Tom Freeman, Senior Advisor at Treliant, manages the firm’s Credit Risk services for banking, FinTech, and mortgage clients. Tom has over 30 years of experience in both the industry and as a consultant. Previously, Tom has held executive roles at SunTrust (now Truist), including, most recently as Corporate Executive Vice…
As we enter 2021, credit markets continue to face stress. Although a vaccine promises an eventual end to COVID-related impacts on credit, pandemic-related risks are a critical component of the year’s credit risk outlook. With widespread vaccine distribution unlikely before summer 2021, many businesses will continue to experience disruptions.
Small businesses are particularly stressed. Many businesses have already failed and others will not survive an additional six months of lockdowns and restricted activity. Some current estimates forecast a failure rate of 50 percent for small businesses across the U.S.
As the impacts of COVID continue to ripple through the economy, they will vary by economic sector and region. In addition, despite declining unemployment claims during the late summer and fall of 2020, the second wave of COVID brought a spike in unemployment claims in December. The Federal Open Markets Committee expects GDP to rebound in 2021, but unemployment will decline at a slower rate and will not return to pre-pandemic levels until 2023. The net result is likely to be a slow economic recovery.
In addition, the Federal Reserve has indicated that interest rates are likely to remain flat for the next two years. As a result, banks’ net interest margins will remain compressed. When compressed margins are combined with the potential for adverse credit markets and increasing needs for capital, the next few years will be difficult for banks.
In 2020, lenders made numerous accommodations to both consumer and commercial borrowers as a result of the COVID pandemic. Economic recovery effects are a key consideration in the 2021 credit risk outlook and will impact the status of borrower accommodations.
Ongoing Disruption in Commercial Real Estate
First, we will consider commercial real estate (CRE) markets, which have been significantly disrupted by COVID, and where the effects will persist for an extended period. Lockdown-driven business closures have interfered with current tenant abilities to make rent payments, especially in the retail, personal services, hospitality, and multifamily residential sectors. Shopping malls have been hard hit, and recovery may require repurposing existing space.
Some changes initially driven by COVID may be permanent. Global Workplace Analytics predicts 25-30 percent of employees will continue telework multiple days per week, permanently. Several companies have announced permanent remote work policies for at least portions of their staff. If this is the beginning of a trend, rental income and values for office space will continue to decline.
There are intense revenue pressures on multifamily properties, since unemployed and under-employed tenants are delinquent in rent payments and eviction moratoria are in place. Despite relief efforts by government-sponsored enterprises (GSEs) such as Fannie Mae, there are limited support options for property owners, and owners of small multifamily properties may face significant hurdles to property retention.
Even after eviction moratoria end, there is no guarantee that owners will recover past-due rents. Further, the remote work arrangements developed during the pandemic may lead to flight from urban cores and additional downward pressure on market rents.
There are other stresses facing the CRE market as well. Although CRE prices declined during 2020, CRE capitalization rates remain relatively low. Banks are tightening lending standards for CRE loans. The expiration of the Federal Reserve’s Term Asset-Backed Securities Loan Facility (TALF) could exacerbate risks in the CRE market, since both commercial mortgage-backed securities and Small Business Administration securitizations with CRE mortgage collateral represent the large majority of assets pledged as collateral for TALF loans.
In short, the worst-case scenario is a complete reset of CRE portfolios and a return to strict cash flow-based valuation and underwriting. Lenders may need significant workout expertise that is no longer available in their employee base.
A Stressed Residential Mortgage Market
Accommodations on one- to four-family residential mortgages are coming to an end. Under the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), borrowers whose mortgages were backed by the federal government or a GSE could request forbearance of up to 12 months. Borrowers will begin reaching the end of their 12-month CARES Act forbearance periods in March 2021 unless Congress extends this benefit. Above-average unemployment rates are expected to continue after forbearance periods expire, causing an increase in distressed mortgages. In 2020, Federal Housing Administration loans reached the highest delinquency rates since 1979. If this trend continues, 2021 could be worse than 2008-2009.
For borrowers that cannot afford any repayment plan, home disposition strategies, such as property sale, deed-in-lieu, short sale, or foreclosure may have to be considered. However, the effects will vary significantly by geography, since some locations are also experiencing significant home price appreciation. Distressed borrowers in those areas will have more flexibility in workout options.
Forbearance resolution options will require servicers to staff with specialized skillsets and utilize analytics in order to assess in a timely fashion each borrower’s situation and ability to repay debt. Servicers are likely to need additional staffing to process peak volumes. Staffing concerns will be exacerbated at mortgage servicers that are also lenders, as high volumes of refinancing continue.
