As we begin to close out the year and take a January sigh of relief, I want to take a brief hiatus from our recent “Exhilarating Basics of Credit” discussion to address some of the trending we are seeing in credit and the strategic steps we are proactively implementing in order to be ready for the challenges of 2019. Many of you may ask why I would care to share this information publicly? The answer is simple, whether you are a colleague, a competitor or a customer these things will hopefully help to provide you a peek inside my concerns. As the credit landscape surely changes and evolves in the years to come, all of us will undoubtedly be impacted. Rather than wait until something goes wrong, I have always found these types of communications the best way to initiate a dialogue amongst all of us. If you disagree, I happily welcome the dialogue and encourage you to chime in for a healthy debate. After all, isn’t that one of the benefits of social media.
Cash-out refinance requests will be given additional scrutiny.
The Wall Street Journal shares, “More than 80% of borrowers who refinanced in the third quarter chose the ‘cash out’ option, withdrawing $14.6 billion in equity out of their homes, according to government-sponsored mortgage corporation Freddie Mac. That is the highest share of cash-out refi’s since 2007...”1 While this certainly was not unexpected in an interest rate market where consumers are not going to refinance to simply lower their existing rate, it is something to be cautious of. Excess leverage for all of our clients can put a tremendous amount of stress on their financial positions as well as their families and mental health. We will be more closely monitoring cash out requests as well as the average Loan-to-Value (LTV) of our Single Family Residence portfolio of assets during 2019. That being said, I believe that our portfolio of assets is strongly positioned having always maintained prudent underwriting practices. Easy to say when we started lending in October of 2007 at what would be the height of “The Great Recession.”
New residential construction deliveries are flooding the markets.
With hot markets cooling down and mortgage rates rising, the homebuilders are starting to need to make concessions to move new construction projects. As First Foundation Bank has a few construction projects underway and a department dedicated to this product, it makes sense that we tighten up our risk profile in light of the changing market. Bloomberg Businessweek noted that “New home purchases tumbled in September to the weakest pace since December 2016. Sales of previously owned homes dropped for a sixth straight month, the worst streak since 2014. Homebuilding stocks have lost more than a third of their value this year. Of course, rising wages may help put more houses in reach. Starter homes are still in demand, and some smaller, more affordable markets such as Columbus, Ohio, and Grand Rapids, Mich., remain as strong as ever. But the shift is especially striking given the robust U.S. economy.”2 While the clientele we service is undoubtedly unique for their financial wherewithal or well qualified based on our prudent underwriting practices, we will be proactive versus reactive in how we look at proposed construction projects during 2019. It is also worth noting that we, like many other banks, began strategically tapering back exposure to construction two years ago.
Newly built and leased up multifamily residential properties have only downside risk.
The impacts to the single family world and the construction world also impact our largest portfolio of assets, our multifamily portfolio. While many of the projects we finance are under some type of rent control, new construction proposes a particular challenge during financial times headed in to recessionary economies. The problem is simply one of downside risk with no upside potential. Put another way, financing newly constructed projects with leases at or near market highs while entering in to an economy where rental or leasing concessions are likely going to be necessary means that the Debt Service Coverage Ratio (DSCR) underwritten to at origination can only go down as the market sees rental concessions begin. For the time being, we are only seeing rental deceleration in top markets across the U.S. rather than impactful rental concessions. It should come as no surprise that this is largely due to the extent to which supply growth (deliveries from new construction) has put downward pressure on occupancy rates in metros like Los Angeles, San Francisco and San Diego where new construction is particularly prevalent.3 As we enter 2019, First Foundation Bank will be particularly cautious around new construction take out financing for multifamily properties.
Businesses are taking on more leverage and consumer spending is still high.
