Regulators Have Begun Warning About Inflated Loan Portfolios in a Slowing Economy
The economy is rolling along. Good times are here. Let’s lend more money.
That’s the tune many banks were singing two years ago.
But as the smoke signals of an economic slowdown keep getting thicker and blacker, that tune is changing.
Many commercial banks already have tightened the reins on lending, especially in their construction and commercial real estate portfolios, since losses in those areas are increasing. Federal regulators are making comments to banks, warning them of the growing portfolios.
“When you come out of a long-term growth economy, you have a situation where banks were very accommodating in underwritings and credit extensions,” said Norman Katz, a banking analyst with MCS Associates in Irvine.
Because of the hot economy, many banks have inflated loan portfolios that could take a dive when the economy slows and delinquencies and bankruptcies increase.
Bank examiners with the Federal Deposit Insurance Corp. reported more frequent occurrences of risky underwriting practices in three of the seven major loan categories in the six months ended Sept. 30 compared with the prior period: construction, commercial real estate and home equity lending.
According to Rich Brown, the chief of economic and market trends of division insurance with the FDIC, banks’ construction-loan portfolios have grown more than 20% annually for the past three years.
“There is an economic cycle and we are cycling out of a very hot growth economy into a slowing environment, with tougher business conditions, more bankruptcies expected and more failing companies. That clearly is translating into credit quality problems in the portfolios,” Katz said.
The growing number of problem loans have regulators and the industry worried. A strong economy spurred aggressive lending practices by banks in the 1980s. But as recession rolled in at the end of that decade and real estate values dropped, borrowers started defaulting on loans. Some banks failed.
“Commercial real estate and construction lending was the leading cause of failures of banks and savings and loans in the late ’80s,” said Ed Carpenter, a bank consultant with Carpenter & Co.
The dot-com fallout and the slowing of businesses related to that sector have fueled the fire. Bank of America’s non-performing assets rose 70% to $5.5 billion as of Dec. 31. The story is the same with UnionBanCal Corp., parent company of Union Bank. The bank’s non-performing assets grew from $170 million at the end of 1999 to $408 million at the end of 2000.
Many of the larger banks have already been tightening their lending guidelines and turning borrowers away.
“Major banks have cut back lately on construction and commercial real estate loans. They are being tougher with credit issues,” Carpenter said.
A September survey by the Office of the Comptroller of Currency, the 69 largest national banks, which hold 89% of the total loans in the national banking system, showed little overall change in underwriting guidelines, while some of the banks had tightened their lending. But the report also expressed concern over the amount of risky credit banks held “as a result of relaxed underwriting and risk selection in prior years.”
But since loan demand is still high, the smaller banks, hungry for growth, are picking up the business. The banks insist, however, that they are following their original lending criteria and are only making safe loans.
“We are still bullish on the Southern California economy. But we are looking closely at our loan portfolio,” said David Rainer, president of U.S. Bancorp’s Southern California operations.
Banks headquartered in Orange County grew their construction portfolios by 108.1% in 1998 and 38.13% in 1999. For the first nine months of 2000 those portfolios only grew 7.51%, according to a report by Carpenter & Co. The portfolios are still performing, although they are carrying higher risk.
“The loan losses and non-performing assets are at minimal levels. The times are good, but yellow caution lights are flashing,” said Rich Brown, the chief of economic and market trends in the division insurance for the FDIC.
Right now, all regulators can do is offer advice,the banks are operating within the rules.
“We don’t tell the banks what loans to make. They are using their own discretion,” Brown said.
Regulators are making warnings to banks, especially the smaller community banks, to make them aware of the proliferation of construction projects in a slowing economy, and changing real estate values.
“We make sure bankers are aware of the building, to make sure the projects they have are viable under a wide range of economic scenarios.” Brown said.
But the recession and string of bank failures in the early ’90s may be resonating yet in the minds of bankers and moderating their lending now.
“The banks and lenders are a lot better prepared. We should have better results than the last time around,” Katz said. n
