Thomas Curley 0:00

This is Ahead of the Curve: A Banker’s Podcast

 

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Thomas Curley 0:11

Welcome to this episode of Ahead of the Curve: A Banker’s Podcast, I’m your host Thomas Curley and I am here with Rob Newberry. Rob is a veteran of the podcast so far and so we’re excited to have him back on. He’s a Senior Advisor on Abrigo’s Advisory Services team and he’s currently a faculty member at the Graduate School of Banking at the University Of Wisconsin Madison. And over the last ten years he has been focused on working with financial institution leaders and regulators to develop a suite of credit administration tools for financial institutions and maybe most importantly for today’s conversation, I know he grew up on a dairy farm.

 

Rob Newberry 0:52

That’s right Thomas, yes. That’s why I’m an ag expert, I milk cows for many years. Glad to be in the business world not on a dairy farm.

 

Thomas Curley 1:04

Well we’re certainly excited to have you on the talk ag lending. I know it’s a bit more niche topic than some of the ones that I know you’ve jumped in on in the past, but I think it’s an important one especially for many community financial institutions out there. So I wanted to jump right in and Rob, you know, I know we’ve got high inflation across the board potentially meaning, you know, some high input cost. And my assumption is that there might be some increases in loan demand for ag banks. Is that kind of true on your end? You know what’s going on in the market?

 

Rob Newberry 1:35

Yeah, so a couple things going on with that comment. The first one being, yes, eventually it will definitely lead to more loan volume. Now it’s one of the interesting things about the pandemic and the stimulus packages. I think maybe ag was, I’m gonna say, a little overstimulated by government direct payments. Which did a couple things, hopefully ag producers were able to pay down their debt load or debt carry which would make it easier for you to give them money going forward and make the credits have less risk. However because they got government subsidies and then commodity prices also went up at the same time as kind of like a double whammy where they were liquid with cash and really have been able to absorb to this point a lot of the increases in expenses. So kind of think of it this way, a lot of them prepaid some of their expenses for this year last year because they had some direct government payments and commodity prices were good. So the real impact hasn’t really hit a lot of the ag producers, but it is coming for sure.

 

Thomas Curley 2:50

Awesome! And then I know we’ve got a lot going on globally, which I think more than other industries affects the ag space, you know, any comments on the war in Ukraine or any other of the economic issues and how that might play into some of the banks and credit unions out there in the ag space?

 

Rob Newberry 3:09

Yeah I mean there’s a couple things going on specifically with the war in Ukraine is we get a lot of our fertilizer from Ukraine or were, so that price even for the non ag producer if you were just a homeowner going to buy fertilizer’s doubled or tripled in price just for a bag of it right? And so significant increase in fertilizer and then we have the oil issue right? And so Russia being a big oil supplier as we cut those ties the cost of fuel has exploded as well. So, two of the main inputs for ag have had the highest inflation and so kind of get this double whammy of, you know, fertilizer going, up gas prices going up, and with the also with the increase in interest rates. Thomas I’m not sure you’re probably aware that we had a significant increase just the other day. First time since the mid 90s I think that interest rates were hiked by 75 basis points.

The other main input a lot of times on ag is interest expense, so 3 of the biggest expenses have all significantly went up and so we have those things kind of going on in the ag landscape. Commodity prices are up so one benefit that we will see is because Ukraine’s not producing grain right now, the demand for a grain will go up. So commodity prices still should stay up. I think I read an article yesterday that they anticipate commodity prices at least through next year kind of being 5% higher, so pretty steady or higher which is good. But I guess the biggest concern I kind of have with that Thomas is with the high input costs. You know we were able to take advantage of that in 2021 and 2020. The flipside is and we’ll have high input costs and then when the commodity prices drop, we’ll be caught on the backside of that and that’s when a lot of folks will get in trouble. So if you remember back in 2019 and that’s the last time interest rates were this high, farm income was not very good right? I mean that was some of the ag stuff was getting pretty tight, not a lot of profitability and then COVID hit and things significantly changed. Now we’re kind of back to where we were March 3^rd, 2020 is when prime was 4.75 so exactly where we were before COVID from an interest rate perspective.

 

Thomas Curley 5:36

So what you’re saying is we should go and dust off some of those old white papers and blogs from 2019

 

 

Rob Newberry 5:42

Yeah absolutely, you know, and it’s interesting because, I think maybe you’ll ask me a question about how the 80s and ag crisis ties into now and, you know, one of the things that, a new term, it’s not a new term, it was back in the 80s to it’s called stagflation. Which basically means where we’re having inflation but our GDP is actually declining. So typically when you have inflation that means our economy’s booming in, you know, where it’s more expensive to do things because we have to pay more money for people to work and everything’s going great. We’re kind of in a unique situation that we have inflation and after the pandemic and you know now we’re raising interest rates to also shutter GDP that we have stagflation which is we have not enough supply but the demand isn’t really growing. And so that supply chain issue still, we’re still dealing with COVID issues, and we have you know microchip issues and we have all these other things still going on it’s interesting. Stagflation was also in the 80s ag crisis, it’s kind of, was one of the leading causes that created that issue back in the 80s so.

 

Thomas Curley 6:51

Yeah, no, we’ll definitely talk a little bit more because I wanted to get your thoughts on, you’ve written a white paper for us recently and I wanted to get some of your thoughts on that. Before we jump off the state of the ag landscape, always like to ask as I’m reading other ,you know, articles across the industry they’ll sometimes call out specific regions or maybe dairy farmers or ,you know, corn specifically. Are there any sectors that you think present a unique opportunity or maybe areas or vice versa? Maybe something to look out for from just some of the data that you’ve been seeing.

 

Rob Newberry 7:24

Yeah, you know, the only thing I saw that and it really didn’t concern me I mean steer so like livestock pricing looked like it was going to be level or down a little and with the high input cost of corn right? So when commodity prices of corn is high, it’s more expensive to feed your cattle. So if if the cost that the producers are getting for cattle is actually going to decline a little and their input costs are going to go up, there might be a little concern in the cattle lot. You know, cattle, cattle feeder, lot, ranch issue. The only other issue Thomas is with high input costs just commodity prices in general. If we take a dip in any of them just with a high input cost, it could lead to some significant issues rather quickly right? Just because everybody will be flipped upside down pretty quick.

 

Thomas Curley 8:18

Gotcha. And I guess that probably leads into the next question I had. We alluded to at the top end about, you know, will some of this stuff lead to increase demand given some of the stimulus that they’ve had and been able rely on the past couple of years. Do you see that being a something that’s gonna happen real soon or something that might still, like you said, is still being delayed a little bit? It might take some time to catch up.

 

Rob Newberry 8:42

Yeah I would anticipate that the volume will start picking up next year. So the next ag cycle. We’re kind of, you know, we’re, I’m in the Midwest here Thomas, you’re aware of that but you know we got all our crops in so we’re through that phase of the lending cycle. Once they get those crops in, depending on commodity prices I think next cycle you’ll see a lot bigger demand for loan volume because of the high input costs. Folks won’t want to prepay their expenses like they did previously coming into 2022 and I think you’ll see ag demand significantly increase going forward. So I think most folks have probably burned through the stimulus and their liquidity getting to where they’re at now in that we should see an increase in volume in 2023 as we start the ag cycle again.

 

Thomas Curley 9:37

Great and I think that that’ll be some good news. Obviously there’s always some nuance to that as I know obviously we don’t love inflation and some of the other things that come with it. But I think some good news for financial institutions out there.

Switching gears a little bit and we’ve already talked a quick second about the 1980s farm crisis. You wrote a white paper that had a little bit information in there and I wanted to get your thoughts on how you see the current environment similar to the 1980s. What should lenders be keeping an eye on based on your experience?

 

Rob Newberry 10:10

Yeah, a couple things. One is there’s always folks that chase hot deals. When commodity prices are high land values go up, so we’ve seen a significant and increase in land values. So then people that want to buy the land have to buy it at the highest level. That with high interest rates make that a lot riskier because if the ag land is elevated and then comes back to more normal pricing folks will feel like they are underwater right in their current purchase. So it just makes that debt load a lot heavier for them to carry as you go forward. And so Thomas that’s one of the big concerns and that’s what happened in the 80s was, a couple things. One is commodity prices drop but farmers had a lot of inventory. Well in order to survive they had to sell their inventory and that was what was backing up a lot of the loans. So then all of a sudden there were a lot of loans that were basically unsecured because they had sold the inventory underneath the bank without the bank being aware of that. The only good news is usually in inflationary time real estate’s a good thing to hold because the values go up. Now, the bad thing is if it’s a bubble and prices come back down, you maybe paid too much and if you’re paying ,you know, the current interest rates that have went up significantly in the last two months you can get caught on the backside of that. And that’s kind of what happened in the 80s.

