Investors Should Heed FDIC Warnings Of Key Credit Risks To Banks

The Federal Deposit Insurance Corporation (FDIC) warned of potential credit and market risks that market participants should definitely heed. In particular, the FDIC’s 2019 Risk Review Report released yesterday highlighted concerns in the agricultural, commercial real estate, energy, housing, and leveraged lending sectors.  Additionally, the risk review report covered the significant rise in bank loans to non-banks.

Six years of agriculture prices and recent trade tensions are impacting agriculture borrowers. “A slowdown in the agricultural economy is an important risk to the FDIC because farm banks are a large source of financing for the agriculture industry and represent about one-fourth of banks in the United States.”

Community banks hold almost 70%, ($127 billion)  of total agriculture loans. Furthermore “Eight percent of all banks and 31 percent of farm banks hold a concentration of agriculture loans above 300 percent of total capital. Exposure to agriculture lending is concentrated in the Midwest.” Fortunately, loan restructuring has helped borrowers not reach adverse credit quality and default levels of the 1980s. Yet, ongoing trade tensions do not bode well for the US agricultural sector.

In the commercial real estate (CRE) lending area, the FDIC pointed out that “Vacancy rates are low, and property prices and rents continue to grow for CRE in general.” Yet, the report warned that “ overbuilding in some multifamily and industrial segments and oversupply of outdated retail properties may weigh on CRE fundamentals going forward.” It is important to remember that during the 2007-2008 crisis, “banks considered to be CRE lending specialists failed more than twice as often as the average community bank.”  Since mid-2017 FDIC bank examiners have noted areas where banks which have CRE concentrations can improve risk management practices, especially in governance and oversight and portfolio stress testing.

All banks should be focusing on the housing sector, because it is slowing down. According to the FDIC “Signs of a slowdown in sales are emerging in the housing market even as house prices continue to rise across most of the nation. Affordability is a growing concern as income growth lags the rise in house prices and mortgage payments.”

Unlike the mid-2000s, banks are less exposed to residential mortgages and there are new mortgage regulations. Nonetheless, banks exposed to residential mortgages should be reviewing the credit quality of their portfolios as the economy continues to slow down. “Among FDIC-insured institutions, the condition of the residential mortgage portfolio is favorable, but some banks report significant loan concentration levels and increased competition.”

For banks exposed to energy loans, FDIC found that they were resilient to oil price stresses in 2014-2016.  Yet, the FDIC report pointed out that energy sector high-yield debt remains elevated.  Rating agencies have shown continued credit quality deterioration the energy company debt.  Unsurprisingly, the FDIC found that some banks have high concentrations to the energy sector. Fortunately “Examination findings show that only a handful of FDIC-supervised banks, concentrated in the FDIC’s Dallas Region, have more than 25 percent of loans tied directly to oil and gas lending.”

Unsurprisingly, the FDIC dedicated a section to leveraged lending and collateralized loan obligations. As I have written extensively, the rise in leveraged loans, and particularly that the majority are covenant- and document-lite, should concern investors, regulators, and legislators.

Leveraged loans are often sold to special purpose vehicles which package them and issue collateralized loan obligations (CLOs). About 16 percent of U.S. CLOs ($96.0 billion) are held by U.S. banks. The largest banks hold 85% of that amount, with the largest holders being Citibank, JPMorgan, and Wells Fargo. “Bank-sponsored or affiliated funds with exposures to corporate debt or leveraged loans represent another potential source of exposure, as banks have felt compelled to step in and support their related funds during times of stress.”

No one should be complacent about nonbanks’ role in the financial sector.  The FDIC’s data shows that “Bank lending to nondepository financial institutions, which is primarily driven by noncommunity banks, has expanded seven-fold since 2010 and now exceeds $400 billion.” Many of these nonbanks have increased their lending to mortgage borrowers and to companies. Hence, the interconnections between banks and nonbanks should be monitored carefully. Many of these nonbanks are less well regulated than and more opaque than banks.