The Monsters Under the Bed

I have found that the best way for me to gauge loan demand is to check in with friends that sell bonds to banks. Judging by the string of curses and insults flying my way, I take it that loan demand has been solid, and that pipelines are returning to what most banks consider “healthy” levels. However, with a pick-up in volume there is also an inevitable increase in the “you should see what the guy down the street is booking” statements. As a banker, whenever I heard lenders say this, I had an immediate question, “What about the monsters that are hiding under my bed?”

Even though we all inherently believe that we are booking solid credits (after all, we don’t approve deals that we expect to go bad), the reality is that there are always risks creeping into the portfolio. This in itself is not disastrous; banking is at its very core a business of taking and managing risk. The danger, instead, comes when we take risks of which we are blissfully unaware. Take, for instance, the Office of the Comptroller of the Currency’s (OCC) Annual Survey of Credit Underwriting, which was released this month. I’ll let the OCC sum it up:

This year’s survey showed a continued easing in underwriting standards, with trends very similar to those seen from 2004 through 2006,” said Jennifer Kelly, Senior Deputy Comptroller for Bank Supervision Policy and Chief National Bank Examiner. “As banks continue to reach for volume and yield to improve margins and compete for limited loan demand, supervisors will focus on banks’ efforts to maintain prudent underwriting standards, monitor portfolio credit risk, and reduce exceptions to policy.

Experience tells us that an industry-wide easing of standards will lead to losses. Take a look at the graph that covers the last credit cycle:

credit underwriting trends 2014

Much of the cyclic nature is a necessity in an asset based business like banking. There were a whole lot of banks that had to pull back on lending to be able to lick wounds and properly heal. Nonetheless, it seems that after every bust, our collective memories seem to somehow get a little shorter. Obviously the similarity to 2006 does not mean that we are headed towards a repeat of the 2008 crisis, but I think we all know that there is some amount of pain baked into that kind of shift in sentiment.

So, where will that pain land? Good question. However, I think the news of the last few days offers some possibilities worth thinking about.


In case you’ve been hiding under a rock, oil has gotten cheaper. A LOT cheaper (via the St. Louis Fed):

crude oil prices

Oil is perhaps the most important global commodity, and given that prominence, a price change on this scale is going to have severe implications. Indeed, one of the first major dominoes to fall has been Russia due to the outsized economic reliance on energy exports. With lower oil prices has come a currency crisis, and nothing leads to political and social upheaval quite like price instability. Closer to home, many are wondering how the price drop might affect shale production, which is notoriously capital intensive. What is the breakeven price in some of the newer shale fields? And just as important, will the debt markets continue to be as forgiving of tight cash flows and flimsy balance sheets as billions of dollars of debt is scheduled to be rolled over in the coming months?

I am reminded of the housing market crash in 2008 and 2009. Was anyone else surprised at how many borrowers were indirectly depending on housing? I worked with a bank that financed a manufacturer of boat trailers. Anyone care to guess how most of the eventual buyers were paying for their shiny new boats? Why, HELOCs, of course! Our boat trailer guy didn’t stand a chance. The economic recovery of the last several years has largely been an energy driven recovery. Oil field jobs in places like North Dakota, Oklahoma, and Texas (where Rick Perry claims 40% of the nation’s post recovery jobs have landed) have spurred new housing, new hotels, new retail developments, and support industry jobs by the tens of thousands. You may know your direct exposure to oil, but do you have your arms around the indirect exposure?

Interest Rates

In part due to the drop in commodities prices and the accompanying deflation fears, interest rates have fallen throughout 2014. While falling rates have become par for the course (happy 6th birthday yesterday to 0% Fed Funds, by the way), it’s worth thinking about where we were a year ago (via

treasury yield curve

The yield curve was incredibly steep, and all of the experts were convinced that higher rates were finally on their way. Most banks were building these higher rates into their budgets, and structuring loans and bond portfolios accordingly. I’m not sure why we are still surprised by this, but the forecasts were all dead wrong. In fact, as Jeffrey Gundlach points out in this interview, rates not only went down, they went down without us ever seeing a real bounce back towards higher levels. Now 2015 is being forecasted as the year, finally, when rates will move higher. Why? Well, because the Fed says they might move the overnight rate away from 0%, and that means the rest of the yield curve should respond in kind, right? If the last few weeks are any indication, long term yields might just refuse to cooperate. After all, in the face of global weakness and a strengthening dollar, there will be a whole lot of relative value buyers of long treasuries. Would you rather own debt from Spain yielding 1.78% or from the United States yielding 2.07%? And, given the amount of global weakness, I’m not so sure the move in the Fed Funds rate is a guarantee. How much faith do you have in your institution’s rate conviction?

The Bottom Line

While we are in the midst of a recovery, it is a fragile one. It has been a long time since bank board rooms have seen optimism, and that unfortunately can cloud our view of risk. If you are convinced that the guy down the street has monsters under his bed, make sure to check under your own bed as often as possible. Stay diligent, and make sure you use price and structure to ensure that at the very least, your bank is the one that gets compensated for the risk that lurks just out of sight.

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massive change by sookie is licensed under CC BY 2.0

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unrealized gain loss to tier 1 capital

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