Executive Summary: Credit quality is beginning to emerge as a more significant issue at many lenders to the small business and lower middle market segments in the United States. While we expect most business banking portfolios to perform well during a downturn, some lenders are already suffering from a willingness to “stretch” in order to continue to build volume.
The quote that accompanies this newsletter underscores what can happen when bankers become too reliant upon quantitative models. Fortunately, most small business groups operate with a “nose-to-the-ground” approach to their businesses, increasingly leveraging technology while working to maintain knowledge of any shifts in their clients’ needs and/or performance. Nonetheless, questions are emerging about small business credit quality, and the best players are putting a bright spotlight on this area. At present, small business loan volume continues to grow while the first signs of portfolio problems are surfacing.
Fast Small Business Loan Growth Continues
Let’s look at some facts about loan growth in U.S. small business market:
• Total small business loans grew by 7.8 percent from June of 06 to June of 07, up from 5.6 percent the year before
• As of June 30, the top ten small business lenders (including cards) had increased their small business outstandings by 27 percent over the previous year. Some of that growth rate resulted from acquisitions
• Loans have increased in maturity over the past two years. Loans between $100,000 and $1 million remain outstanding for an average of 215 days, 87 days (67 percent) higher than two years ago. Smaller loans have also increased their maturity to 179 days from 142
• Just over 50 percent of small business loans involve commercial real estate
These numbers tell us that banks are continuing to focus on lending to small businesses. At the same time, the long-expected consolidation of small business into the hands of larger players is occurring. Banks appear to be becoming more aggressive with the loans they make, continuing to rely on commercial real estate and, at least until recently, lengthening credit exposures in what we view as a volatile market.
One example: business loans based upon home equity. Ten years ago, I had a conversation with the head of small business credit at a top-tier New York bank. While discussing “new” credit products, he rejected the concept of providing small business loans based upon an owner’s home equity. Why? First, if the owner could not repay the business loan, the bank would have to act on the collateral and enter into expensive and time-consuming court proceedings to gain control of the asset. Second, the loan’s secondary position increased its risk. Third, if the equity in the home were to decline, the loan would become at least partially unsecured.
Ten years later, this credit expert’s employer features home equity-based loans for small businesses and touts the opportunity it affords business owners to liquefy their equity.
Lending standards have changed and so have the risks.
Is Quality Deteriorating?
Based upon recent portfolio analyses, credit quality appears to have begun to deteriorate, albeit to a limited extent so far. PayNet, an information services company that provides lenders with predictive credit and risk management tools, has analyzed the industry’s performance based upon its internal database of small business loan transactions. Their assessment quantifies on an industry-wide basis what we are seeing at some individual lenders: delinquencies are up, with third quarter trends suggesting that bad credits will continue to increase for the foreseeable future.
PayNet’s analysis for the U.S. market includes:
• Average delinquencies for the third quarter 2007 are expected to reach 2.57 percent, the highest percentage since 2004
• Delinquencies past 90 days are up, at 58 basis points. A year ago, delinquencies were at 44 bps
• An analysis of loans by vintage after seven quarters on the books suggests that loans made in 2006 are performing less well than those made from 2003-2005
None of these numbers suggest that small business portfolios are falling off a cliff. Problem levels are low and, at most banks, will remain so. In fact, one of the most disturbing statistics we have seen recently shows that small business lending as percent of total C&I lending has actually declined over the last two years. Rather than focusing on building the small business franchise, the banking industry as a whole has pushed on in areas now being featured on the front page of the Wall Street Journal.
What Should Lenders Do Now?
Whatever problems that will emerge probably already exist with the portfolio. As in previous downturns, the losers will be those that allowed too many credit exceptions, that relied on collateral whose value has dissipated, or who failed to structure transactions with rigor. All basic actions that good lenders demand. Another fundamental factor was highlighted in Monday’s New York Times article on Goldman Sachs. It discussed how Goldman managed to miss the bullet that so many other investment bankers took in the heart. One analyst emphasized the quality of their credit culture: “The risk controllers are taken very seriously…They have a level of authority and power that is, on balance, equivalent to the people running the cash registers. It’s not as clear that that happens everywhere.”
The best lenders are aggressively reviewing their portfolios and limiting and laying off risk with which they are not comfortable for whatever reason; they are tightening up and rethinking collection policies; and, they are reevaluating credit criteria and acceptable collateral.
Concluding Comment
The numbers we see from PayNet, other industry sources, and our own client experience show that, as buttoned down as most small business lenders have been, the industry may be in for a bumpy ride. Yesterday was the time to begin to address risk issues; fortunately, however, for most lenders, acting today or tomorrow will probably be sufficient to avoid major write-offs.