 

Thomas Curley 11:36

Gotcha. One thing I’ve heard you talk about is risk scoring models. Are there some strategies that you think folks start to implement to mitigate the potential of some of those things from happening in their ag portfolio?

 

Rob Newberry 11:49

Yeah there’s a few things. And so unfortunately inflation hits the ag industry in a couple ways. If it’s a family farm you have it hitting you kind of double. You have your living expenses, a lot of times when we talk about credit analysis for ag we do what we call a global analysis, which means we’re gonna look at the farm income and the personal income and use that combination to qualify the borrower. Well if you have high input costs and inflation, so your living costs also go up and you’re using the same source of revenue to cover that it’ll squeeze that credit and, you know, the other big thing we have going on right now Thomas is we have CECL going on. So we have third and fourth quarter this year where all folks will be trying to implement CECL. Depending on the methodology they pick if they pick like a default loss given default method, right, and they do like what I would call loan grade migration, understanding that changing in that credit grade based on some of these things that we’re talking about will also have an impact on the amount they’d have to reserve for CECL. So, you know, that probability of default method is one of the methods I’m sure several institutions are probably using in that and so that’ll be something to be aware of on that front as well. The other thing is understanding cash flow right? We know that as interest rates go up that’s one of the major expenses, making sure that the borrower can cover both interest and expense on that front will be critical. And just watching, I think what happened in the 80s Thomas to go back just a second is a lot of times we didn’t have the due diligence. We knew they had inventory but we really didn’t check to see if it was still there. I think keeping our eyes on the ball a little more this time and so if we do get things a little tighter making sure if we do have inventory as collateral, we know that it’s there and we actually look at it. So if it’s a tractor, is it a pedal tractor is it a real tractor right? Understanding what is really the collateral behind some of those notes.

 

Thomas Curley 13:58

And you mentioned, you know, land is always a good asset to have typically during inflation periods. But obviously if there’s some sort of bubble, there could be something wrong with that. Anything that they should be doing on the pricing side or anything of that nature to be ready for any potential risk on something like that happening?

 

Rob Newberry 14:19

Yeah there’s a couple things they can do on pricing. Glad you ask that question Thomas. Really two things come to mind. Typically in a raising rate environment, we do a couple things right? We kind of were afraid of interest rate risk as bankers, so we typically want to go short and when you do short-term loans you’re working in the narrow part of the net interest margin band. So, you know, usually you don’t charge as much for a 1 year commitment as you do a 15 year mortgage because you have that interest rate risk. Well if you’re always working in the narrow band and your cost of funds goes up, you just have a less opportunity to make money as a financial institution. So one of the things you can do from a pricing perspective specifically if you’re competing with, you know, Farm Credit and some of the other government-backed agencies is you might want to consider going a little longer in your product. Offering products that give the customer a little protection as well from a fixed rate perspective. So I’ve seen a lot of ag clients that do like a 1 year fixed line of credit basically or a loan, but you know the spread’s very narrow on that instead of doing a 7 year, you know, 25 balloon or something. And so trying to understand maybe your product mix and creating features that the customer will pay up for that protection that they get from a credit risk perspective can be huge as you go forward in a raising rate environment because I don’t think rates are done moving up Thomas. We talked about, you know, the name of the podcast, ”Ahead of the Curve.” The curve’s still going up right? So there’s probably still a couple more interest rate hikes out there. And trying to understand how to price those will be critical to maintain your profitability as a financial institution.

 

Thomas Curley 16:13

Gotcha and I think you’ve already alluded to this a little bit but I know one thing that Abrigo from a software perspective is really trying to help people make smarter loans and be able to catch things if something starts to go bad. Are there any tips or tricks that you would maybe want to let the audience know about how to identify those problem loans before they get to that point, especially with an ag lens there?

 

Rob Newberry 16:40

Yeah there’s a couple of things you can do and I know a lot of ag folks might not be aware of thi,s but there are specific business codes even related to ag. So there’s not one ag, you can get as specific as corn farming, you know, honeybee farmers. You can get very specific in those NAICS codes. So one is understand your concentration risk and do stress testing. And so whether it’s, you know, we’re in a raising rate environment, what happens if their debt service coverage changes by 25%, can they still make those payments? Is the first thing. The second thing I would say is proactively manage your portfolio. So knowing that, you know, as financial institutions we’re typically a little leery of interest rate risk. We probably have a bunch of folks maybe resetting here in the near future. So if you had a operating line or you had a three-year balloon or five-year balloon, you might look to see if they’re a good credit can you take advantage and maybe you refi them a little early to take advantage of the interest rate cycle. If you look at this, at the interest rates today it only cost fifteen more basis points from a two year treasury to a ten year treasury. So very flat from two to basically thirty years is almost the same interest rate, so it doesn’t really cost you more money to go longer. It’s more convincing your board and forgetting all that stuff we said that was really bad about interest rate risk and actually booking some longer term fixed product on your books. Which one, is it improves your pricing, two, it reduces the credit risk a little because you’ve locked them into a rate, so if rates go up in general but your farmers are locked in at 5% versus moving it at up to 7% there’s that more ability for them to make profit because you’ve already got them locked in.

 

Thomas Curley 18:35

Awesome. Well so the intention was to hit on some of the the top concerns for ag bankers for sure throughout this podcast and so we’ve hit on the market just generally, globally. we’ve hit a little bit on the inflation, the rising rates, and some of the credit risk. One things that always pops up when I look at surveys and other resources that ag banks are worried about are competition right? And we mentioned Farm Credit, but what are some ways you’ve seen clients stand out in the ag space as it’s getting more and more competitive as we go each year.

 

Rob Newberry 19:10

Yeah I mean there’s a couple reasons for seeing that right, Thomas? One is there hasn’t been a lot of loan demand so you’re fighting over table scraps right, currently. So it gets pretty competitive in that space. A couple ways that some institutions can separate, I’ve seen them separate themselves, is one is try to avoid what I call commodity pricing on your loan products. Don’t offer the exact same product that all the banks around you are offering because then you’re going to get rate shopped and that that hurts everybody, right, because you’re only as good as the lowest person in your community or vicinity and you’re kind of at their mercy. But if you can create products with either features that people are willing to pay up for, one is even if it’s the same price if you have a different feature you might attract customers that you wouldn’t normally get and be able to close a higher rate because you have other features. Specifically knowing that we’re in a raising rate environment, once again giving them some long-term protection is probably a huge win. But even if it’s maybe a little lower rate but charging a origination point or letting them buy down the rate a little, you know, simple things like that Thomas that can separate yourself from, you know, everybody selling table salt would be a huge win I think for customers. The other one is just be proactive with your customers right? Understand we’ve just went through the pandemic, so a lot of them probably had some stimulus money but kind of understanding where they’re at and being proactive as you manage their portfolio so you don’t lose good customers that you have. So there’s attracting new customers to get growth and there’s maintaining the ones you have, so trying not to lose the ones you have.

 

Thomas Curley 20:55

Awesome! One question I had and I was wondering if, you know, I midwestern banks we’ve got a lot of producers and farmers out there that they like going into the branch but I was curious on if you’ve seen a huge shift towards technology, really digital application type tools at some of these ag banks and if that’s another way to start to differentiate too?

 

Rob Newberry 21:17

Yeah, you know it’s interesting Thomas because the pandemic I think’s taught us all whether you’re an ag farmer or you know us Thomas that we can work remote and be more efficient and especially with rising input costs and all those things. We’ve had this request multiple times of being able to have ag customers submit their financials electronically, being able to input them themselves and do all kinds of fun cool things, or being able to sign online. So, you know, if you can be in the field and not at a bank, you’re probably more efficient. So technology is definitely playing a role. not only there but you know think of all the automated machinery equipment that’s controlled by GPS right? You don’t even have to really drive your combine anymore it drives itself and so technology is becoming a bigger and bigger role in ag and I think some of the farmers that are a little longer in the tooth are starting to understand that piece. And we also have kind of a new generation of farmers coming in that are used to that type of technology, and if you don’t have it will be disappointed and probably bank somewhere else. So you have this kind of niche of some older folks finally getting to understand the importance of technology and newcomers expecting it and if you don’t have it, they’ll find someone that does. A couple ways technology is impacting them.

