While the pandemic appears to be far from over, we at LSQ are gaining clarity into likely scenarios banks will encounter given the most recent financial data and feedback obtained from our numerous commercial banking partners. We feel compelled to share key observations and expected outcomes as we look toward Q4. Our hope is that you derive value from these insights and determine a path that works best for you now, with some thought into the yet to be determined future of commercial banking.

The credit quality of C&I and CRE portfolios is steadily deteriorating

You don’t need us to tell you that COVID-19 has upset the global financial markets. We have all been and continue to be affected by the pandemic. New loan originations at U.S. commercial banks, excluding those from the Paycheck Protection Program (PPP), have taken a nosedive according to data released by the Federal Reserve and Small Business Association. Banks have deployed protectionary measures, particularly with new customers in this unstable economic environment.

It’s no surprise that the pandemic is negatively impacting the credit quality of commercial industrial and real estate (C&I and CRE) portfolios. However, the extent of this impact remains somewhat veiled, largely due to government pandemic relief and stimulus programs that have rolled out in response to the shutdown. While these programs may have provided momentary relief for some, they have likely concealed the true extent of credit damage to C&I and CRE portfolios. Consider the following:

Businesses borrowed more immediately before, during, and after the initial shutdown

The Federal Reserve of Economic Data reports C&I usage across all U.S. commercial banks in late-February to mid-April jumped from $2.3 trillion to $2.95 trillion. This was mostly a result of SMEs employing PPP funds to position for an extended period of downtime. Refinitiv reports that companies borrowed almost a year’s cash in the first five months of 2020. The takeaway— previously leveraged companies are now further leveraged.

The end of relief programs may be in sight

Banks, particularly smaller ones, initially issued PPP loans to their respective customers first, opening up the program more broadly after these initial portfolio loans were made. Many recipients of the loans have been operating on these funds due to lack of revenue and may continue to rely on these funds in light of rising caseloads and the specter of a second round of shutdowns.

In addition, several banks granted 90-day forbearances to segments of their portfolios when the pandemic started in mid-March with the expectation that the U.S. would flatten the new case curve by mid-June. At the time of this publication, the U.S. has nearly double the reported cases than it did in March, and states continue to report record numbers of infections. Banks will have to address this miscalculation in some form, be it extensions or exits.

CRE portfolios will likely decrease and degrade

The pandemic has caused companies to reevaluate their usage of office space. In addition to simply moving to work from home (WFH) models, there is an expectation that companies will adopt Silicon Valley’s bullpen style setups with considerably less space devoted to personal offices. This is likely due to companies transitioning to blended work environments. With a potential surplus of available office space, values of Class A and B spaces would be driven down, overextending initial valuations in this segment.

New construction projects for travel, hospitality, and retail are another concern. Valuations have not been issued since the pandemic hit. Inevitably, these will catch up to current book valuations, presumably creating shortfalls.

Reserves are fortified, but it’s too early to weigh the effects of COVID-19

Thanks to lessons learned from 2008’s financial crisis, Q1 reserve requirements by banks were unprecedented. After scratching slightly beneath the surface, we discovered the following:

Many large banks had reinforced reserves

The larger banks in Q1 of 2020 reserved, on average, 5X the quarterly average over the prior five years. This likely signifies that banks were bracing for the potential or eventual degradation of credit quality in their portfolios. The five largest banks put away ~$24 billion in quarterly loan losses in Q1 compared to ~$5 billion quarterly combined over the previous 36 months.

Provisions were increased without proper allocations

Many banks made the provisions mentioned above hurriedly due to the speed upon which COVID-19 befell the U.S., bypassing the standard practice of tying loan loss reserves to specific cohorts of high-risk accounts. Thus far, the pandemic is complicating the banks’ ability to pinpoint future losses. As time progresses, they will gain a better understanding of specific transaction challenges.

The Main Street Lending Program recently rolled out with a laundry list of requirements and covenants

The Federal Reserve’s Main Street Lending Program (MSLP) will inject up to $600 billion of liquidity to help small and medium-sized eligible businesses (fewer than 15,000 employees or annual revenues under $5 billion) that were in sound financial condition before the pandemic. Composed of three main loan types— new, priority, and expanded loans— the MSLP offers facilities from $250,000 and ranges up to $300 million with interest rates set at LIBOR, plus 3%.

Unlike PPP loans, MSLP loans are not forgivable and must be repaid over five years, which may be ambitious, given overall economic uncertainty. It’s also important to note that, like PPP, MSLP puts companies in the position of doing business with the federal government, likely for the first time. This relationship can bring unique regulatory compliance challenges, including restrictions regarding distributions, compensation, and employee retention.

While the program has evolved since inception, and industry-specific coalitions continue to lobby for additional inclusivity, it’s clear that MSLP will leave numerous companies wanting more financial flexibility and freedom. Many businesses will likely be driven to seek alternative funding solutions due to ineligibility or distaste for the extensive requirements and covenants.

Consolidations may be on the horizon

There is a growing consensus that we will experience a new wave of bank consolidations. While many banks in the U.S. reported five years or more of profitability, some lack the experience and resources to stomach a potential onslaught of write-offs and other pandemic-related losses, which could lead them to sell.

Others may simply be unable to overcome portfolio losses and will be forced to sell due to overall poor performance. As banks unearth the extent of true losses, the pricing for sales will take time. Thought leaders in this area predict a timeframe of 12–18 months.

We believe that banks will look to exit numerous loans as clarity sets in

LSQ estimates that the uptick in workouts will not occur overnight. Rather, it will commence around the close of Q3, gradually increasing as banks continue to analyze their portfolios in detail, likely with a downsized workforce given the pressure to reduce costs.

Commercial loan bankers and broker will need to look beyond traditional financing options and leverage their alternative lending networks to help mitigate the damage. Alternative lenders like LSQ, for example, offer smooth transitions to invoice, PO, inventory, and equipment financing solutions. Our commercial loan brokers and banking partners also find value in bypassing covenants and expediting underwriting for faster payoffs on their workouts.

Where we all land, once this pandemic ends, is a mystery. However, its effects on commercial banking are far more predictable, given the nature of the challenges outlined here. We encourage you to remain engaged with your financial networks and to touch base frequently in order to stay abreast of any opportunities that may serve you and your customers well.

Together, traditional and alternative lenders will be tasked with the immense responsibility of managing liquidity for many U.S. businesses. Let’s do our homework to ensure that businesses are given the best opportunities to keep the doors open and serve the members of our communities with unique products, exceptional services, and stable employment.

To learn more about what we're observing and how we're helping banks serve customers while avoiding charge-offs, contact LSQ.