A tidal wave of nonperforming loans is expected to land on banks’ balance sheets in the second half of the year in large part because of the coronavirus pandemic.
But how management teams will react to this influx is a critical question bankers need to ask themselves now. Will they follow the strategy that worked during the Great Recession to revive growth? Or will they get bogged down in a long war with their balance sheets?
History shows that the fastest way to get healthy is to engage in active portfolio management and sell problem loans after the market resets asset prices.
Concrete example: the radically different result of American banks compared to European banks in the aftermath of the financial crisis.
Many US banks, pushed by regulators, quickly ceded billions of dollars in distressed loans in the secondary market. They avoided long workouts that sucked up management time and capital.
By acting decisively, the banks were able to put an end to the problems and refocus on new loan arrangements in a relatively short period of time.
What followed was a decade of phenomenal growth and share price appreciation for US banks before the pandemic.
In contrast, European banks have adopted an “expand and pretend” strategy, hoping to resolve the credit problem through adjustment. The biggest European banks are still sitting on 500 billion dollars in bad debts, despite an increase over the past four years mainly due to the disposal of bad debts. While U.S. banks had $ 83 billion in non-performing loans in the fourth quarter, according to the Federal of Saint-Louis.
Other factors played a supporting role in the unbalanced performance of US banks. But the experience of the previous crisis clearly shows that banks with a large number of NPLs cannot grow organically or by acquisition. The price of their shares suffers greatly.
Another key element of the Great Recession is that a strong balance sheet is a big advantage in mergers and acquisitions.
Banks that divested distressed assets and rebuilt their balance sheets were well positioned to grow through mergers and acquisitions. The same scenario is likely to happen again in the United States, as regulators and shareholders will want it to happen.
Regulators will seek healthy banks to absorb weaker ones and strengthen the financial system. Shareholders will see the pandemic as an opportunity to gain market share, especially mid-sized and community banks looking to expand their existing footprint or into contiguous areas.
Additionally, the revaluation of current asset values is more evident in commercial real estate, the type of asset that has wreaked havoc on banks in the last cycle. CRE is experiencing a unique change in business and consumer behavior that is likely to occur over the next few years.
For example, vacancy rates are expected to recover to levels reached during the Great Recession. CBRE predicts vacancy rates will increase over the next two years, peaking at 15% for offices and 12% for retail.
The demand for commercial premises is also low. Jones Lang LaSalle said on his first quarter conference call that office rental activity has fallen “drastically”, 20.8% in the United States and 28% worldwide, compared to the previous year. And investors remain pessimistic about the outlook for the office, retail and hospitality sectors.
All of this means that bankers must decide quickly whether they will adopt an active portfolio management strategy to deal with the expected increase in delinquencies.
If management teams adopt this strategy, they should start by placing pre-COVID problem loans into their own category.
Most likely, these credits do not return and must be sold first. The much larger category will be distressed loans that will emerge once the full force of the pandemic hits.
Another proactive step is to stress test portfolios now to see around the curve.
Many banks lack prospective visibility into their loans because they do not frequently update key data such as loan-to-value and debt-to-income ratios after loan origination.
As a result, loans can display a debt service that does not exist. This is a systemic problem across the industry. Stress tests can analyze loan performance and the impact of leverage. The analysis will help determine which loans should be held or sold.
Once the problematic loans have been identified, the question is how to sell them.
The secondary market for whole loans remains very liquid and is a viable option for maximizing collections on distressed loans.
Sellers should find lots of buyers. The distressed debt funds add to the significant dry powder that has already been accumulated. Hedge funds and opportunity funds will emerge, along with banks and other financial institutions that will selectively buy assets that match their business strategy.
Investors hoping for clearance prices will likely be disappointed. Judging from the experience of ten years ago, the demand for distressed loans will far exceed the supply.
Prices will adjust based on seller status and warranty, but will not require additional discount to find offset prices. The sellers will have the upper hand.
If the last financial crisis has reaffirmed anything, it’s that active portfolio management is working.
Let the markets revalue assets so that buyers and sellers can determine the best course of action. For banks, the best solution is usually to give up loans quickly to boost growth.