The Tightening Commercial Credit Market
Although the fallout from the various large bank failures earlier this year seem to largely be behind us, the banking industry is continuing to struggle from a wide variety of stresses that do not seem likely to disappear anytime soon, including the following:
Shrinking Deposit Balances - not a day goes by where there is not news of shrinking consumer deposit balances, which is impacting all Banks. But on top of this, rising interest rates have led many individuals to pull excess balances out of Banks to invest them in other higher yielding funds, putting further strain on deposit balances. Banks lend their deposits out, so banks need to have excess deposits to keep lending.
Declining Net Interest Margins - As interest rates have risen, banks have had to raise interest rates on money market accounts, certificates of deposit and other bank instruments to keep deposits in their institutions. On top of that, many Banks have loan portfolios with fixed rates locked in well below current Fed interest rates, which are putting stress on net interest margins. As net interest margins decline so does Bank profitability. The stress on profitability is causing lenders to have to raise interest rates for new loans well above where market interest rates should need to be, creating additional stress and making it harder to get loans done.
A Growing Number of Problem Loans - Many lenders are seeing the number of problem loans start to spike up. This is being driven by economic factors such as inflation as well as by higher interest rates and other market stresses businesses are suffering from. When problem loans spike up, lenders usually tighten their lending standards to protect the Bank’s loan portfolio from further deterioration.
Dropping Real Estate Values – Without a doubt, commercial real estate values have been declining in many markets and asset classes, specifically as it relates to office buildings and retail properties. Higher interest rates have further compounded this problem. This is creating additional stress on Bank loan portfolios causing many Banks to back away from lending directly to office and retail properties, as well as some other asset classes and construction projects.
Declining Economic Conditions – the downgrade of the U.S. Government debt combined with other economic weaknesses Banks are seeing, has caused a growing concern we are heading into a recession. Lenders have become more conservative in lending, especially to those businesses and industries most likely to be impacted by a recession.
Liquidity Issues – The reason Banks like Silicon Valley Bank failed earlier this year is not typically because of bad loans. Banks typically fail because they end up in a position where they no longer have the liquidity necessary to operate. Today, as a fallout to the recent bank failures, Banks are hyper focused on having strong liquidity, which means maintaining a higher level of cash on hand. One way to do that is to lower a Bank’s loan-to-deposit ratio, which is the ratio between the amounts of deposits a Bank has versus the amount of loans the Bank has. In order to lower this ratio, most Banks must reduce the amount of lending they do or push out maturing loans.
With all of the pressures Banks are currently facing, it is not hard to believe they have pulled back on commercial lending. Unfortunately, a pull-back in lending and market liquidity is one of the things the Federal Reserve is seeking in order to slow down inflation. If less capital is available in the market, then less pricing pressure can be put on the price of goods and services because there are less dollars to chase those goods and services. However, when lenders stop lending and access to capital tightens up too much, that is often what causes a recession. When businesses do not have access to capital via loans to support operations in troubling times, in order to stay liquid lenders often times have to layoff staff and cut other expenses, which has a ripple effect throughout the entire economy. In essence Banks tightening credit out of concerns about a possible recession ends up being one of the factors that contributes to that recession taking place. It becomes somewhat of a self-fulfilling prophecy.
In today’s market we have seen a pullback in lending from probably 85% of the banking institutions we work with, and we have even seen a pullback in lending from many non-bank lenders as well that rely on lines of credit with commercial banks for a portion of their funding. That pullback in lending varies from those lenders who have just slightly tightened lending standards to lenders that have for the most part completely pulled out of the market and are doing very little lending or are only lending to existing clients. Almost all lenders are back to requiring a full banking relationship, and even lenders focused on real estate lending want some sort of deposit relationship with that relationship today. We have also seen pricing skyrocket, and I am looking at the largest spread in conventional bank pricing I have ever seen in the market in my 25+ year career. I still have some lenders pricing deals in the low 6% range while others are in the mid to upper 8% range for a 5-year fixed interest rate. That is a pricing spread of close to 3% for lenders pricing the same deal in the same market. Usually that pricing spread is closer to 0.50% to 1.00%.
Although it is clear Banks have tightened and are likely to continue tightening credit in the short-term, it definitely is not all doom and gloom. Banks have higher required Tier 1 Capital Ratios today and much larger loan loss reserves (money reserved to cover future loan losses) than they did prior to the Great Recession. Also, there are substantially more alternative funding sources in place providing all sorts of commercial financing than there were in the past. There is no question the banking industry is going to remain tight in the near future, and commercial loan borrowers are going to have a harder time getting access to lending and the lending they do get is likely to be at higher interest rates, we do expect this to be short-term. Once inflation is in check and when the Federal Reserve starts to lower interest rates again, capital should start to free up quickly.
If you are a commercial loan borrower in today’s market you need to be prepared. We would highly recommend you start the renewal process on any maturing loans a full six-months in advance of maturity so you do not end up in a position where a lender does not renew you. I would also be prepared to speak with other lenders in the market about interest rates and terms available to be sure you are getting a fair deal from your lender and are not with an institution pushing the higher side of market interest rates. Lastly, if you have any assets, specifically real estate that are under-performing or might not cash flow at higher interest rates, consider in advance how you are going to address that issue at maturity. Things to consider:
Do you have the capacity to paydown debt at maturity?
Is this an asset you can bring another investor in on to pay down debt?
Can you sell this asset before maturing to pay off the debt?
Is there an alternative lending product I can take advantage of? These are all questions you should be asking in advance of any loan maturity.
We are here to answer questions about what is going on in the market and provide you with assistance however we can. Please do not hesitate to reach out to us at any time at 630-988-4852 or at brad@commerciallendingx.com. Remember, everything goes in cycles. This cycle will not last forever, and eventually Banks will once again be flooding the market with loans. After all, most Banks need to actively lend to make money.