Mortgage Observer

The Basis Point: Banking in 2014

Sam Chandan

Sam Chandan

The United States banking system enters the new year on solid footing. While higher interest rates have weighed on residential mortgage activity, pulling bank revenues lower, other measures of performance show the sector drawing further away from the legacy of the financial crisis. Call reports show that provisions for loan losses dropped to their lowest level in 14 years during the third quarter of 2013. Net charge-offs fell by nearly half from a year earlier, to their lowest level in six years. A gauge of systemic health, the FDIC’s deliberately opaque count of problem banks declined to 515 institutions during the quarter, representing just 1.1 percent of net assets in the banking system.

Improvements in the performance of legacy balance sheets coincide with new lending across a wider range of banks. Across all asset classes, net lending increased by $69.7 billion during the third quarter. Multifamily and commercial real estate and construction loans were all contributors to that sum. Reengagement in property lending is still weighted to relatively larger markets, but the imbalance is less severe than during the early stages of the recovery. Investors in secondary markets and relatively smaller assets have seen a marked improvement in access to credit as banks’ focus has shifted away from legacy distress.

Default rates are down: The default rate on multifamily and commercial mortgages fell to 1.9 percent in the third quarter, its lowest level in almost five years. Default rates have been cut in half for commercial properties, falling from a mid 2010 peak of 4.4 percent down to 2.2 percent. Lifted by strong fundamentals and preferential access to subsidized capital, apartment loans have registered an even more dramatic decline in nonperforming rates. From a peak of 4.7 percent, the multifamily default rate has fallen to below 1 percent for the first time since before the recession. Construction loan default rates have fallen from nearly 17 percent to less than 5 percent as of the third quarter.

Bank lending is on the rise: Lower rates of delinquency and default reflect a shrinking pool of distressed legacy debt. But to an even greater degree, nonperforming rates have dropped because of the dilutive impact of banks’ new lending activities. Net lending on multifamily and commercial properties increased by $17.3 billion in the third quarter, feeding a year-over-year jump of nearly $60 billion. For the first time since the financial crisis, net construction lending increased in the second and third quarters. Construction loan balances were up modestly across multifamily and commercial property projects, by $900 million in the second quarter and $3.6 billion in the third.

Nonbank competition is on the rise: Apart from mammoth residential and commercial projects underway across New York City, banks in smaller markets may be returning to construction lending earlier than intended. Competition for high-quality financing opportunities is rising among both banks and conduit lenders. A more crowded landscape for permanent lending is spilling over into the relatively uncontested construction and development arena. Competition is also exerting a predictable influence on underwriting standards. In the multifamily sector, in particular, the most aggressively underwritten loans coincide with direct competition between banks and subsidized agency lenders.

Credit unions are shoring up the lower bound: Few segments of the market are woefully underserved relative to the their credit quality; the market for very small-cap loans is among the segments where dislocations persist. Helping to alleviate some of the inefficiency, regional and community banks’ small-cap lending is complemented by credit unions. The latter remain a small share of overall commercial property financing but play an outsize role in originating loans below $5 million. Institutional borrowers may dismiss the lower bound of the market as irrelevant, but a more balanced recovery is inevitably more robust. 

There is still hope for distress investors: For short-lived construction loans, the tally of real estate owned has fallen by nearly 50 percent. Banks have been relatively slower in drawing down their multifamily and commercial portfolios. Even where loans have been modified, recidivism persists as a vexing challenge for institutions saddled with weaker borrowers and assets. Across more than $20 billion in troubled debt restructuring, more than a third are once again delinquent or in default. For construction loans, the recidivism rate is nearly 50 percent.

Banks expect more lending: The banking stars are not in perfect alignment, as detractors of the Volcker rule have made certain to restate loudly as the provision has taken shape. While that rule has been finalized and will take effect in 2015, regulatory initiatives addressing capital requirements and long-term bond issuance are incomplete. Those uncertainties present a challenge for the banks but are hardly determinative of current lending trends. Banks’ resistance in adopting more robust processes for measuring and mitigating credit risk are as much a drag on activity as any regulatory moves.

When asked about commercial real estate, lenders are sanguine. In the most recent CRE Lender Sentiment Survey, published each quarter by the Real Estate Lenders Association and Chandan Economics, lenders indicate overwhelmingly that they plan to originate a larger number of loans in 2014. Where it demands caution, lending is poised to grow faster than the count of creditworthy borrowers.   

Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School. The views expressed here are his own. He can be reached at dsc@chandan.com.

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