 

Thomas Curley 22:41

Yeah I think the beauty of what you were just talking about is that by having the technology doesn’t mean you have to use it for every single customer or producer that you’ve got. You can, you have the opportunity if that’s what they want to do but they can still come into the branch if needed. So it’s just a nice to have those options when you need it I think.

 

Rob Newberry 22:58

Ya Thomas if you look at it the opposite way, it could be a deal killer if you don’t have it right? But it’s not a, you know, that doesn’t necessarily mean they’ll use it. But if you don’t have it and you have once again as farms turn over to the next generation, that generation’s grown up using their phone to do everything right? And so if you don’t have that ability you’re going to lose out just because you don’t have that ability. Not that they will use it every time because they might come in the institution or you might need the technology to go out and see them instead of having them come in the branch. Can you go out there with technology and iPad or something else and digital signature and do some other things that are pretty cool versus them having to come in and sign a paper.

 

Thomas Curley 23:41

Good things to keep in mind for sure. So, I want to go ahead and start wrapping up our time here. If listeners take, you know, anything away from the conversation I was curious if you had maybe two or three main points that you’d want them to think about after the call keeping in mind we’ve got you know financial institutions across the United States with ag portfolios listening in.

 

Rob Newberry 24:06

Yeah, a couple things. One is, you know, don’t panic, the loan volume will come back. And so I think to your point earlier Thomas about the credit risk, making sure that your model is updated and that you understand that, you know, with high input costs the risk is commodity prices falling and the profitability of those customers going forward in inflationary times right? So that would be one. One is also, I would say do the due diligence whether it’s when you’re doing the credit and looking at the collateral or whether it’s managing your loan portfolio and trying to catch things before they go south on you right? Trying to fix things as you go. And then I guess the third one is, it’s okay to say no, so don’t fight over the table scraps that might not be worth fighting over. So we talked about, you know, there’s not a lot of loan demand right now. However, that doesn’t mean you should go try to chase every deal and either make no money on it because you’ve offered such a low rate or you pick up customers that you normally wouldn’t have done based on your credit policy just because you’re not having any loan demand. So, if it’s a bad loan, it’s a bad loan so, you know, just because there’s not any good loans out there don’t pick up the bad loans. If that makes sense Thomas.

 

Thomas Curley 25:30

I think that will do it for our episode today. For those that are new listeners or those that haven’t subscribed yet, you can find this podcast and future episodes on abrigo.com or you can find it on your favorite podcast app or platform. You can search Ahead of the Curve: A Banker’s Podcast or simply Abrigo. Thanks so much for listening and we’ll be back again with our next episode soon. And Rob, just want to thank you as always for joining us and talking a little bit of ag.

 

Rob Newberry 26:01

Thanks Thomas for having me and look forward to talking to you and everyone again soon.

 

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Thomas Curley 0:00

This is Ahead of the Curve: A Banker’s Podcast

 

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Thomas Curley 0:13

All right, welcome to this episode of Ahead of the Curve: A Banker’s Podcast. I’m your host Thomas Curley and I’m here with Matt Anderson, Managing Director at Trepp. Matt’s a recognized leader in the banking industry and works closely with financial institutions, regulators, clients, and prospects to identify emerging market needs in order to grow Trepp’s financial institution analytic and forecasting tools.

We also have repeat guest Rob Newberry on today to join Matt. Rob is a Senior Advisor on Abrigo’s Advisory Services team and is a current faculty member at the Graduate School of Banking at the University of Wisconsin-Madison. And over the last ten years he’s been super focused on working with financial institution leaders and regulators to develop a suite of credit administration tools for financial institutions. So, we are excited to have both of them on today to talk about commercial real estate lending. So, thank you both so much for jumping in.

 

Matt Anderson 1:12

Thanks for having me.

 

Rob Newberry 1:13

Yeah, glad to be here Thomas.

 

Thomas Curley 1:15

So, let’s jump right in then, Matt I figure we would start with you. We have lots of financial institutions listening to this podcast and I’m sure top of mind for them is the state of the market. CRE lending I know is a pillar for many bank and credit union portfolios across the country, so I wanted to ask you, you know, how would you maybe describe the current CRE landscape as a whole from a global view but also maybe a little bit domestic as well?

 

Matt Anderson 1:43

Thanks Thomas. So yeah, we’re in a really strong position at the moment. The momentum for the last couple quarters has been quite strong. Interest rates are still low. They have been really low, but they’re on the rise so the concern I think for everybody in the market right now is maybe we’re at a transition point right now from a very low rate but strong growth environment to now a high rate and uncertain growth environment. So, it’s been great so far, but definitely some clouds on the horizon. High inflation and higher interest rates being, you know, among the top concerns and then clouding that outlook of course is the situation in Ukraine with war there and in the disruption in food markets globally and oil markets globally. Oil and food are both key components of inflation, so we’re in a very strange spot right now. It would be an awkward position even without war in Ukraine but that just complicates things even further and, you know, on the rising rate front it’s pretty much guaranteed that the Fed is going to raise rates at their next meeting.

Now the talk is of course around 50 basis points but that would still put the Fed funds rate, you know, .75 which is you know, not really that high in the scheme of things. So, it’s a big jump big single period jump but it’s not a big absolute jump from you know where rates have been in the past. Having said that, the market is already pricing in future increases according to how we unwind, you know, future expectations from the yield curve. Looks like the market is expecting about a 300-basis point increase over the next two years and, you know, the long-term rates have now gone over 3% so that the 10-year rate is right around 3%. That’s going to increase borrowing costs across the board.

 

Thomas Curley 4:15

Anything you’d add to that Rob?

 

Rob Newberry 4:18

Yeah, Matt I had one question. Do you think that the increase in rates and inflation has a positive or negative impact on the credit risk of existing commercial real estate? Right? So, if it costs more to build a new commercial real estate building how will that impact the market as we kind of look forward the next few years.

 

Matt Anderson 4:37

Yeah, that’s a great question. So, for floating rate borrowers, of course, higher interest rates are going to mean higher costs sort of in the near term when those rates readjust, reset they’ll be resetting to higher rates. So, their payments will be going up and as a result, you know, the debt service coverage ratio that’ll go down and that’s a that’s a key metric for you know credit risk. It’s one that we look at in our default and loss modeling. So that’ll for floating rate borrowers, and that’s about roughly half of the commercial real estate market is you know on fixed on floating rate debt you know, so for that segment of the market, the risks will go up pretty immediately. How high they’ll go up is the other you know part of that question. There’s probably a lot of capacity still among those borrowers to handle rate increases. I’m not sure if 300 basis points though would be that easy to you know to handle, you know, that’ll remain to be seen.

There’s another component of the interest rate or rising interest rates and that’s the impact on cap rates. So, when long-term rates go up, real estate underwriting so evaluations tends to be keyed to long-term rates so as those go up your cap rate expectations will go up as well and that’ll have a negative impact on prices. In the short run, there are kind of a couple potential negative impacts on credit risk. So, one just the debt service coverage ratio for floating rate borrowers and then for everybody the negative impact on valuations from higher cap rates. Interestingly though we recently put out a study where we took a look at the long-term impacts of higher inflation and higher interest rates. And perhaps not too surprisingly the longtime folks in the commercial real estate industry, commercial real estate does tend to have a positive correlation with inflation. So higher inflation leads to higher income higher rental income and in the long run that leads to higher valuations. So short term definitely, you know, a lot of risk but longer term for folks that can last the next couple of years and beyond, longer term those negative impacts will smooth out as a result of higher income.

 

Rob Newberry 7:47

Great okay.
Thomas Curley 7:49

And I know you mentioned a study Matt that y’all released and I know I try to do my best to keep up with all the blogs and data releases that Trepp has on a pretty consistent basis. Are there any, you know, reports or data releases recently that stuck out to you as far as certain verticals or sectors that performing better or worse in the commercial real estate area?

