So, what do we bankers need to know to get through 2024 and beyond? Former Defense Secretary Donald Rumsfeld offered this observation: “Reports that say that something hasn’t happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know.” Say, what? So, what do community bankers need to know that they do not know yet about emerging credit risks? What do commercial real estate, consumer borrowing behavior, and regulatory overload have in common—they are all problems right now.
Commercial Real Estate: Here’s the Dirt
Mark Twain was fond of real estate investment: “Buy land, they’re not making it anymore.” Although residents of Iceland and of the Big Island of Hawaii might disagree as they watch volcanoes there frequently spew out new acreage, real estate is generally seen as a rewarding long-term investment except during periods of rising interest rates. Why?
A leading commercial real estate data analysis organization, Trepp reports that the higher cost of capital as well as higher cap rates, in conjunction with other macroeconomic factors, has resulted in tumbling property values, lower loan-to-value (LTV), and stricter underwriting constraints on minimum thresholds for debt service coverage ratio (DSCR) and debt yield. For example, about $300 billion in CMBS and Freddie Mac loans are maturing in the next 24 months. Given the higher rate environment, underwriting terms will also be stricter now for loans that need refinancing, compared to origination. At minimum debt yields of 10% to 14%, Trepp calculates that even at a lenient scenario of a 10% minimum debt yield threshold, 42.2% of the total maturing loan amount would fall short of refinanced loan balances given the current NOI for each loan. Trepp also estimates that at a 10% minimum debt yield, about 21% of the maturing loans would have a refinanced loan balance that falls short by more than 25%.[i]
Office building vacancy has been driven by Covid’s work-from-home solution, but multi-family housing’s high rents, the slowdown in warehouse demand, and high mortgage rates have stunted real estate demand across the board. With all these problems, how do banks end up with so much real estate collateral in the first place? Imagine you are the new CEO of a community bank. The board has hired you to grow the bank, and as you look at your options, you weigh real estate lending vs. consumer lending. How much in bank resources do you need to make a $10 million commercial real estate development loan vs. $10 million in auto loans? The CRE deal costs you a CRE lender and some construction support staff. Your average car loan is $25,000, so you need to book 400 car loans with the assistance of an auto lending team. The CRE project generates high-paying construction jobs, and the related multiplier effect adds more jobs in retail, wholesale, and manufacturing. The auto loans reward a few auto dealers, mechanics, and car salesmen. If your bank is committed to community economic development, you will probably go with the CRE deal. Maybe it’s time to perform interest rate and cap rate sensitivity analysis on your real estate collateral to check your loan-to-values?
Consumer Lending: What’s in Their Wallets?[ii]
On the other hand, maybe you figure you are safer with lots of smaller car loans than one big goose egg real estate deal in your loan portfolio. What could go wrong? After all, the unemployment rate is at its lowest level in fifty years. Well, being employed doesn’t mean you can earn enough to get by. Consumer debt topped $5 trillion in November as Americans coped with rising prices using their credit cards carrying an average 20.74% interest rate. Toss in mortgage debt, and average household debt is over $17 trillion. By August of last year, the number of Americans rolling credit card debt from month to month exceeded the number of people paying their bills for the first time in history. Maybe that’s because the San Francisco Fed estimated that aggregate savings had dropped by $1.9 trillion to $190 billion in just the last two years. Credit card delinquencies have crept up to their highest level since 2017.
Worse, borrowing for big-ticket items has cratered not just car loans, but also furniture, flooring, carpet and appliances which had already been hurt by declining home sales as a consequence of the run-up in mortgage rates. One risk tool to consider it monitoring credit score movements on all those consumer and mortgage loans.
Regulatory Guidance: As a Rule, It’s Not
Mark Twain advised: “It is good to obey all the rules when you’re young, so you’ll have the strength to break them when you’re old.” Well, the ABA is almost 150 years old, so it should be old enough and strong enough to wade through the latest regulatory swamp. In fact, the ABA’s past chair Dan Robb has been campaigning against a “tsunami of regulatory and legislative overreach,” including the CFPB’s junk fees campaign, the Section 1071 final rule, the Fed’s Reg II debit interchange price caps, and the Credit Card Competition Act.[iii]
The GAO has also criticized bank regulators for skirting the regulation process by issuing guidelines and guidance instead of rules. Why? —no time-consuming public comment and counter-proposals to digest. This shortcut is not a new issue– On Sept. 11, 2018, federal banking regulators issued an interagency statement confirming “that supervisory guidance does not have the force and effect of law, and the agencies do not take enforcement actions based on supervisory guidance . . .guidance can outline the agencies’ supervisory expectations or priorities and articulate the agencies’ general views regarding appropriate practices . . . however . . . supervisory guidance, no matter how helpful or illustrative, does not have the force and effect of law.” Nevertheless, while mired down in the muck of guidance, guidelines, rules, and regulations, bankers are increasingly competing with non-bank lenders not burdened by any regulatory expectations.[iv]
Déjà vu All Over Again
Oscar Wilde complained, “Nowadays people know the price of everything and the value of nothing.” You would think after the pain that real estate lending has inflicted on our economy in previous recessions, we would have learned our lesson by now. Covid has wreaked havoc on occupancy rates in the new work-from-home environment, but you would think that the positive job market would have rewarded working consumers with higher compensation. Unfortunately, inflationary prices and an uncertain economy have discouraged consumption of big-ticket items like cars, appliances, and homes. As bankers try to manage real estate and consumer loan risks, the regulatory authorities have responded to recent bank failures by dumping more guidance on banks while non-bank competitors skate under the regs to bag former bank clients. Haven’t we seen all this before? As Mark Twain warned, “History
[i] Emily Yue, “An Update on Refinancing Risk for Maturing Loans: A Debt Yield Scenario Analysis,” March 14, 2024, https://www.trepp.com/trepptalk/an-update-on-refinancing-risk-for-maturing-loans-debt-yield-scenario-analysis
[ii] Mike Maharrey, “Consumer Debt Tops $5 Trillion for First Time Ever, January 9th, 2024, www.moneymetals.com
[iii]“Robb Discusses Regulatory Tsunami, Talent Development on Podcast, ABA Daily Newsbytes, March 19, 2024
[iv] Joe Mont, “Tackling the contentious issue of guidance vs. regulation” Compliance Week, Sep 12, 2018 11:15 AM, https://www.complianceweek.com/tackling-the-contentious-issue-of-guidance-vs-regulation/2145.article