2015 And Beyond: Where Could the Next Round of Problem Loans be Lurking?

The U.S. economy ended 2014 on a high note. GDP growth in the second and third quarters was up 4.6 percent and 3.5 percent, respectively, and unemployment was below 6 percent for the first time since before the recession. Amid positive economic signs like these, many small business owners are feeling more optimistic about the future of their companies. The Small Business Optimism Index, which is calculated each month by the National Federation of Independent Business (NFIB), indicates that small business owners are growing increasingly confident in their outlook for the future. The most recent Index reading ticked up to 96.1, its highest level of 2014.

Especially encouraging for community bankers is the rise in the number of small business owners who say they plan to increase capital spending in the near-term. This could point to increased demand for small business loans in 2015.

Learning Lessons from the Past

As you gear up for what could be one of the best years for small business lending since the economic crisis, it would be wise to remember some of the lessons of the past. This includes lessons not only from the most recent recession, but from all the recessions that have occurred over the past few decades.

One of these lessons is that problem loans tend to arise in industries that share a few common characteristics. These include:

  • High levels of fixed costs.
    •  Lots of debt layered in with these costs.
  • Owners who tend to live extravagant lifestyles.
  • Vulnerability to drastic and often unforeseen changes, especially changes in the political and regulatory environments, tax laws, competition and technology.

Going back about three decades, we can see that agriculture exhibited these characteristics in the late 1970s before a crash in ag prices led to a wave of bad ag loans and numerous bank failures. Energy was the next problem loan industry in the mid 1980s, followed by commercial real estate in the late 1980s and then technology and the dot-com boom and bust of the late 1990s.

Airlines and auto manufacturers were problem loan industries exhibiting these characteristics at various times throughout the early 2000s. And residential and commercial construction, income property and financial services were all industries that experienced a significant run-up, ushering in the financial crisis and Great Recession.
Industries to Watch Now

With this in mind, which industries should community banks be watching especially closely right now in anticipation of possible future problem loans? Here are a few possibilities to consider:

Agriculture – To borrow a quote from the great Yogi Berra, it could be “déjà vu all over again” when it comes to agricultural lending. Many farmers today are farming on land they’ve leased from investors, for which they are paying higher rent due to soaring land prices. At the same time, farmers have bought or leased a lot of new equipment, driving up their fixed costs substantially. Meanwhile, overseas demand for U.S. agriculture products is waning while ag production is increasing, which has led to a surplus of agricultural goods and lower prices.

Coal – The EPA’s Clean Power Plan, announced last summer, and a new climate agreement with China announced late last year by President Obama are just the latest shots fired in what many consider to be the Obama administration’s ongoing “war on coal.” At this point, any number of changes (especially regulatory) could have damaging effects on the U.S. coal industry.

Healthcare – The U.S. healthcare industry is in the early stages of undergoing transformational changes as a result of the Affordable Care Act (ACA). There will be winners and losers with any legislation of this scope. Right now, it looks like community hospitals and small, private-practice physicians may have the hardest time thriving (and even surviving) in the post-ACA healthcare world.

Fracking – Hydraulic fracturing, or fracking as it is most commonly referred to, has transformed large swaths of the U.S. energy industry and revitalized entire regions of the country where shale rock layers have been discovered deep underground. Drilling companies have taken on significant debt in order to set up and maintain fracking operations, but falling oil prices could signal an early end to the fracking party.

If this happens, many cities and communities that have prospered due to the fracking boom could be adversely affected. This is what happened to many communities in Texas back during the oil boom and bust days, as businesses of all kinds shut down when the oil economy collapsed.

Ethanol – In 2007, the Renewable Fuel Standard program increased the volume of renewable fuel required to be blended into transportation fuel sold in the U.S. This has led to an explosion in ethanol. But ethanol production requires huge amounts of water — as does fracking — and only so many straws can be punched into the underground aquifers that are being tapped for both of these purposes.

Also consider that the ethanol blending mandate requires that more ethanol be blended than what can safely be used by engines in many vehicles today.

Municipalities – Detroit is the poster child for troubled municipalities, along with several smaller cities in California and a few other states that have recently filed for Chapter 9 bankruptcy protection. Some economists are predicting more municipal bankruptcies as cities deal with the high cost of providing defined benefit pension plans for employees and healthcare benefits for retirees without raising taxes or cutting services.

Lend to These Businesses Prudently

This isn’t to suggest that community banks shouldn’t lend to businesses in these industries. Most of them are relatively healthy right now and may offer good opportunities for you to grow your portfolio with profitable new loans.

If you do, though, you should perform careful due diligence on these businesses before lending them money. Only lend to the strongest borrowers that can demonstrate a long-term track record of success and that practice conservative financial management, including assuming modest levels of debt. And carefully examine the owners’ personal lifestyles to see if they are living more extravagantly than perhaps they should.

Also watch out for concentrations of loans to businesses like these in order to limit your total exposure to these industries. Be sure that concentration limits are in place and that you have a proven method for tracking loan concentration in your portfolio. You also need to have policies, procedures, systems and controls in place to manage and monitor your concentration risk.

We welcome the opportunity to talk with you further about how to minimize your bank’s exposure to problem loans. Give us a call to schedule a convenient time to meet. Sonny MacArthur, smacarthur@pkm.com (404) 420-5631