 

Matt Anderson 8:11

Um, yeah, excellent question. So, from a share you know performance numbers standpoint, sector wise of course lodging is still you know problematic from, you know, the covid impacts and there’s still some lasting impacts there. Although that’s been you know, tapering off, it’s not gone all the way. So, lodging took a big hit and it’s been coming back but still viewed as high risk. Retail has recovered a lot of ground, retail was also hit with higher delinquency and default rates, higher risk ratings for all the, you know, sort of usual reasons. At the other end of the spectrum, industrial was the darling of the pandemic and still is ah. Volume in the industrial space is probably two or three times what it was pre pandemic in terms of loan volume. It’s still, it’s sort of a not exactly a niche market but it’s a smaller segment dollar wise within the commercial real estate landscape just because, you know, tends to have lower per square foot valuations. So even a large warehouse you know isn’t necessarily going to be as expensive as a you know, mid-sized office building for example. But industrial was, you know, is still reaping the benefits and tailwinds from the pandemic. And then multifamily which, you know, there was a lot of handwringing about multifamily early on in the pandemic but really whatever forbearance that lenders had to extend for the first, you know, several months of the pandemic by the end of 2020 that was really tapering off and now there are only like a few loans here and there that I know of that that our clients have told us that still are getting still under some sort of forbearance. So multifamily is bounced back in a big way and of course rental increases are up strongly and in multifamily so the big question mark right now is the office sector. Office had, excuse me, office had done well through the pandemic partly as a result of long-term leases that are in place that even though office occupancy or physical occupancy had gone way down all the space was still, you know, leased out and the tenants were paying on those leases. But you know, occupancy still hasn’t bounced back in a huge way at least in the in most of the major urban locations. So, I’d say urban office is the big question mark right now. We’ve seen delinquency rates go up a little bit there, so it’s not for the bank loans that we survey the office delinquency rate is about 1.5%, that’s up from pre pandemic level of about 0.5%. So, it’s noticeably up from where it was, having said that you know in the in the great financial crisis those were you know much higher delinquency rates. Commercial real estate overall was at about a 10% peak delinquency or default rate. So, you know, office is nowhere near that at the moment but risk ratings are higher. Lenders, our bank clients in the major markets are keeping a close eye on their office loans. And then from a data point standpoint we did put together some data recently on the office market and we tallied an estimate of about 320 billion of office loans that are coming due in the next couple years. So, this in 2022 and 2023, that’s across the entire landscape. About half of that is bank lending and about half of that is non-bank lending, but still, that’s a big number. There’s currently, there’s plenty of liquidity and there has been plenty of liquidity to handle that but that’s a pretty big number at a time when everybody’s got lots more questions than answers about the future of office.

 

Rob Newberry 13:02

So, Matt would you see the potential for folks to try to change the business use of their space? So maybe moving it from office space to warehouse on the bottom floor to help with the vacancy rate.

 

Matt Anderson 13:22

Ah, yeah, that would that’s an excellent point. We have seen things like that happen in the past where if you go back to previous cycles like in the great financial crisis or even before that back to the early 90s you had cases where, you know, entire markets were really depressed and as a result, the building owners had to get creative and find different uses for those spaces. So, we have seen cases where, for example, office would be converted into residential of some sort or hotels for like multi-story office. You could do that sort of thing. So yeah, it would all depend on the location and physical parameters of the building itself. But I think you’re right, I think owners and lenders if they become owners of real estate, they’ll have to you know, get creative about some of those uses.

 

Thomas Curley 14:32

Shifting gears a bit. You know we’ve been walking through a little bit on the current landscape, but for some listeners I know some more practical tips and tricks when it comes to navigating these volatile times will be super helpful. So, Rob I wanted to start with you and see if maybe from your experience working with institutions if you’ve maybe seen a few common pitfalls amongst those that have you know a lot of CRE in their portfolio and what you would recommend staying clear of or preparing for in that circumstance.

 

Rob Newberry 15:02

Yeah. I think one of the things that people or financial institutions today have, I don’t want to say it’s a common pitfall but there’s a lot of liquidity in the bank market right now. So, they compete pretty heavily against each other for the few commercial real estate loans that are out there and so they might be underpricing the risk that they’re taking on. And so, if you have a commercial real estate I think it’s important to understand your pricing model and make sure that you are pricing in the risk that you’re taking and just not trying to fill your balance sheet full of loans because commercial real estate is the only one you can find out there. Does that make sense Thomas? So that’s one of the common pitfalls. The other one is just understanding, I think as Matt mentioned, there’s a lot of uncertainty in the market so making sure that you’re doing the appropriate stress testing at the transaction level when you’re underwriting the credit initially and then ongoing as we get some of these questions answered on, you know, how the market will perform. And some of these other things that there’s just a lot of unknowns on will people move back to office space, will they still work from home and we talked about do they change the main use of those spaces? So, there’s just a lot of unanswered questions yet that I think you have to be aware of in that you should be building stress test models around your commercial real estate portfolio to make sure that you’re not blindsided in two years if all of a sudden things start to go a little south on you.

 

Thomas Curley 16:39

And I know we’ve done a couple other presentations in the past too, I know another best practice that we’ve talked about, you know, is some of the specialization and getting more in the weeds and I think to the point that Matt was making earlier that I think there are certain sectors or segments that are a little bit more uncertain than others. Is that something that you would recommend for institutions to maybe focus on a certain area or smaller dollar amounts or something around something like that?

 

Rob Newberry 17:08

Yeah I would, you know, it’s like having a good stock portfolio Thomas. I think a good rule of thumb is to have some good diversification. Now there are some vectors that are performing or segments better than others, however, in the big scheme of things if you have a well-balanced portfolio, you’ll be better off. So, you don’t want to load up all on lodging obviously, but if you had a good mix of lodging and warehousing and industrial light manufacturing your overall portfolio will probably perform a little better than putting all your eggs in one basket. So once again, understanding that concentration risk is pretty important and if you have an opportunity to mitigate some of that concentration risk in the next few years as you’re kind of boarding new opportunities or things are refinancing take advantage of that to get a nice balanced CRE portfolio versus you know, sometimes just based on where the financial institution is you get some unintended concentrations and be aware of those as you’re booking your loans and moving forward for sure.

 

Matt Anderson 18:17

Yeah, and I’d add to that. Diversification is of some sort anyhow is definitely your friend because you never know, even the best performing sector right now could be next year’s you know worst performing sector. That happened. So, we’ve definitely seen it with some of our clients that went heavily into, you know, what seemed like really safe sectors and over the long term they really are only to be blindsided by some short-term hiccups in in particular markets or particular product types. So yeah, that can definitely happen. One comment I was going to make about potential pitfall for the kind of flip side of going for diversification, just be a bit careful about out of footprint lending. That tends to be something that the regulators tend to focus on quite a lot for good reason. If you’re lending outside of your geographic footprint, not that you can’t do it, but you just want to make sure that you’re dotting every I and crossing every t when you when you do that.

 

Rob Newberry 19:31

Yeah, and I could talk a minute about we call them participation loans in the community banking space and they probably have a little kind of a dirty word if I mentioned those back in 2009/10/11 because a lot of community financial institutions thought they bought a lot of their problems to mass point through probably trying to diversify but getting things outside their footprint. And there’s some simple common best practices on making sure you’re doing site reviews and doing the same due diligence you would a loan in your own territory. So, make sure you’re not treating it as an investment but actually as a loan and do the same due diligence. But there’s probably also a little extra making sure because it’s outside of your area, potentially outside of your area of expertise and lending in general but also out of your local market. So, you might not even know what’s going on in that geographic area so doing some site visits and doing your checking is critical if you do decide to do participation loans. And Matt I do see that as probably an opportunity because there’s a lot of liquidity and not a lot of loans in certain areas. And so one of the ways to solve that problem is to do participation loans and making sure you understand what you’re getting into will be a key for that.

 

Thomas Curley 20:51

On a slightly different note, but I know one best practice that we’ve talked about in the past is around just management reporting. Matt are there any specific types of dashboards or risk assessments that you would maybe recommend for an institution that has a focus on CRE to make sure they’re understanding their portfolio as well as I need to?

