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Strategic Thought Leadership for Community Banks


By David Brown – RMPI Consulting LLC (October 2006)

“There are three kinds of lies: lies, damn lies, and statistics.” Does this phrase popularized by Mark Twain in the 1800’s hold true for today’s credit quality statistics? The simple answer is yes. Most banks have been fortunate over the past five years. When banks have made mistakes the borrowers have been able to tap into equity created by the super-charged real estate market. When a customer was asked out of a bank there was always another institution waiting for their business. However, over the last nine months these options have been diminishing. So how is this effecting the banks and are we on the edge of a recession?

On the positive side:

The credit quality of banks in New England is showing no signs of weakness. RMPI Consulting LLC (“RMPI”) monitors key credit indicators for banks with total assets under $10 billion in New England. These statistics tell us that as of June 30, 2006, these bank’s past due loans are at their lowest point of the new millennium. Since the recessionary times of 2001, the percentage of past due loans1 have been decreasing.

The chart below details both the percentage of past due loans to total loans and the percentage of charged off loans to total past due loans from December 31, 2001 through June 30, 2006. This chart details two layers of credit issues. The total past due loans relative to total loans of 87 basis points (“bps”) as of June 30, 2006 is at a millennium low. This figure was an improvement from December 31, 2005 and the five year average of 89 bps and 107 bps, respectively. The second trend noted is the loss exposure of the banks for loans that have become past due. As the chart indicates, banks are continuing to minimize their losses on past due loans. As of June 30, 2006, the percentage of total charged off loans to total past due loans was at 7.5%. This figure was an improvement from December 31, 2005 and the five year average of 8.37% and 10.68%, respectively.

Traditionally, there are early indicators of an impending credit decline. One such early warning sign is an increase in loans within the 30-89 days past due category. When the past due loans are broken down into different categories, 30-89 days past due, over 90 days and nonaccrual, no early warning signs can be found. The banks are still showing a reduction in the level of 30-89 days past due loans. As of June 30, 2006 these levels were at 53 bps down from December 31, 2005 of 59 bps and the five year average of 69 bps.

On the economic front the statistics continue to be positive. Unemployment for New England is at a healthy 4.6%. The unemployment figure has varied between 4.5% and 4.7% over the past two years. The growth in Gross Domestic Product (“GDP”) has been 4.1% nationally through the first two quarter of 2006. Economists are expecting the 2006 GDP to be a healthy 3.2%.

The State of Connecticut is a microcosm of the New England and National markets; only better. The levels of past due and charged off loans for June 30, 2006 are 62 bps and 6.6%, respectively. Both figures are a better than the New England averages. Connecticut’s unemployment of 4.5% is below both New England and the US averages of 4.6% and 4.7%, respectively.

So life is good…right?

There is no easy answer, but the quick answer is no. In 2005, many economists predicted a recession or at least stagnation in the economy in 2006. Though we have seen some slowdown it has not been to the level predicted. With few exceptions the economists are continuing the call for the downturn, but now saying it will begin in 2007. Why the pessimism? First, the inverted yield curve is more than just a drain on banks earnings. Historically it has been an early indicator of an economic recession. According to a 2003 analysis by the Federal Reserve Bank of San Francisco, each of the six recessions since
1970 was preceded by a yield curve inversion. However, in the past whenever the yield curve inverted and a recession followed, both short-term rates and long-term rates were on the rise. This time, short-term interest rates have been climbing gradually while long- term rates have remained fairly flat, indicating financial conditions aren’t as tight as they have been in the past. However this fact does not negate the daunting correlation between the inverted yield curve and the past six recessions.

