Susan L. Hodges 2016-03-14 16:52:08
Credit and collections professionals see early signs of imbalance
WATCH A TRUCK IN NEED OF A WHEEL ALIGNMENT make its way down the highway, and you can’t help but notice the quiver. Barely visible at first, the back-and-forth movement increases if unchecked until the vehicle is a hazard to drive. Ken Katz, Senior Credit Manager at Wells Fargo Equipment Finance, Inc., in Minneapolis, is watching a different kind of wobble—albeit a slight one—in his firm’s credit and collections.
“Delinquencies and write-offs for the last two to three years were as low as they could go, and we’re still at a very good level,” says Katz. “But we’re starting to see a slight trend in the other direction.”
Eric McGriff, Chief Credit Officer at Everbank Commercial Finance in Parsippany, N. J., reports a similar situation. “I’d say we achieved bottom—the best credit and collections could be—in late 2014 to early 2015,” he says. “Since then, we’ve seen some degree of rising delinquencies and slightly higher charge-offs in a number of segments where the borrowers represent a wide range of small businesses.”
Miles to Go
The Thomson Reuters/PayNet Delinquency Index (SBDI) shows the changes in black and white. Small-business delinquencies in both the 31- to 90-day and 91- to 180-day categories increased by 1 basis point in November 2015 compared to October, and the PayNet Small Business Default Index (SBDFI) shows that 12-month rolling default rates are now moving as well, up 9 basis points year over year as of November. Aside from the wobble, though, the rest of the truck appears sound. Tom Ware, Senior Vice President of PayNet, Inc., the Skokie, Ill.-based provider of small-business credit data and analysis for the commercial and industrial lending industry, lends his perspective:
“We have to realize that delinquency and default rates are moving up from record lows after the Great Recession,” he says. Optimal conditions occurred in the wake of the recession, when lenders were extremely cautious, borrowers were equally cautious and weak borrowers were no longer in business. But all of these circumstances have had time to change. “Now the situation is very competitive and lenders are complaining about margins and starting to talk about the beginnings of irrational exuberance,” says Ware. Using another metaphor, he says, “You could say we’re in September of the economic cycle. It’s still nice and warm out there, but it’s no longer peak season.”
Defaults in mining and agriculture illustrate the point. The PayNet SBDFI shows the mining industry leading default rates for November up to just over 2%, from 1.34% one year ago. Agriculture, hurt by falling grain prices and fewer exports as world economies slow, is not far behind, with a default rate of 1.42%, up from 0.88% one year ago.
Katz points to plunging oil prices that are draining the lifeblood from boomtowns near domestic drilling sites and industries that support oil and gas enterprises. “Even if your company isn’t directly involved in oil and gas, it might be affected by tentacles that reach to other parts of the economy: service providers, transporters and builders of infrastructure,” he says. “Those businesses now need fewer people because there’s a lot less business to be done.”
“Delinquencies and write-offs for the last two to three years were as low as they could go, and we’re still at a very good level. But we’re starting to see a slight trend in the other direction.”
–Ken Katz, Wells Fargo Equipment Finance, Inc.
But as funding professionals point out, dips in equipment segments affected by each of these developments are roughly balanced by growth in other areas such as construction, healthcare and transportation (see cover story, page 20).
“The situation leads me to believe we’re returning to a norm,” says McGriff, “and it’s a norm that’s better performing than in the past.” Having lived through more than five years of ever-improving credit quality, he says now is “the first time many of us have had to say that delinquencies and defaults are starting to inch up.”
“You could say we’re in September of the economic cycle. It’s still nice and warm out there, but it’s no longer peak season.”
–Tom Ware, PayNet, Inc.
Response Required?
From a management perspective, McGriff believes the changes call for credit and collections departments to review staffing levels and collection strategies. “When things are going really well, you make decisions about the timing of calls, realizing there’s less to be gained from hitting accounts very early,” he says.
“But as delinquencies begin to rise, you have to look again at staffing and collection activities, because if you don’t, you can get behind the curve and find yourself with delinquencies that are further increased because you haven’t staffed or acted appropriately.”
Mike Infante, Chief Credit & Risk Officer for Cisco Systems, says his company is making modifications to incorporate non-credit risks as part of its business operations. “Although the basics of credit and collections haven’t changed, we do see a shift in the macro-economic landscape as the needs of businesses change,” he says. Cisco customers “are asking for increased flexibility and for structures that require the credit and risk management team’s active involvement,” he adds.
The credit operation at many equipment-finance firms has evolved into a credit and risk-management function, Infante says, generating needs for new capabilities that help customers align their technology and other assets with their business needs. “We’ve been building up an enterprise risk-management function to incorporate non-credit risks as part of our business operations for some time now,” he says, “and I think the credit and risk organization generally needs to continue to build such capabilities to keep our businesses relevant to our customers.”
Ware knows whereof Infante speaks. “Two things are happening with deal structure,” he says. “Borrowers want to make less of a commitment and pay for equipment only when they use it. They also want services and perhaps supplies bundled with equipment, which oft en involves multiple providers. So yes—the risks and demands of our business are changing.”
Katz mentions changing demands as well, saying Wells Fargo continually looks for technology solutions to solve service issues. “We don’t see anything new in credit and collections procedures, but there’s an ongoing trend to use more automation to build interfaces with customers so they can see their leases, and so vendors can submit deals through portals,” he says.
“Although the basics of credit and collections haven’t changed, we do see a shift in the macroeconomic landscape as the needs of businesses change.”