 

Matt Anderson 21:13

Yeah, I think getting a good hand, I mean a lot of it’s pretty straightforward conceptually but then in practice ends up being more challenging. So, believe it or not just being able to summarize your portfolio and have a handle on, you know, where your portfolio is both geographically and property type wise. Maybe by vintage things like that being able to produce metrics on your portfolio at those different levels is meaningful and useful for management and your board to keep an eye on. Anytime you talk to your regulator you want to be able to impress them that you really know what’s going on both in your portfolio and then in your markets. So, once you have a good handle on what’s going on in your portfolio, then being able to expand that and look to your markets and have an idea of how your portfolio and its performance fits within the broader market. I think those are those are all useful things. And we’re getting a lot of questions from folks these days that are essentially trying to do that, so measure just the content of the portfolio, the performance of the portfolio, and then the risks, the forward-looking risks in the portfolio. If you can do that at all those different levels, I think you’re in good shape. Having said that, a lot of the big challenge that we come across these days seems to be around information and information systems. So, lot of banks believe it or not still really don’t have information systems that are up to snuff. There’s a lot of data that’s still in hard copy files somewhere, paper files or if not a paper file then a Pdf file. And really, you need to get it out into an accessible electronic format where you can do something with it.

 

Rob Newberry 23:35

Yeah Thomas, and I would probably add to what Matt’s talking about, you know, unfortunately a lot of community financial institutions still probably have segments a little higher probably at the call code level versus broken down even into the simple commercial segment or vectors that you might want to look at. So, adding some simple things like NAIS code and property address really make a big difference when you’re trying to segment your portfolio not only just for informational purposes and dashboard, but also as you look for CECL and other opportunities.

 

Thomas Curley 24:13

Well one last topic I wanted to hit on because I know it’s always of interest to our listeners is a regulatory perspective. And so I know we’ve already spent some time discussing the markets and best practices, but for financial institutions with high CRE concentrations or a good chunk of their portfolio, you know, what is expected of them right now? Anything different from the usual, Matt?

 

Matt Anderson 24:35

Well really some of what we just alluded to a minute ago about, you know, having a good handle on your portfolio where it is and how it’s performing. That’s certainly part of that, you know, information push that you’re going to get or request you’ll get from your regulator. And then yes as far as stress testing goes, being able to do reasonably rigorous stress testing on your portfolio. That’s going to be a pretty key thing. If you can go down to the loan level and stress at that level then that’s great, otherwise, we’ve seen institutions that will aggregate like loans together and then you know handle their stress testing at that level. That works too. So, you could bundle your you know Houston industrial properties together and take a look at how they’re performing or your, you know, Miami multifamily properties and look at things that way. That works but definitely if you can run your portfolio through the scenarios that the regulators provide for the large banks that tends to be a not exactly a requirement but it’s a bit of an expectation at the regulator level for when they go and do an exam for banks with concentrations.

 

Thomas Curley 26:14

Makes sense. One other topic I know we discussed a little bit before our call today around regulatory expectations, Matt I think you’re the one that brought it up but just saying you were hearing more about climate or environmental risk from the regulatory perspective. You think that ties in a little bit to our CRE conversation today?

 

Matt Anderson 26:32

Yeah, absolutely. So, we’ve started to hear from some of our bank clients that the regulators are asking them pointed questions along the lines of stress testing now instead of just outright expected loss figures under different scenarios. They’re asking more open-ended questions about environmental or climate risk and so they’re asking the banks basically to come back to them and take their portfolio and, you know, define to the regulator where the environmental risks or climate risks in their portfolio are. And then step two of course will be, okay so you know what are you doing to mitigate those risks? It’s good and bad that the regulators are asking at this point pretty open-ended questions. So, the good part of that is that if you can define or craft your own response as long as you’re basically you know covering the content of the question, which is just to say something about your environmental exposure or your exposure to climate risk, then it’s really up to you to figure that out and report it back to the regulator. The downside of that is, of course, then you have to figure it out. But folks out there have started to, you know, make an effort at doing that sort of thing and I’ve seen some creative responses already to, you know, trying to assess the risk in the first place and then say something about what it what it looks like going forward. Just one thing to add on the stress testing front, so there is a sort of intersection between climate risk and stress testing. Some of our clients have been asking for climate risk scenarios for doing the stress testing. So, the idea being, okay there’s a, you know, climate impact of x or y for these different markets, then how does that translate into stress testing type impacts. And so that’s something that we’ve also been exploring recently with some of our clients.

 

Rob Newberry 29:11

Yeah Thomas, and I would add that I love the concept that Matt just talked about on the on the back end on the portfolio. But I also love pulling it forward into the initial risk assessment when you’re underwriting the deal upfront, so understanding upfront how you would classify the environmental risk is one of the major items underlying the total risk along with cash flow, LTV value, and you know understanding that environmental risk will be key I think as we continue to go in the future on commercial real estate and some of the issues we might have with climate issues.

 

Thomas Curley 29:48

Yep, good points and all things to keep an eye out for. Looking at time here I wanted to go ahead and start wrapping up our conversation. Matt I’ll start with you and then Rob feel free to jump in but if our listeners take anything away from our conversation today, maybe, what would be your one or two items you want to leave them with?

 

Matt Anderson 30:11

Yeah, I suppose just reflecting on the last few minutes of what we’ve talked about, you know, we are really at an interesting point or problematic point for the markets overall. So, conditions are really good at the moment or have been good. Loan performance overall is quite good, but I am concerned about the impact of higher interest rates, higher inflation, to really how we’ll you know deal with that will be, that’ll help define the markets over the next, you know, twelve to twenty-four months and even beyond. At the same time, you know, that does kind of plug into our discussion around information systems, dashboards, and stress testing so to the extent that you can model those higher interest rates and the impacts they’re going to have, that’s an important feature of what I think real estate lenders out there right now should be doing on their portfolio. And I liked Rob’s point about making new loans, any new loans that you’re making you want to factor in higher interest rates for sure as a feature of the future landscape and make sure that they can handle those higher rates moving forward.

 

Rob Newberry 31:40

Yeah Thomas, the only thing I was going to add to that was don’t be afraid to do commercial loans right now, commercial real estate loans. So even though there’s uncertainty, here’s still opportunity. You probably make more net interest margin spread on a CRE loan than you would on an investment right now. So don’t be afraid to do it just because there’s uncertainty in the market.

 

Thomas Curley 32:00

For those that are new listeners or maybe haven’t subscribed yet, you can find this podcast in future episodes on abrigo.com or you can find it on your favorite podcast app or platform, just search Ahead of the Curve: A Banker’s Podcast or simply search Abrigo. It’s a little bit shorter. Thanks so much for listening and we’ll be back again with you soon with our next episode and I just want to thank both Matt and Rob so much for their time and insights today. We sure do appreciate it.

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Thomas Curley 0:00

This is Ahead of the Curve: A Banker’s Podcast

 

~music interlude~

 

Thomas Curley 0:11

Welcome to this episode of Ahead of the Curve: A Banker’s Podcast. I’m your host Thomas Curley and I am here with Zach Englert today, who is a consultant with the Abrigo Advisory Services team. He helps provide institutions with real time solutions in the form of credit risk management strategies and regulatory compliance. He is a common speaker on webinars here at Abrigo and with other associations, as well as conferences, covering current events and the impact on financial institutions portfolios. And recently he has been laser focused on stress testing which is why I’m so excited to have him on today. So welcome to the podcast Zach happy to have you on.

 

Zach Englert 0:54

Thanks Thomas, super excited to be here.

 

Thomas Curley 0:57

Awesome! Well, I’m excited and so let’s go ahead and just jump in here. You know financial institutions, banks and credit unions are facing a lot of uncertainty right now and I’m sure we’ll get into some of those specifics there, but just with the overall economic environment currently. I know that you have some thoughts specifically on how stress testing can be a huge help but I thought a good thing to start off with might be really defining stress testing and maybe diving into what is required as far as regulatory perspective and then maybe what are some more prudent things institutions should be doing on the flip side.

 

Zach Englert 1:36

Yeah, thanks Thomas. A few different things to think about when we’re talking about stress testing. The first being is what type of stress testing are we going to be doing because we throw out the word stress testing fairly often. And depending on where you are at a financial institution, depending on what stage of an economic cycle you may be in, it may have different meanings. The idea of stress testing is essentially taking your current economic situation in your current business model and saying what happens if we change some of the variables that you’re facing. Whether to the upside or the downside.

