We Are in Third Period Of A Loosening Of Bank Underwriting Standards: Goldman

We Are in Third Period Of A Loosening Of Bank Underwriting Standards: Goldman

Via Goldman Sachs: We are in the third period of a loosening of bank underwriting standards in the past two decades. The outcomes of the first (1993-1998) and second (2004-2007) were materially different, as the former resulted in an acceleration in loan growth (9% per year) with minor implications for credit losses, while the latter contributed to the financial crisis. Lower leverage, new regulations (particularly capital) and limited demand could make this time different.

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Banks To Continue To Loosen Expected In Third Period

In fact, without a return in demand, we expect banks to continue to loosen via duration extension and moving further into risky lending areas. Given the significant pick-up in comments around loosening of underwriting standards, we take a deep dive into the topic and look at the implications in three key lending markets (1) C&I (including syndicated/leveraged lending), (2) commercial real estate and (3) auto. Key observations from past cycles:

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  • Loan growth accelerates (+): While loan balances have advanced just 2% during the current loosening cycle, past cycles yielded average growth in the 8-10% range (see page 6), implying an acceleration from here could be on its way. That said, (1) changes in regulation, (2) new capital standards, (3) continued run-off portfolios and 4) low levels of demand due to high cash balances at corporates could prevent us from seeing growth move back to those levels.
  • Spread compression increases (-): Loans are similar to other products – if you make them less expensive, more will be consumed. Cycle to date, C&I spreads are down 90bps from the peak to 3.5% vs. 130bps of compression in the 1990s and 250bps in the 2000s), implying they could compress an additional 60-90bps. While large corporate has seen the most compression thus far, middle market and small businesses appear poised for further compression (see page 9). Without higher demand, the growth vs. spread compression trade-off might not manifest itself, leading to riskier lending.
  • Structures weaken as terms extend, collateral lessens and lenders “move down market” (-): If an acceleration of loan growth does not materialize, we expect banks to (1) further extend durations (some are offering 96-month auto loans, 10-year fixed rate C&I loans are becoming more popular) and (2) engage further in riskier lending, including syndicated and leveraged lending (see pages 17-20) and subprime auto.

The biggest risks, in our view, are that (1) credit eventually could turn and (2) asset sensitivity could be reduced. In the prior two cycles, charge-offs began to rise (or at least stabilized) three years after the beginning of the loosening cycle. However, given how severe the credit cycle was in the last crisis, we think a rise in credit losses in the near term is unlikely. That said, if higher credit losses do materialize, this could be a risk to market expectations, in our view. In terms of asset sensitivity, some banks are offering 10-year fixed rate loans. Once rates rise, we estimate banks making these loans will go from earning their cost of capital (10% ROE) to 0%, in addition to reduced asset sensitivity. That said, this could take multiple years to show up in the data.

What does this mean for the stocks? While spread compression will show up, higher losses can take long periods of time to show up (see the 2003-2007 cycle). Therefore, outside of credit issues, any bank’s ability to outgrow its peers could be a significant driver of share price outperformance. Our analysis suggests owning risk seekers (FITB, RF and STI) and growth at a price at this point in the cycle. Below we divided the group into four categories, which we believe could drive share performance:

  • Risk seekers: these loosen standards for greater than peer growth. Margin pressure remains lower due to term extensions, moving down the credit spectrum or lower collateral requirements. Own these stocks during the loosening period. Fifth Third Bancorp (NASDAQ:FITB), PNC Financial Services (NYSE:PNC), Regions Financial Corporation (NYSE:RF) and SunTrust Banks, Inc. (NYSE:STI) screen in this bucket.
  • Growth at a price: these loosen standards and are willing to trade growth for a lower spread. Margin pressure is high as loosening is most likely limited to price concessions. These stocks tend to outperform to a lesser extent. Bank of America Corp (NYSE:BAC), Capital One Financial Corp. (NYSE:COF), City National Corp (NYSE:CYN), First Niagara Financial Group Inc. (NASDAQ:FNFG), JPMorgan Chase & Co. (NYSE:JPM), KeyCorp (NYSE:KEY), Synovus Financial Corp. (NYSE:SNV) and Wells Fargo & Co (NYSE:WFC) screen in here. ? Margin preservers: Maintaining spread tends to drive these away from deals, leading to lower growth. Spreads usually move with industry. These stocks tend to underperform slightly, but are usually strong performers “through the cycle.” Comerica Incorporated (NYSE:CMA), Huntington Bancshares Incorporated (NASDAQ:HBAN), M&T Bank Corporation (NYSE:MTB) and Zions Bancorporation (NASDAQ:ZION) fit this category.
  • Risk averters: Prudent discipline drives lower growth and less chasing of yield/higher margins. Shares underperform during credit loosening period. First Horizon National Corporation (NYSE:FHN), BB&T Corporation (NYSE:BBT) and U.S. Bancorp (NYSE:USB) fit this category.

