick said. “We know the losses will be terrible.”
Bankers are entering a new year feeling a sense of déjà vu about regulatory warnings over commercial real estate concentrations.
A decade earlier, regulators were warning that CRE exposure could lead to earnings and capital volatility. While many bankers said those concerns were overblown – arguing that few institutions were in trouble – hundreds of banks ended up failing.
Fast forward to today and regulators are expressing similar reservations, warning that areas such as multifamily could become problematic. Bankers, however, say they believe the industry is better equipped to handle an economic shock, pointing to a system with more capital, backstops from borrowers and improved risk management processes.
Only time will tell if those views are correct and whether bankers will remain relatively cautious.
“You see comments about taking a foot off the gas,” said Peter Cherpack, principal of credit technology at Ardmore Banking Advisors. “The enthusiasm for real estate for many bankers is now somewhat tempered.”
Still, the industry struggles “with bankers who have short memories,” Cherpack said.
Several banks exceed recommended CRE levels, as a percentage of total risk-based capital, prompting regulators late last year to remind banks of their guidance on concentrations. Regulators prefer that CRE remain below 300% of a bank’s total risk-based capital and for construction and land development loans to stay under 100%.
Regulators said in a joint statement that “many CRE asset and lending markets are experiencing substantial growth, and that increased competitive pressures are contributing significantly to historically low capitalization rates and rising property values.”
There is no prohibition for going over those levels, and the numbers aren’t considered limits. Banks may still be targeted for more supervisory analysis and, as a result, should implement enhanced risk controls, such as stress testing for CRE portfolios.
New York Community Bancorp and Astoria Financial earlier this week terminated a $2 billion merger after facing regulatory delays that some industry observers believe could be linked to CRE concentrations.
It seems unlikely that a focus on CRE will let up next year. Fitch Ratings warned last month that CRE lending at U.S. banks had reached record levels that are unsustainable.
“I don’t think commercial real estate will be dropping off the radar,” said Patrick Ryan, president and CEO of First Bank in Hamilton, N.J. “Other areas like cybersecurity might also become an area of focus … but it may not replace CRE.”
A review of the financial crisis provides some rationale for regulators’ diligence. A 2013 report from the Office of the Comptroller of the Currency and the Federal Reserve found that 23% of banks that exceeded guided levels for both CRE and C&D loans failed during the three-year economic downturn, compared with less than 1% of banks that stayed below those levels.
The Federal Deposit Insurance Corp. did not provide a comment for this story. The OCC and the Fed did not comment on the record.
“There’s the sense that the industry got a little ahead of itself and loaned too much on deals that were not tangible,” said James Kaplan, a lawyer at Quarles & Brady. “It was unclear that these buildings would have tenants, and banks got left holding … something that didn’t have too much value.”
Some industry observers believe those numbers don’t tell the full story, pointing out that not all types of CRE perform the same. Many of the defaulted loans were tied to residential projects that failed when people stopped buying homes.
“I think the way regulators classify CRE – at least from a numbers standpoint – is suboptimal,” said Jon Winick, CEO at Clark Street Capital. “Many of those losses weren’t really CRE projects. They were … classified as CRE but they were really residential.”
Banks largely pulled out of funding speculative construction and development loans after the crisis. Roughly 320 banks at mid-2016 exceeded the 100% guidance on C&D loans as a percentage of total risk-based capital, versus nearly 2,400 in 2007, based on regulatory data.
“Banks understand that construction is more of a risky market … and the first one to collapse,” said Tim Scholten, founder of Visible Progress, a consulting firm. “A project that is half done isn’t good collateral.”
The $4.8 billion-asset Peapack-Gladstone Financial is among the banks that pulled back from C&D loans, which accounted for most of its losses during the last downturn, said Vincent Spero, the Bedminster, N.J., company’s head of commercial real estate.
“We just don’t have the stomach and the appetite for those loans,” Spero said. “You need the infrastructure in place to complete those loans, so we have pursued a different strategy.”
Peapack-Gladstone is focusing on the rent-regulated space for multifamily loans, an area that has historically had lower chargeoff rates and better credit analytics, Spero said. The bank has a CRE to total risk-based capital ratio of almost 590%, according to BankRegData.com.
Peapack-Gladstone has spent close to $1 million on processes, data analytics and third-party vendors to “ensure from a risk management perspective that we’re on top of it,” said Chief Credit Officer Lisa Chalkan. The company earlier this year hired a real estate expert to provide granular data on asset classes that management uses to evaluate limits on different types of loans.
“With the reissuance of the guidance, it was abundantly clear that the regulators were focused on real estate,” Chalkan said. “It just seemed like a prudent time to make changes.”
Industry experts also believe that banks are better capitalized today and would be in a better position to withstand a significant economic downturn. Total risk-based capital at banks with less than $10 billion of assets averaged 15.5% at Sept. 30, up from 14.4% a decade earlier, according to the FDIC.
Banks have also been more careful about underwriting, risk management and deals outside of their comfort zone, said Mitch Razook, president of RLR Management Consulting. Stress testing is also helping a number of banks.
“Lenders are better educated now and underwriters are more conservative,” Razook said. “Banks have a lot more controls in place.”
Though the $1 billion-asset First Bank has a CRE focus – CRE to total risk-based capital was roughly 390%, according to BankRegData.com – it has resisted the urge to diversify by branching out into areas where it lacks expertise, Ryan said. Rather, the company works to have varied assets, such as retail, industrial and mixed use, within its CRE book.
While there is talk that banks are loosening standards, Ryan said he believes many institutions are normalizing their stance after years of having tight criteria.
“If you compare what banks and borrowers are doing today, it is much more controlled, rational and logical compared with what was happening from 2005 to 2007,” Ryan said. “It is probably a better, happy medium.”