So, some of the types of stress testing we may be looking at would be credit stress testing, where we’re stressing individual loan level cash flows and collateral values to see what happens to that individual credit if we are changing those specific variables. So essentially will the borrower be able to make payments or will the class or be able to cover any remaining debt should something go wrong? We also deal with a lot of capital stress testing, which is essentially is the financial institution still well capitalized in a stress scenario? So, in that scenario we’re going to be stressing the financial statements, we’re going to be stressing the loan level losses, and essentially say if this institution begins to have losses, do they have enough money? Do they have enough capital in that rainy day fund to be able to cover that? And last but not least we also have liquidity stress testing, which is essentially saying, can a financial institution meet its obligations during a stressed environment? Banks and credit unions, they have bills to pay. They have deposits that they need to be able to make sure that they’re able to cover in the event that there is a run on that cash basis. As well as they may also have the capability where loans are currently having a lower and lower yield and they’re not able to adequately make enough money to stay in existence. So, there’s all these different types of stress testing and really what we’re looking for from the advisory side or from the supervisory existence and guidance is we’re saying, can you make payments in these stress scenarios? Can your institution still have enough capital to be able to cover that information or to cover those obligations?

So, there’s a lot of different ways that you can approach it and auditors, regulators, what they’re really looking for is, “are the scenarios actually providing a reasonable expectation of potential losses or are you just making up some numbers?” Some of the things that they should be looking for are, are the stress scenarios going to be identifying key financial institution vulnerabilities? Is it going to have a reasonable impact on the stressed events as well as is this going to have a adverse impact on earnings, loan loss reserves, or different areas of capital. And those stress tests should be evaluated pretty consistently so that an institution can maintain appropriate capital that is in line with its overall risk profile. So covered quite a bit there, but that’s kind of a high-level overview of what is stress testing and why are we supposed to be doing it.

 

Thomas Curley 4:40

Great, that makes sense and I know there’s, you know, a fair amount of OCC bulletins and FED statements and I also saw some hypothetical scenarios from the FED, OCC, and FDIC recently. How should institutions take some of those recent statements and incorporate that into their thinking of stress testing?

 

Zach Englert 5:02

So, one of the things that I would highlight is in 2012 there was a plethora of community bank stress testing guidance. A lot of that information came in line with DFAST, which is no longer applicable to institutions under 250 billion in total assets. But the main components of that are still appropriate for institutions who have strong risk management capabilities as well as are participating in a capital planning process. So, what I would highlight is from the 2012 supervisory insights for stress testing at community banks, they highlight that the strategic value of stress testing may be greatest during the expansionary phase of business cycles. During times when losses are minimal and property values are rising, stress testing assessments of riskier assets in concentrated positions can help management anticipate potential risk. Well, I’ll pause there and highlight Thomas that luckily, we’re not seeing anything remotely like that right now. Definitely not seeing an expansionary phase of the business cycle, definitely not seeing rising asset prices, and definitely not seeing concentrated areas where there may be additional risk. So, one of the things that we’re encouraged to do is make sure that we identify that risk and essentially identify, can we cover in the event that we may have some issues there?

 

Thomas Curley 6:21

Yeah well, you’ve alluded to some of the, kind of, economic turmoil that we’ve got going on right now. Let’s maybe talk about a couple of those things and maybe why stress testing specifically is something that institutions could turn to as an opportunity to help their institution out.

 

Zach Englert 6:40

So, in 2019 we started taking a focus on stress testing because a lot of the institutions we work with are in a allowance-related capacity, we are heavily involved in building the CECL models. And during that time period again, in an expansionary phase, we were saying what could go wrong in the future? And we had incredibly low unemployment and there was a lot of liquidity in the markets. We saw a lot of cash free flowing to different areas, whether that was real estate investments, commercial real estate, or equities such as stocks. Then 2020 happened and no one saw a black swan-esque event like the pandemic. And there was a lot of fear in a lot of institutions saying what is going to happen going forward?

Now ultimately, we saw a significant amount of fiscal support come in from the federal government that staved off or a lot of institutions believe, delayed the charge off activity that they would have expected in an event like that. So, we had some institutions say, hey how can we begin stress testing to make sure that we can keep a finger on the pulse on what that may look like? And as the pandemic slowly continued to develop, as people got a better understanding of what was going to happen from an economic situation, I feel like stress testing started to get pushed to the wayside because we saw a reopening, we saw that cash flow startup again, and we saw a lot of borrowers begin to continue to spend to continue to invest. And then we saw a war break out in Eastern Europe and so we have some of these events that were continuing to compound on these unexpected scenarios at a macroeconomic world level that’s having material impacts here in the United States. We’ve seen significant increases in food prices. We’ve seen significant increases in oil prices and that’s going to push discretionary income for a lot of borrowers lower. We’re also seeing some macroeconomic changes in terms of the work situation; we’re seeing huge increases in work from home. That’s going to change how commercial real estate is valued especially as 2023 is going to see the largest rollover rate for renewals of commercial real estate in United States history. So, there’s a lot of these macroeconomic happenings that are fundamentally changing how we manage risk, how we do business, and to have the capability to be able to evaluate that and see what that impact could be I think is going to be super important for these institutions.

 

Thomas Curley 9:09

Gotcha, that makes sense. And you’ve kind of in some of the other answers already alluded to some of the questions that institutions can solve using stress testing. But I guess probably the bigger question is, you know, what is holding institutions back from stress testing? So, you mentioned in 2019 it started to pop up a little bit more and then we kind of put it on the wayside again. Like what are some of those difficulties that folks are running into?

 

Zach Englert 9:35

Some of that is going to be data management in terms of do we have the data to accurately provide stress tests. So, a lot of institutions like to run commercial real estate stress tests leveraging net operating income, leveraging debt-to-service coverage ratios, loan to value ratios and they may not be pulling that information into a single aggregate place. So, if an institution has debt-to-service coverage information, but it’s on their lending platform and they do all of their loan analytics on their loan analytics platform, they’re going to see disjointed data coming from that effort. And it can be very time consuming to pull all of that out into various excel templates or other software and try and build those reports. In alignment with that we also have the supervisory guidance saying you need to be doing stress testing. You need to be stress testing these individual items, but they don’t really offer a lot more depth associated with that. So essentially an institution can run a stress test, they can get results but they don’t really know are those results good? Are those results bad? If you are very well capitalized today at a let’s say a 15% tier 1 capital leverage ratio, which for those of you who are listening and may be unfamiliar kind of with some of those standards or benchmarks or what we may be looking at there; a slap on the risk level I would say is 8%. So, institutions are very well capitalized right now and a lot of those institutions are then stressing and getting 10%, 12% as their severely adverse scenario and, it’s kind of looking, it’s like well we stress tested but we’re still incredibly comfortable. Are we okay? And we haven’t seen regulators come out and give everyone a firm thumbs up on what that may look like. So, we’ve got this idea of, hey we may have mixed data on one side, we may have mixed results on the other side. So how can we get a firm understanding of what is good and what is bad?

And for the data side I think you’re going to have the instance of garbage in garbage out. So, if you can focus on what that process is going to look like and how to get to that good end goal, just make that process repeatable. I would say the same thing on the actual results where you say is this good, is this bad? The first thing is, it repeatable? If it’s repeatable and you can consistently get to really good results, I would say that you’re in a really good spot and that’s highly defendable compared to what you may see previously where, hey one stress tests were really good, one stress test were really bad. But if it’s consistent then you’re going to develop a process that’s going to be very comfortable for your institution to be able to defend. The other thing is if you’re getting really really good results, what we like to do with our clients is build out a break the bank scenario or break the credit union scenario where we’re saying what needs to happen for us to no longer be able to meet capital level requirements. And if you document that out and you showcase, hey we have to drop capital levels by 7 or 8%, then in most cases that’s relatively unrealistic scenario, but from the past three years I hesitate to say unrealistic scenario due to the fact we’ve had a number of those actually occur. But when you’re looking at that information it’s super important to be able to look at that and say what would need to happen and if your scenario happening is we need to see a 50% reduction in commercial real estate values or we need to see a 30% reduction in business cash flows, then you can pretty reasonably say to your regulators that we’re in a very comfortable position from a capital perspective. And to be able to have that document to prove that outputs them in an excellent place because a lot of institutions don’t have that recurring process in place today.

