Four Industries to Watch in 2017

Jay Lucas

Director of Credit Services

March 28, 2017

Believe it or not, the current economic recovery started in the summer of 2009. It is now seven-and-a-half years long, or more than twice as long as the average U.S. expansion, and the third-longest expansion on record. It’s anybody’s guess whether this expansion will go on to set a new record or stall out sometime this year or next.

As a community banker, however, you might want to pay close attention to the length of the expansion for one simple reason: The heaviest loan losses tend to be incurred on credits made during the last two years of a recovery. This could make now an especially critical time for lending activity at your bank.

Unprecedented Lending Challenges

Community banks have faced unprecedented challenges over the past 12 to 18 months due to compressed net interest margins. These challenges have been caused by a wide range of factors, including the Federal Reserve’s accommodative monetary policy, constraints on banks’ ability to earn fee income, and rising compliance costs.

In this environment, many community banks have determined that the best way to grow their bottom line is to increase loan volume among their small business and commercial real estate (CRE) customers. To grow the top line, community banks have been more aggressive in their underwriting, structure, extending maturities and limiting personal guarantees. However, many small businesses have been unwilling to invest in growing their productive capacity, while consumers have remained slow to open their wallets wide.

As a result, some banks have shifted their focus to more esoteric types of lending such as loans to facilitate buyouts of shareholders, special distributions and mergers and acquisitions. And some banks have resorted to riskier lending practices in order to compete for the best loans — including compromising their underwriting standards and loan structure and getting more aggressive with loan pricing.

Exercise Lending Caution

In the 2016 OCC Survey of Credit Underwriting Practices, Examiners’ assessments indicate the aggregate perceived level of risk in underwriting as conservative, moderate, or liberal. The assessments consider all elements of underwriting, such as appropriateness of loan structures, adequacy of and adherence to internal policies, adequacy of risk selection processes and decisions, and appropriateness of loan controls. The primary findings from the survey were;

  • Banks continue to ease underwriting practices in response to competitive pressures, expanding credit risk appetites, and a desire for loan growth.
  • While overall underwriting practices remain satisfactory, an increasing tolerance for looser underwriting has resulted in continued movement from more conservative underwriting practices to more moderate underwriting practices, a trend consistent with past credit cycles.
  • Credit risk has increased since the 2015 survey in commercial and retail lending activities, and examiners expect the levels of credit risk in these areas to increase over the next 12 months. Primary areas of concern are aggressive growth rates, weaknesses in concentration risk management, deterioration in energy related portfolios, and the continued general easing of underwriting practices.

Given the stage we’re at in the economic recovery — not to mention the aggressive stance some community banks are taking with loan underwriting, structure and pricing — it might make sense to start exercising the same caution urged by regulators in leveraged lending with other types of loans. In particular, focus your attention on industries with a historical tendency for problem loans. These include industries where borrowers have high levels of fixed costs with heavy debt layered in along with large investments in non-productive fixed assets. Also pay close attention to industries where business owners tend to live extravagant lifestyles, as well as industries that are vulnerable to drastic changes in the political and regulatory environments, tax laws and technology.

Reading the Tea Leaves

In reading the economic tea leaves, here are four industries that might warrant especially close attention this year:

  • Automobiles — It has been boom times for the auto industry recently, with record U.S. auto sales. But sales could slow down in 2017 if the economy hits a speed bump.

An early indication of a potential slowdown surfaced with an unexpected decline in automobile sales in September. With auto demand easing last year from the torrid pace of 2015, automakers started relying more heavily on rebates and discounts. The volume of incentives per unit sold in September set a new record for a single month, according to J.D. Power.

One trend that could negatively impact auto sales in the near-term future is an extension of the automobile replacement cycle. The average term for a car loan is now 68 months — a new record, according to Experian. As consumers stretch out their car loan terms further, they are in less of a hurry to buy a new car.

  • Multi-family housing — This industry has also seen healthy growth, especially in large cities as Millennials eschew single-family homes to live in hip in-town apartments and condos. Multi-family housing remains an industry where community banks often have a competitive advantage.

However, the multi-family party could be winding down in the near future. Rents for urban apartments are soaring beyond affordability for many Millennials, while others who are starting to settle down are discovering the merits of single-family homes for raising families. Also, foreign investment that has driven multi-family construction could start to dry up — especially from China, which has placed limits on these types of investments.

In late 2015, the regulators issued a statement to remind banks about existing regulatory guidance on prudent risk management practices for commercial real estate lending activity through economic cycles. It’s a good bet the regulators will continue to monitor CRE and multi-family lending closely in 2017 and 2018.

  • Agriculture — Two years ago, regulators voiced concerns about the agriculture industry, even though it was fairly healthy at the time. Today, falling commodity prices, inflated land values, rising factor input and equipment costs, high levels of carry-over debt, and slumping farm incomes are making the regulators look almost prophetic.

Some see a replay of the agriculture bubble of the late 1970s and early 1980s, and there are certainly some similarities. But it’s also important to point out the differences. For one thing, farmers today aren’t as leveraged as they were then and they typically have more equity due to rising land prices. But many farmers are farming on leased land for which they’re paying higher rent.

  • Energy — The energy sector has yet to recover from the downturn that started when crude oil prices plunged from over $110 per barrel in mid-2014 to below $30 per barrel by the end of 2015.

Oil prices have recovered somewhat, averaging around $43 per barrel in 2016, but they aren’t expected to reach anything close to triple digits again anytime soon. The U.S. Energy Information Administration is forecasting that Brent crude oil will average $52 per barrel in 2017.

Also look at covariance

Even if your bank doesn’t have direct lending exposure to these industries, you still need to be careful. Your borrowers could be indirectly tied to these industries and thus affected by industry problems and weaknesses. Auto industry dealers and suppliers and the myriad industries connected to the construction industry are good examples.

The bottom line: Make it a practice to perform careful due diligence on businesses in the industries noted here before lending to them. Restrict lending activity to the strongest borrowers who practice conservative financial management, have low levels of debt, and can demonstrate a long-term track record of success.

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