By Bill Pilkington
In Part One (Great Lakes Banker, June 2024, page 28), I presented facts that led to the carnage that was the “Great Recession” beginning about 2007. Our free market economy has demonstrated an economic check generally every 10-12 years. For purposes of our discussion, I will use the “standard” definition of recession…two quarters of negative GDP. The dynamics of our current environment are not as simple as our definition suggests. Similar to the Great Recession, the government will play a significant role in causing the next recession through massive inflation, manipulating interest rates based on political winds, artificial employment, and new misguided initiatives (think price setting and down payment grants for new home buyers). All these factors conspire to suggest the timing of the pending “real recession” is most likely the second half of 2025.
Starting with Agreement
At this point, I see general consensus on where we are and the challenges ahead. I have had the privilege of meeting with bankers, regulators and consultants. Now is the time to address the issues and seek solutions before another apocalypse where we subsequently split into our respective factions and are relegated to our respective corners. When it comes to regulators, one of the challenges, and probably the largest impediment to success, is the difference between field and office staff, particularly in federal regulators. Almost to the person, field staff is committed, well meaning and a great source of information based on their experiences. In the Great Recession, I had the unfortunate experience of witnessing regulatory friends and colleagues in the field fall ill due to the cognitive dissonance between what they knew was right and what they were instructed to do. The good news is right now most are dealing with examiners-in-charge and subject matter experts. It is time to work on solutions.
Adding Granularity
Last recession, the hardest hit sectors were residential mortgages and land construction and development loans. This coincided with Barney Frank’s everybody should have a house legislation that created, then eliminated, demand for housing. This time around social mores will play a prominent role in sector performance which will necessitate finer metrics. It is no longer worthwhile to report around call report definitions to delineate aspects of the commercial loan or commercial real estate portfolios. For example, commercial real estate has a wide range of attributes within its definition, each with distinct risk elements. The risk profile of owner occupied office space housing a well established company with a stable balance sheet and good income that has performed for years is drastically different than new construction, partially spec office space that inherently relies on an expanding economy for demand. Throw in the relatively new phenomenon of work remote/at home and you have supply greatly in excess of demand pushing returns down and nonperformance up. What time and experience have taught us is our old buckets don’t work any more and by adding granularity we can better identify risk and allocate resources.
Jettison Risk
Most grading systems reflect a loan grade that corresponds with regulatory loan grades resulting in a one to seven or eight system. Popular since the dawn of time, or the 80’s, the system is workable if used properly. However, in a dynamic economic environment, I found that my worst rated credits were not always the ones I wanted to jettison. As a regulator, I would apply loss projections of 20% substandard, 50% doubtful and 100% loss and sometimes 10% special mention with a 1% charge against the remaining portfolio to quantify the overall risk of loss in the portfolio. While woefully inaccurate, it did deal with a couple necessary issues. The risk of default (classification) and the loss given default (% allocated.)
Given the importance of loss given default, I recommend applying this to the entire portfolio, certainly low passes and all classifieds. By definition, this allocation will change on an ongoing basis based on the nature of collateral and the prevailing economic market. While this is also true of possibility of default, PoD won’t keep you up at night the way LGD will. So, you have gotten your credit evaluation all fancy like and the one thing you are sure of is, whatever numbers come out of it are inaccurate but a good guess nonetheless. The point is, any of our evaluation systems are best guesses and if done correctly (back-test often) should provide you a relative assessment of risk which you can use to prioritize your resolution efforts. This relative assessment of risk should also match your biometric risk assessment tool…your gut. Behind the closed door of my office, I would celebrate the payoffs of problem and emerging problem loans. You know your portfolio better than anyone else. Identify the dirty dozen credits that will have you dancing if successfully resolved.
Have your loan officers identify their dirty dozen, regardless of grade, and document their strategy in a recessionary environment. Unsurprisingly, you are likely to have many relationships that need to vacate. Right now, before any downturn, is the time to encourage credits to move on. There are many non-bank financial institutions that currently have growth goals without due emphasis on quality or simply lack the credit savvy that you possess.
Your Regulator is No. 1
I have spent over 26 years as a regulator, ten as a banker, and five as a consultant. The Great Recession brought out the worst in everyone. The environment was moving quickly, everybody’s “system” underperformed the needs of the day. Community bank’s were not responsible for the environment but fell victim to it as we lost 400 banks nationwide, nearly all community institutions. Whether a regulator, a banker (that’s right, they closed the first bank I went to work for) or a consultant, I made a point of attending every closing procedure I could. The sadness and tears of once proud employees searching for reasons the 100+ year old bank failed on their watch. The uncertainty of possible new employment with an unfamiliar employer and unfamiliar co-workers. While I knew most would be fine, I could never find the words to allay their concerns. So…
Let’s not go there!! Collectively, “we” have exceptional and bright people. I have had the privilege of participating in schools, conferences, presentations as both presenter and attendee, regulator and banker. Document the extra steps you are taking to manage your risks. Be prepared to discuss your dirty dozen. Have very pointed discussions on what you do and how you do it. Unless you are untouchable, be prepared to discuss capital augmentation plans (a good thing to do at your Annual Meeting of Shareholders). No lying or truth stretching allowed; they are like your physician who needs to know that you have a donut every morning. In return for the confidence and respect you show, you will receive the same. Focus on the issues and not the messenger. And rig for heavy running. It is better to be prepared for the worst and experience mild outcomes than being unprepared for a potential maelstrom. We have been through this once and now we know the task before us and realize that we will collectively be Better Together.
About the Author
Bill Pilkington is a 25 year regulator and 10 year banker. He can be reached at 734-558-7427 and PilkingtonLLC@outlook.com.