 

Thomas Curley 13:22

Gotcha that’s cool. You wonder how many folks, if they had that in place pre-2019, if they had any of the scenarios hit by chance.

 

Zach Englert 13:31

That’s one of those things that it’s better to have it and not need it than needed and not have it. Like an insurance policy, like contingency planning I’d prefer to know what’s going to happen in the disaster versus have to figure it out as we go along.

 

Thomas Curley 13:46

For sure and before we kind of move on to some other questions we’ve got, you know, does this change a lot by asset size in your experience as far as some of the challenges kind of across the board.

 

Zach Englert 14:00

Very much so. And some of that is going to be data related, some of it is going to be supervisory guidance related. Prior to 2018 institutions over 10 billion in current assets had to comply with DFAST and those were relatively strict reporting requirements associated with stress testing capabilities. So, institutions that were approaching 10 billion or over 10 billion in 2018 are fairly familiar with how to develop a really strong stress test. Whereas the majority of institutions in the United States at the credit union and bank level are sub 10 billion in total assets and they’re being told you need to stress test. But again, back to my earlier statement, they’re not necessarily being told what are good results, what are bad results especially if you’re not even close to the regulatory minimums. So, in those scenarios what I would highlight is you’re generally seeing below about 500 million in total assets, a simple stress loss rate scenario is more than sufficient to meet regulatory expectations. Once you start approaching about a billion in total assets 1 to 2 billion, you’re going to see something where you may want to see multiple scenarios in place and if you have a CRE, land, or construction concentration. The expectation is most likely going to be that they would expect to see some form of loan level stress test as well as that top down or loss rate stress test and over 2 billion in total assets in alignment with a lot of other type of banking activities. Generally, at that asset size you’re going to start seeing those expectations change and get a little bit more stringent. Now I would highlight that that expectation is totally dependent on your regulator, whether that’s a state regulator, whether that’s OCC or FDIC. So, there’s a lot of variables, whether that’s geographic or otherwise but from a general guidance perspective I would say those breakouts that I just highlighted would be a good starting place if you’re looking how can I get started in stress testing today.

 

Thomas Curley 15:58

Gotcha. Yeah, that’s helpful for even me visually to kind of break out kind of the different areas and like you say they’re good starting points. And I think that’s a nice lead into kind of our next set of questions where, you know, we’ve talked a fair amount about the why and why it’s so important and why it can be helpful to conduct stress testing on a more consistent basis. But we’ve probably got folks listening that this is, you know, they don’t do it very often or they’re trying to get in more of a routine or repetition kind of what you were saying as far as making it a very repeatable process. How can an institution really get started? Where are some of the areas where that can be helpful for them?

 

Zach Englert 16:36

For an institution that has a CRE concentration or very material portfolio, they have a material construction or farmland portfolio as well, I think that the easiest place to get started is with that loan level or bottom-up stress test. And that’s something that depending on how they build it they should be able to run on a quarterly basis. And the idea there is, do you need to stress every single commercial real estate loan? Probably not, but just being able to identify your top 10 largest or your top 10 borrower relationships is something that you should be able to stress on a recurring basis. And if you are applying the same methodology and the same input on a quarterly basis, building that out should not be difficult to update because you’re just going to be rolling forward the inputs into the model. You’re going to be rolling for the balances if you’ve got updated financial statements, you’ll be uploading that info. If you want to apply a simplifying assumption such as property values going up or down by 5% from where they were last quarter, 5% over a quarter is probably a little aggressive, but we’ll say maybe 1% quarter over a quarter. But to be able to develop that out, then I think that you’re going to see a really strong risk management culture be built up simply because you’re performing that on a quarterly basis and it’s a starting point. And as your institution grows, as your lending limits change over time it’s very easy to step that up from the top 10 largest relationships to the top 20. Or to take that process and automate it utilizing software and do all of your CRE loans. There’s a lot of different ways that you can build that out.

From a capital perspective if you’re not doing so today simply starting with a stress loss rate scenario, applying it to the whole institution even if you’re looking at it from a regulatory check the box exercise is a huge step forward from doing nothing. And a lot of institutions are saying hey, because we haven’t started, because we haven’t been told to do anything, we can comfortably continue to not do anything. I think just starting puts you in a really strong spot to edit because the really difficult part is having to create the stress test. But there’s enough material out there to be able to build one and then edit and once you start doing it on a recurring basis it’s a lot easier to make adjustments to be able to say hey instead of doing it once a year, I’m gonna do this twice a year, semiannually, as opposed to just annually. Or if I want to do it more often I can change my stressors to where my severely adverse, which may not have been that bad, I can crank those numbers up and you can really see that impact in a real time scenario as opposed to me asking the question hey Thomas what happens to the hotel on the corner if their vacancy rates drop by 10%? You’re going to look at me, I’m going to look at you and we’re both going to say I don’t know. Well already just saying that out loud, you can see how valuable that information may be if you can go and immediately plug that into the model and see the impact on not only that individual loan, but if that’s a material relationship what’s the impact to your financial institution. And that’s a lot of information that may be not beneficial if it takes you 7 hours to do it. But if it can take you 3 minutes to find out that answer then that’s a lot of powerful information to have at your fingertips.

 

Thomas Curley 19:53

For sure, like you said it’s always good to have the information, be able to pull it if you need it as opposed to having to spend all the time or not even know how to go about it. So that’s a great, that’s a great point. Are there some common mistakes or say lessons learned in your experience you’ve seen where folks start to, kind of, build this out and maybe there’s a chance for us to give them a heads up before they start diving in there?

 

Zach Englert 20:16

Yeah, so a lot of institutions they may have their allowance modeling being done by their accounting or finance team and their stress testing is done by their credit team or vice versa. And then somewhere else in the institution you may have someone performing the strategic planning exercise with their asset liability management model. Well, all three of these models are forward looking. The ALM model is going to be used for budgeting purposes, for capital planning purposes. Generally speaking, in capital planning you’re also going to have stress testing. So, institutions normally are doing all three of these exercises in some capacity even if it’s a simple spreadsheet model for one of them or if it’s a robust third -party software model that they’ve built and worked with the team to be able to utilize. If those 3 models are telling very different stories, then when you’re presenting that information whether to auditors or regulators, you’re going to have some probably nitpicky responses where hey why aren’t these things talking to one another or why are these not in alignment with one another. Your baseline stress test in theory should be what you expect to happen with probably a little bit more stress loss rates. Your allowance model should say this is what we expect to happen and your asset liability management model should be what you expect to happen if you have three different forecasts with three different expectations of what you’re gonna, you expect to happen. Generally speaking, it points to a lot of errors in all three models.

So, the idea there is because we have these forward-looking scenarios, let’s make sure that they line up with one another and again, it’s a lot easier to edit than it is to create. You can pull over some of that allowance modeling and stress testing. You can pull over some of your stress loss rates into your asset liability management modeling when you’re saying what do we expect to happen in the event that interest rates rise. Right now, we’re expecting as much as another two-hundred basis points of interest rate rises this calendar year. And if that were to occur you’d want to know what’s the impact of that on my portfolio and if we coincide that with a stressed loss rate environment, again just more powerful information and a lot of institutions aren’t taking advantage of today because they’re having three separate teams or three separate individuals running their models their own way instead of having those talk to one another and all.

 

Thomas Curley 22:47

Gotcha. Sounds like a classic example of work smarter, not harder if you can get all three of those complicated exercises to use some of the same inputs then you should be in good shape.

 

Zach Englert 22:57

Very much. So.

 

Thomas Curley 22:59

Well, you’ve alluded to and you were just talking a little about asset liability and CECL and we even talked about way back, you know, credit on the credit side. What are some of the use cases for the results? So, let’s say we get everything aligned and they’re kind of telling the same story, you know, what are some of the results that they institutions can look forward to having and kind of helping grow and manage the institution moving forward?