Former Fed Chair Janet Yellen recently joined the chorus of warnings about the $1.6 trillion “leveraged loan” market. Specifically she pointed out that “central banks are starting to worry that the corporate world may have taken on too much debt, and that the stock of risky debt overhanging the global economy might start to behave the way subprime mortgages did before 2008.”4 While I am not as concerned about our own portfolio and the level of risk we have taken on, I do believe that examples of foolish lending have returned to the market once again. When Net Interest Margin (NIM) gets crushed due to increasing interest rates, banks of all sizes start sacrificing credit quality chasing yield. You may be asking “why businesses taking on more leverage is bad if the economy is still growing?” Consumers are indeed very confident and by late Thursday afternoon of Thanksgiving Day this year online sales reached $1.75 billion representing growth of 28.6 percent year-over-year, according to Adobe Analytics data noted by Fox Business’ website.5 The problem is that when consumers are refinancing and pulling cash out of their homes as we previously spoke about, the increased sales and spending can support the leverage. However, if interest rates rise and those businesses with variable rate lines of credit have progressively higher and higher payments to make it can be challenging and places some stress on these businesses. CNBC noted recently that the Fed minutes pointed toward the strong likelihood of another quarter-point adjustment in the central bank’s benchmark rate target next month, so one would be wise to anticipate that stress coming.6 Further compounding that stress is the looming likelihood of a potential recession. JPMorgan put the odds of a recession happening in the next two years at 60%. (That jumps to more than 80% over three years.)7 Consumer spending would gradually slow and the result is that those higher payments for leveraged businesses could be too much for them to be able to pay back. As we continue to grow and scale our C&I platform amongst all of our multiple product offerings, we must be mindful of these risks proactively so that we are ensuring our borrowers, clients and friends are given the best possible chance at success. Sometimes that will mean saying “no” to an applicant who may qualify now, but who’s business has not weathered these economic events before and is yet highly susceptible. Really, this comes down to maintaining our excellent existing credit discipline as the landscape around us starts to take on more risk.
The credit turtle also beats the quick growth rabbit in the risk credit race.
As a last note, we have seen an unusual amount of credit requests across all product types in which a borrower and/or guarantor has significant character issues. The full gambit of felonies, bankruptcies, prison sentences, short sales, foreclosures and more have been presented with Letters of Explanation (LOE) explaining away the circumstances in a theoretical light that should be acceptable to First Foundation Bank as a lender. I fear that one well mitigated exception could lead to another exception and another. Before we know it, allowing lending to these types of applicants becomes a pattern and/or practice. Traditionally, “character” is one of the “Five Cs of Credit.” We get so lost in the quantitative impressiveness of some of our clients that we forget that there is a viable qualitative aspect to lending and credit. Character, sometimes referred to simply as credit history, is the first “C” and refers to a borrower’s reputation or track record for repaying debts. This information appears on the borrower’s credit reports, negative news searches, public records searches and each of which can provide detailed information about how much an applicant has borrowed in the past and whether they have repaid their loans on time. These reports also contain information on collection accounts and bankruptcies, and they retain most information for seven to ten years. We will be tightening down our acceptance of explanations for significant character flaws as we enter in to 2019 without regard for the length of time that has passed since it occurred. “The Great Recession” was eleven years ago now and to simply write off a significant character flaw as having lapsed ten years ago would be foolish as we enter the next recessionary economy.
Thank you and you are appreciated!
While you can logically expect us to refine our lending and credit platform constantly in response to the micro and macro economies around us, these are a few of the key issues that I wanted to share with everyone so that we all broadly understand how today’s banks are being proactive versus reactive. Certainly, some transactions that come in from clients, friends and colleagues will be passed on and I hope that this helps shed some light on why those decisions are likely to be made to protect our shareholders, employees and even those applicants who may have requested the credit. One thing to remember if you are ever denied for a loan or credit request, largely the only thing that takes a bank down is the same thing that can take you down. If you lose, the bank loses too and at its most basic we are all trying to guard each other’s success. References for some of my own statements have been included below, but what I really want to hear is what you think. What scares you? Do you disagree? What fears do you have for 2019 and beyond?
References:
1 https://www.wsj.com/articles/borrowers-are-tapping-their-homes-for-cash-even-as-rates-rise-1543159864
2 https://www.bloomberg.com/news/articles/2018-11-20/free-vacations-100-000-discounts-homebuilders-get-desperate?utm_campaign=news&utm_medium=bd&utm_source=applenews
3 https://irei.com/publications/article/falling-occupancy-decelerating-rents-multifamily-housing-sector-finally-runs-economic-resistance/
4 https://www.businessinsider.com/janet-yellen-leveraged-loan-warning-2018-10
5 https://www.foxbusiness.com/markets/thanksgiving-day-on-pace-for-record-3-7b-in-online-sales
6 https://www.cnbc.com/2018/11/29/fed-points-to-december-rate-hike-but-is-worried-about-tariffs-and-debt.html
7 https://www.gq.com/story/how-to-survive-the-next-financial-crisis