There are more pressing indicators of potential problems in the New England economy and the bank’s credit quality. Prime rate for commercial customers increased 400 bps in the last 24 months and residential mortgage rates increased approximately 180 bps over the same time period before settling back to130 bps. The residential housing market has slowed down significantly. The level of single family sales is down 21.6% from August 2005 to August 2006 in Massachusetts. The single family sales price also declined over the same time period by approximately 8%. Foreclosure sales for residential real estate have increased 72% over the same time period. Reports for Connecticut are similar to that of Massachusetts with both a slow down in sales and a reduction in sales prices.

The impact of both the sales slow down and the price reduction of real estate may soon be affecting credit quality of most New England banks. When one looks at the balance sheet make-up of the average New England bank, areas of concern start to appear. The typical New England bank has 67% of its assets in loans. Of the total loans, 54% are residential mortgage. With the rising interest rates, the potential for adjustable rate mortgages (“ARM”) to become past due increases. With an 8% decline in pricing, it will not take long for the equity of a first time home buyer to disappear. As the number of days that a home takes to sell has crept past 100 days, the downward pressure on sale price may begin to pick up.

The largest percentage increase in a type of loan on a bank’s balance sheet over the past five years has been residential construction. Attractive because of favorable pricing, these loans now make up over 7% of the outstanding loans of an average New England bank. Unfortunately, this type of loan is taking a double hit. With the sale price decline, the breakeven point for each home increases leaving little room for error. Furthermore, as interest rates increase and the inventory of homes do not turn over, the carry cost of a project is increasing, thereby eroding the equity in the project. In my experience, the majority of our bank clients have expressed this as one of their top credit concerns.

The commercial portfolio may be vulnerable to degradation as well. Approximately 22% of the bank’s loans are commercial real estate (“CRE”) with 8.35% commercial & industrial (“C&I”) and 3.7% multifamily. Much of the CRE and the C&I loans are intertwined as the real estate is owner occupied. As the growth in the economy slows more companies may begin to default on their loans. Companies have already weathered the prime rate increase and a significant increase in fuel cost. The recent fuel decline brings some relief but the pricing is still above 2005 prices. There is currently little margin for error in today’s corporate environment. The current corporate capacity utilization rate in August 2006 was at 82.5% up from 73.9% in 2001 which was a 35 year low. The 35 year high was 85% in 1995. There is little room for companies to achieve more efficient operations.

Competition and banker inexperience will also drive degradation in credit quality. With so many banks chasing the same deals, less experienced bankers have made some bad lending decisions. Some of these loans are sitting on the books of the banks now awaiting an economic or management event that will cause them to explode. Another significant credit concern our clients have mentioned is the lack of credit trained lenders. There are only a few comprehensive loan officer development programs left in the northeast. Many of the lenders who entered the market in the past 15 years never went through one of these programs. Instead banks are relying upon on the job training supplemented by local association courses.

So where does this leave us?

This is not an easy question to answer. Some things are a definite. We will not keep seeing total past due rates in New England at 87 bps. The problem is determining if they will increase by 20, 50, or 100 bps. There are world economic factors that may also help drive that figure higher. The level of residential mortgage defaults will increase when the ARM loans begin to re-price. The market is already beginning to see subdivision loans going bad. This trend is likely to increase. The toughest question is to what level will the economic slow down or worse a recession further erode the credit quality of the commercial loans?

Currently, all banks earnings are being compressed. By not being proactive in managing their credit quality, banks leave their earnings exposed to further compression if the problem loans begin to spiral out of control. The banks may see earnings impacted through increased charged off loans. Bank’s earnings may also be impacted by the loss of earnings on funds used to increase the provision for loan and lease loss due to higher past due loans. A third impact may soon be here as well: the FDIC’s new premium for deposit insurance will be risk weighted.

The bottom line to a bank’s bottom line is to be proactive in addressing their credit quality problems. It is vital that banks are diligently managing the loans already on the books. It is always hard to exit a relationship but if there is potential for loss exposure, exiting now is better than charging off later. With better trained staff and more selectivity when making loans, banks will be in a more secure financial position, even if the already challenging economic conditions worsen.

NE Banks Chart 2006

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