–Mike Infante, Cisco Systems
It is not changing service issues that concern him, however. It is spread compression and the eventual incongruity that can occur between portfolio spreads and credit losses. “With improved portfolio credit quality, lending activity generally increases and lenders tend to become more competitive on rate, which results in spread compression,” he says. “As significant rate competition becomes prolonged, higher spread transactions in a lender’s portfolio tend to become displaced with a lower spread transactions. Subsequently, as credit losses begin to increase off of a cycle low point, profitability can come under pressure given the lower portfolio spread.”
While transaction spreads will generally begin to increase as portfolio credit quality deteriorates, “It usually takes a significant amount of time for the low spread transactions in the lender’s portfolio to be materially displaced by the higher spread transactions,” Katz continues. “During periods of economic change, it’s this lag time that creates a mismatch between the portfolio spreads and credit losses which, in turn, magnifies the impact to bottom line results. Lenders should be thoughtful about how low they are willing to go in transaction spreads, knowing the portfolio performance may change at some point.”
Ongoing Regulatory Rigor
Meanwhile, regulatory oversight of financial firms—particularly banks—continues to expand. A Dodd-Frank progress report issued by the international law firm Davis Polk & Wardwell, LLP, notes that as of the fourth quarter 2015, just 204 of 271 Dodd-Frank rules with deadlines already passed had been met with finalized rules. Rules have been proposed for 34 more, but that still leaves 33 without finalization. In total, Davis Polk & Wardwell said, less than 70% of 390 total required rulemakings in The Dodd–Frank Wall Street Reform and Consumer Protection Act have been met with finalized rules, even though the Act became effective in 2010.
While Dodd-Frank continues to generate requirements for banks, other regulations, such as beneficial ownership of borrower or lessee companies, have been proposed that would add another layer of compliance if implemented. Proposed by the U. S. Treasury Department’s Financial Crimes Enforcement Network as an addition to the Bank Secrecy Act, beneficial ownership would mandate that financial institutions know and verify the identities of every individual who owns, controls and profits from a company planning to use bank services.
“So many mixed signals mean we’ll have to constantly monitor economic data.”
–Eric McGriff, Everbank Commercial Finance
“This will take due diligence to a deeper level,” says McGriff . “If a company with 10 owners who each own 10% opens a bank account, that bank will have to know all 10 owners. How banks integrate compliance with this new requirement into their operations is going to be a challenge and could have a big impact on the credit approval process.”
Another matter expected to place new requirements on banks is CECL, the Current Expected Credit Losses model proposed by the Financial Accounting Standards Board (FASB). Deliberations on CECL are still underway, but decisions related to the model framework have already been made. Banks will be required each quarter to estimate and allow for losses they expect in their loan and debt-security portfolios. “Th is change is huge, because right now banks have to report only on losses already incurred,” says Ware. “CECL, by comparison, will require them to estimate and reserve at transaction origin their expected losses over the life of the loan, thereby accelerating loss recognition ahead of income recognition, contrary to the traditional core accounting principle of matching.”
Implementation isn’t expected until January 2019, but banks will have to provide comparisons with the prior year, meaning models to calculate potential losses and processes to report them will have to be in place by January 2018. Says Ware, “I think the only reason our industry hasn’t yet focused on CECL is because not all the requirements are in place.”
The American Bankers Association is focusing, however, and has expressed concern that any inaccuracy in the CECL model could result in banks building unneeded capital buffers on top of those already required, potentially affecting a bank’s ability to invest and lend.
If bank-owned equipment finance firms really aren’t worried about coming regulation, it may be probably because they have their hands full now. “Banks have felt requirements being ratcheted up in leveraged lending and increased scrutiny on all existing regulations,” he says. Demands for information can sometimes cause bank-owned firms to delve into old portfolios and perform manual remediation to provide the information regulators are asking for. “We’re seeing a lot of this,” says Katz, “and unless you’ve been tracking certain types of lending information for years, you have to go back manually and look for it.”
“Some requirements are the result of lender-specific guidance given banks by individual regulators who supervise them,” observes McGriff . “The challenge can be finding a way to operationalize these new requirements and report on them efficiently.”
Other Considerations
Credit and collections professionals say equipment finance firms are generally prepared for coming changes to international lease-accounting standards, but they’re not as sure about the readiness of their clients. “A lot of customers may have to modify their bank covenants so that their actual accounting outcomes will be different,” says Katz. “Covenants will have to be renegotiated for larger transactions.”
Another potential development—further increases in interest rates—could affect heavily leveraged customers. “Companies with a lot of debt on the books will incur much more cost if interest rates continue to go up,” Katz says. “To the extent that they have floating-rate loans, any change in rates impacts them immediately, having an indirect but possibly significant impact on their capital structures.”
Despite current pressures and looming concerns, however, veteran credit and collections pro’s are calm if not sanguine. “I think the rest of 2016 will bring more of the same,” says Ware. “Because the past recession was so deep, recovery has been slow and segments of our economy are still recovering. Personally, I think the overall domestic economy will be good for quite some time longer.”
McGriff takes it a notch up. “I’m cautiously optimistic that delinquencies and charge-offs will stabilize,” he says. “I look at oil prices and the stock market and the slow-down in China, and I believe we’ll be in for higher-than-normal volatility, but I think in a historic perspective that things are solid.” Even so, he adds a qualifier: “So many mixed signals mean we’ll have to constantly monitor economic data and delinquencies to make sure none of the pockets driving it need specific attention. The days of light collection efforts and consistent improvement are over.”
Susan Hodges writes about equipment finance and other business topics from her office in Wilmette, Ill.
©Equipment Leasing and Finance Association. View All Articles.