When it comes to special assets, many small and medium-sized banks are in a situation reminiscent of the classic 1989 comedy “Weekend at Bernie’s.”
For those who haven’t seen it, the movie centers on two hapless employees who stumble upon their dead boss, Bernie, and try to fool everyone into thinking he is alive while they buy time to determine what to do. Similar to the movie’s premise, there are a lot of lenders, both of the bank and non-bank variety, pretending to be fine when they are in fact also buying time. Banks, in particular, are not kicking anything out and most workout folks simply are not focused on exits for a variety of reasons. In addition, regulators are not pushing even though P&Ls might be bad because liquidity granted by the Paycheck Protection Program has been decent for many borrowers.
Many small and mid-sized banks are very reticent to take losses and it was well known that many were sitting on real problems prior to the COVID-19 pandemic. A more than 10-year run of good times led to a lot of risk taking by banks, leading to the start of significant portfolio problems, which has only been compounded when considering that there have not been many bank failures, absent fraud, in a very long time, nor has there been a wave of kick-outs.
To the uninformed observer, it would appear that banks have no problems whatsoever, but that is truly implausible. A broken business model for a small business banking client before the COVID-19 pandemic is still a broken business model today. All the pandemic did was put a bandage on a major problem via an influx of stimulus.
To that end, let’s talk COVID-19 pandemic ramifications for a minute. National moratoriums and delays on residential and commercial rent evictions and corresponding bank forbearances are about to expire. Once that expiration comes, thousands of restaurants, hotels and hospitality businesses simply won’t make it despite the massive government stimulus we’ve seen in the last year. Making matters worse, the U.S. economy is experiencing inflation, interest rates should rise and not all businesses will be able to pass on the cost increases, which should create real margin tightening. This should ultimately result in more borrower and bank stress. Despite this situation, we’re still not seeing bank kick-outs or major community or regional bank write-offs. In fact, we’re seeing quite the opposite, as banks are back to trading at all-time highs even though most community banks are real estate heavy.
To say the asset-based lending and turnaround community at large is hungry is an understatement — try starving. ABL portfolios contracted significantly in 2020 and have yet to be replenished with new clients. It’s still unclear whether we are at the tail-end of the last cycle or the start of a new cycle, but the stock market does not seem to think problems are on the horizon, as bank stocks are back to all-time highs. For perspective, according to the FDIC, there were approximately 500 bank failures from 2008 to 2014 and approximately 30 from 2015 to 2020. For added perspective, in the United States, a nation with thousands of banks, there have been fewer than 10 bank failures the past three years and this includes 2020! To further quantify, this implies approximately $700 billion in assets of banks failures from 2008 to 2014 and under $15 billion the past five years, meaning the last five years’ amount of bank failure assets equated to 2% of the previous five years. Here is underlying data from the FDIC should any reader want to see for themselves.
Altogether, the key indicators are starting to point to problems for banks, but there does not seem to be distress on the horizon. Non-bank real estate investors and the ABL community are not experiencing increases in deal flow or even signs of it. Billions of capital has been raised, but banks don’t seem to be in a hurry to force clients out or to start signaling they have portfolio problems. The catalyst is always apparent after the fact, but, despite the apparent lack of concern about future distress, it seems like the proverbial can has only so much kicking left in it. At some point, regulators will start to put pressure on banks, real estate owners will reach a maximum number of deferrals, inflation will set in to a greater degree and PPP funds will run out. Any one or a combination of these variables could force banks’ hands quickly.
One key point to keep in mind when comparing the current bank environment with the Great Recession is that most banks have much higher reserves today than in years past. This could be interpreted to mean many banks will be better positioned to take some discounts to free up capital whenever the next round of restructurings take place. However, at some point, the weekend is going to end and banks are going to have to deal with their portfolio problems, unless they are able to produce a sequel to the current circumstances, like the folks behind “Weekend at Bernie’s” did by releasing “Weekend at Bernie’s II” in 1993.