While standards in consumer real estate (mortgage, home equity) remain tight relative to history, several asset classes have experienced significant loosening. In this report we focus on three key lending categories that make up over 53% of bank loans, including C&I, commercial real estate and auto lending. Below we highlight the biggest risks and largest players in each category.

  • C&I (26% of loans): We see four areas of concern – first, we estimate current returns are at cost of capital levels, and we see them falling to 7% if spreads compress an additional 90bps. Synovus Financial Corp. (NYSE:SNV), Zions Bancorporation (NASDAQ:ZION) and City National Corp (NYSE:CYN) screen most at risk here. Second, more middle-market loans are seeing weaker structures and use of fixed-rate loans is increasing (i.e., 10-year 3.5%). If rates rise 300bps, we estimate ROEs would decline from 11% to 0%. Comerica Incorporated (NYSE:CMA) and Regions Financial Corporation (NYSE:RF) most exposed to competition here. Third, syndicated lending is growing rapidly and more regional banks are participating and in greater sizes. They lead only 29% of deals and average commitments are $32mn, leading to concentration risks. Lastly, leveraged lending volumes are increasing rapidly. Volume in 1Q13 reached $185bn (peak of $188bn in 2Q07), with bank participations at $47bn ($48bn in 4Q06). With covenantlight lending back near pre-crisis levels ($85bn in 1Q; $97bn peak in 2007) and Debt/EBITDA, at 4.5-5.5x (6x during 2007) and increasing, risk is building. KeyCorp (NYSE:KEY), Wells Fargo & Co (NYSE:WFC), SunTrust Banks, Inc. (NYSE:STI), Regions Financial Corporation (NYSE:RF), PNC Financial Services (NYSE:PNC), Comerica Incorporated (NYSE:CMA) and Fifth Third Bancorp (NASDAQ:FITB) appear to be those most reliant on leveraged lending growth.
  • Auto lending (5% of loans): Auto is growing rapidly and the result is increased competition as standards are easing. Most of it is pricing pressure and it is occurring in the top of the market (super-prime and prime), where most of the regional banks operate (HBAN, FITB, STI and RF) and excess returns are limited. We view the main risk for our banks is further yield compression, as new money yields are still 50-125bps below portfolio rates. Fifth Third Bancorp (NASDAQ:FITB), Huntington Bancshares Incorporated (NASDAQ:HBAN), Regions Financial Corporation (NYSE:RF) and SunTrust Banks, Inc. (NYSE:STI) face the most risk here. Much of the growth and potential for outsized risks are happening in the used and subprime markets, as used prices are starting to fall and standards are loosening the most in the subprime and deep subprime markets, where terms are extending, LTVs are increasing and credit is showing signs of weakening. Capital One Financial Corp. (NYSE:COF) and BB&T Corporation (NYSE:BBT) are the two banks experiencing increases in delinquencies, both which play in subprime. That said, we estimate returns in subprime are 2x those in prime, and without a turn in credit, we would expect more lenders to move to that part of the market.
  • Commercial Real Estate (22% of loans): While CRE has been a growth laggard, activity is picking up and we see risks as CMBS issuance is on pace to reach 2005 levels and spreads are decreasing, maturities are extending and loan sizes are increasing. While multi-family is the only product in CRE experiencing growth, it has experienced the most spread compression (40bps) over the past year and spreads (205bps) are at the lowest level of all of CRE. For weakening of terms, we have heard some banks area using pro forma cash flows and interest-only in underwriting properties. The risk is that if rental growth does not materialize, debt service coverage ratios may prove insufficient (Exhibit 52), driving credit issues. Lastly, even with further easing demand may not return without a pick-up in employment, which is the key driver of CRE growth, Zions Bancorporation (NASDAQ:ZION), Synovus Financial Corp. (NYSE:SNV), First Niagara Financial Group Inc. (NASDAQ:FNFG), City National Corp (NYSE:CYN), Regions Financial Corporation (NYSE:RF) and BB&T Corporation (NYSE:BBT) are most at risk here.

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Third Period of a Loosening of Bank Underwriting Standards In

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