 

Zach Englert 23:25

So, one of the things that came out in 2018 and has been pushed back just a little bit is an article discussing, essentially, what are you supposed to be doing for CECL and stress testing in the future? And the Federal Reserve came out and they said that you should be leveraging your CECL model results or a forward-looking life of loan model for stress testing after you adopt CECL. So instead of saying hey we’re going to have a completely separate model, let’s just use our CECL model and then we’ll ramp up those variable factors. So, if you’re leveraging a probability of default model and you have your probability of default tied out to an economic indicator, let’s use unemployment for an example because a lot of our institutions are leveraging unemployment. And we see unemployment start to hit a worst case scenario such as the severely adverse scenario provided by the Federal Reserve and we say that we think that the next four quarters is going to be 7.1%, 9.0%, 9.4%, and 10% unemployment rate you would expect that to have a higher loss rate in a stress scenario than what you’re experiencing today. We also probably are going to see prepayments slow during that point in time because again, we’re having higher interest rates in the future. So, if we have higher interest rates that means people aren’t going to be refinancing as actively, so we’re going to slow that refi activity, slowing prepayments so loans are on our books longer. We also have a higher probability of default due to the higher unemployment rate, so there’s two different factors there that are increased risk and because of that we would expect to see higher levels of charge off. All I did for that scenario is I took a CECL model which we’ve documented pretty aggressively and then we’ve applied that same logic into our stress testing scenario. And to back that up again I used information that was readily available from the Federal Reserve for my severe adverse scenario and from historical expectations associated with prepayment activity.

So instead of having to create something brand new for stress testing, copy paste edit, just like when you were in college, right? So sorry anyone out there, that’s not true. Sorry prior college professors. But that’s just an example that you can leverage, something that you’ve done really well and be able to leverage that going forward for other processes. You don’t have to recreate the wheel. You can just edit something and there’s enough information out there where you can get a lot of those forecasts and scenarios for free too.

 

Thomas Curley 26:04

As far as, so I think you just walked through a cool example of using up information from a bunch of different systems and places but it’s not that difficult once you can get the data in the same place. As far as some of those reports, you know, giving and showing the information and the results of those you know what departments or roles do you think would benefit greatly from maybe seeing more of this information on a you know quarterly or yearly basis?

 

Zach Englert 26:34

I am a big proponent of dashboard level reporting. So, if you are a credit manager whether that’s in the Chief Credit Officer role, Chief Risk Management role, or even the CEO who’s looking at a touch base, what is our exposure. Then having an updated capital ratio scenario and various stress scenarios is something that is super beneficial. Super easy, especially when you align that over the next nine quarters. So, you can take your ALM forecast and directly underneath that where it has those financials you can say this is our baseline adverse and severely adverse capital expectations should the same type of thing happen going forward. That’s something that all of those individuals can immediately look at and say hey this story checks out, we’re okay with this or hey maybe these numbers don’t look appropriate. What do we need to change to prevent this from occurring? Again, if we may have a insufficient capital or something along those lines.

The second component would be a very similar report but the top 10 relationships by borrower or balance size, in which case you’re looking and saying if something were to go wrong, and again you’d have those expectations such as a decline in collateral value or plausible decreases in cash flows. If that were to happen, what would we expect to see against those top 10 relationships? So, if our top hospitality client, maybe they have 1 to 5 different hotels, if we were to see vacancy rates increase substantially, again plausible decrease in cash flows. If we were to also see an interest rate increase 200 basis points and we were to see a decline in collateral value 30% reduction due to the reduced cash flows. If all of that were to happen, is that relationship still comfortable? Because most institutions, they have a lot of loans but they are going to have a smaller percentage of those loans for their material amount of holdings and if one- or two-multimillion-dollar seven figure loans go bad, I want to know about it. And the people who are actively pursuing strong risk management want to know those what if scenarios. As we’ve seen over the past three years, what if scenarios are starting to look a lot and lot more likely than they may have been in 2018/2019. So having a high-level capital overview and a high-level credit risk or loan level overview is something that is incredibly powerful for Chief Risk Officers, Chief Credit Officers, as well as anyone on the finance team as well.

 

Thomas Curley 29:14

And, you know, once we get, once institutions get those reports dashboards set up, in your experience working with clients over the last you know year or two, what are some of the actions that you’ve seen folks take to related to capital and strategic planning more often? Are there kind of some trends that you’ve seen there?

 

Zach Englert 29:38

Yes. The first thing I would highlight is the kind of end all be all statement of better credit risk management practices. And that’s something where you’re painting with a very broad brush to be able to say that you participate in strong credit risk management and a lot of institutions are super excited that they have strong credit risk management because they don’t have any losses. However, if no one has any losses does that mean that your institution has strong credit risk management culture or are we a part of a twelve yearlong economic expansionary environment and I’m inclined to believe that it’s the latter.

For institutions that have strong credit risk management culture, they’re able to proactively identify loans at risk and be able to observe them separately. Stress testing put you in a position to be able to actively look at those credits and see are they still comfortable in these stress scenarios, if not, what can we do today to prevent that having a material impact on capital or earnings? And being able to proactively identify when something’s going to affect your earnings is a really strong position to be in when you’re talking to board members or in the event, you’re a public entity talking to shareholders or stockholders because you’re able to say we saw this coming we prevented that. You can see when we’re looking at institutions in 2009 to 2012 that there was a significant difference in the institutions that had strong credit risk management. We had 140 institutions fail in 2009 and 157 in 2010. In 2021 and so far in 2022 there have been 0 institutions that have failed. So as such do we think that this is an event of strong credit risk management today or economic cycle? If we assume that it’s the economic cycle and I think, should we go through another recessionary environment the banks who are not only going to not fail but actually perform incredibly well are the ones who actually exemplified strong credit risk management. And they were able to proactively identify contingency planning as well as loans that need to be downgraded probably before we start seeing those signs of distress. Just to name a short summary of how institutions are using that.

 

Thomas Curley 31:56

No but I think that makes sense. I like putting it in a more historical perspective too and kind of looking at it that way. I think it’s to your point stronger credit risk management can mean a lot of different things to different people. All right let’s put you on the hot seat. If somebody jumped on here and maybe skipped to the very end because they just wanted to hear the summary, what would be the 3 big takeaways you have folks take away from our conversation today.

 

Zach Englert 32:24

The very first thing that I would highlight is if you are not stress testing today, and when I say not stress testing, I mean that you do not have a process in place that you are repeating on at a minimum an annual basis, that’s something that you should start. There is a lot of really great resources. The bare minimum I would do would be to go to the OCC.gov website, type in supervisory stress testing, and they have an example that you can copy paste and apply to your institution I think that that is incredibly simplistic, but at least it’ll give you the capability to say that you’re doing some form of stress testing. After you get through step one, so if you are already stress testing today, great, you’ve already checked the box. Way to go. But if you are not doing that, that would be step one.

The second step of that would be if you have multiple forward-looking models, if you are parallel testing for CECL, if you are live on CECL today, make sure that that model is speaking to your stress testing model. If you are budgeting financial statements on the asset liability management side, if you’re leveraging that data for capital planning, make sure that your stress testing model is speaking to that as well. So, we have all of these disjointed forward-looking models, make sure that they’re no longer disjointed. Make sure they’re all speaking to one another and you can carry that forward.

And last but not least make sure that you have an effective contingency plan. A contingency plan is not “that will never happen to me.” A lot of institutions approach any form of stress testing with that’s not reasonable, that’ll never happen. And in the same way that people say, “hey I’m never going to lose my job,” “I’m never going to default on a mortgage,” “never going to have x amount of credit card debt,” there’s a lot of coulda shoulda woulda. If you have a contingency plan in place, it’s just like an insurance policy that’s capable of being there even if you don’t need it. And is that going to take time? Is that going to take effort to build out? Yes, but in the event that it is needed it is going to pay off tenfold. So, let’s go ahead and make sure that we build out that contingency planning, should you have loans go bad, should you not hit earnings in the same way that you would expect. Again, just start building out strong credit risk management procedures and let’s make sure that we take it a step ahead of being able to say that and actually being able to show the efforts and results of what you’ve built previously. So those are my three things to take away if you just joined or if you made it all the way through.

 

Thomas Curley 34:54

And that folks is the truth about stress testing so no need to be stressed out at all when we’ve got Zach on the line with us. For those that are new listeners or haven’t subscribed yet, you can find this podcast and future episodes on https://www.abrigo.com/. You can also find it on your favorite podcast app or platform just search Ahead of the Curve: A Banker’s Podcast or simply Abrigo because it’s shorter. Thanks so much for listening and we hope to be back again with you soon and we just want to say a special thank you to Zach for joining us afternoon to get excited about stress testing.

 

Zach Englert 35:30

Thanks Thomas and thanks everyone who joined. Talk to you later.

 

~music interlude~