High levels of mortgage restructuring will have a trickle-down effect on both capital and lender bond ratings. Any restructured residential loan has the potential to be classified as a Troubled Debt Restructuring (TDR), and TDRs have higher capital requirements than mortgage loans. A sharp increase in TDRs would result in a significant increase in capital requirements. And unlike commercial loans, which cease being TDRs after 12 months of paying as agreed, residential TDRs remain TDRs. During the mortgage crisis, numerous banks saw bond rating downgrades based on performing mortgage TDRs.
The Restructuring of Consumer Credit
In addition to mortgage accommodations, many lenders offered accommodations on other types of consumer credit, including credit card, auto, and personal loans. If borrowers are not able to return to normal repayment terms, these accommodations may also result in troubled debt restructuring, charge-offs, or repossessions. As with mortgage servicing, lenders may lack sufficient staffing to handle the volume of delinquent borrowers needing assistance.
Persistent Pressures on Business Lending
With respect to commercial loans, the impacts of COVID will persist, especially in sectors most affected by social distancing and travel restrictions. Large companies are seeking bankruptcy protection at a record pace. Small businesses are acutely troubled and are less likely to have capital buffers to survive the economic impact of the pandemic.
The American Bankruptcy Institute expects 2020 bankruptcies to increase more than 36 percent over 2019. Womply, a credit card processor serving small businesses, reported about 20 percent of its customers have closed their doors. Yelp indicates that more than 100,000 small businesses have closed permanently during the pandemic. A December 2020 survey by Alignable, a small business online referral site, finds that 48 percent of small businesses are at imminent risk of failure. More than 85 percent of woman- or minority-owned businesses report needing additional funding to survive.
On a positive note, with the Consolidated Appropriations Act 2021 (CAA2021), Congress made it easier for small businesses to obtain full forgiveness of Paycheck Protection Program (PPP) loans. The act permits certain businesses to receive a second forgivable PPP loan, lets other businesses receive an increase in a prior PPP loan amount, and allows PPP loans to certain 501(c)(6) nonprofits, such as business associations.
CAA2021 implemented a simplified forgiveness process for PPP loans of $150,000 or less and provided more flexibility for PPP borrowers to determine the covered period for forgiveness applications. CAA2021 also expanded the types of business expenses that can be used to qualify for PPP forgiveness. In addition to the payroll costs, mortgage interest, rent, and utilities included in the CARES Act, CAA2021 added operations expenditures such as software and cloud computing services, payroll processing, sales and billing, accounting, and inventory management; property damage costs related to looting or vandalism that was not covered by insurance or other compensation; payments to suppliers for goods essential to business and made pursuant to a contract, or ordered prior to the PPP-covered period; and worker protection expenditures to comply with COVID-19 guidance.
Further, Economic Injury Disaster Loan advances will not be deducted from PPP forgiveness. CAA2021 also overruled the Internal Revenue Service determination that a PPP borrower could not claim a deduction for otherwise deductible costs covered by a forgiven PPP loan and revised the definition of “payroll costs” to explicitly include dental, vision, disability, and group life insurance.
However, it is abundantly clear that that there was significant fraud in the PPP program. Even if the lender ultimately is not held responsible for borrower fraud in PPP applications, fraud in a lender’s PPP portfolio is indicative of failures in “Know Your Customer” and other Customer Due Diligence processes, with implications for the adequacy of the lender’s anti-money laundering program. In addition, the Small Business Administration Inspector General recently recommended that PPP lenders be required to verify that an applicant’s business was established before the mandated date and that the loan amount does not exceed the maximum per employee, the maximum number of employees, or other applicable size standards.
Lenders should review their PPP portfolios to self-identify potential problems in advance of regulatory inquiries and prepare for the additional PPP lending authorized by CAA2021.
Depressed Travel and Entertainment Sectors
The travel and entertainment industries are expected to be particularly slow to return to a more normal performance, though economic pain is spread unevenly.
Business travel is unlikely to return to normal until COVID vaccinations are widespread. Tourism travel will remain depressed, although consumers weary of lockdowns are expressing pent-up demand and travel agents are reported to be booking vacation travel for the first half of 2021.
The restaurant industry remains hard-hit, with the National Restaurant Association reporting that sales remain lower while the costs of compliant operations are increasing. Credit card processing data shows that restaurant spending remains significantly lower than pre-pandemic levels, and dining establishments will continue to suffer until in-person dining returns to normal.
The Alignable survey found 62 percent of small travel and hospitality businesses, 45 percent of restaurants, and 43 percent of entertainment companies were at risk of failure. According to Cirium, worldwide passenger air travel was down 67 percent in 2020, returning to 1999 levels. Consumer services, such as gyms, salons, and spas, are also hard hit, with more than 60 percent at risk of failure.
Struggling Oil and Gas Industries
Oil and gas may struggle well into 2021. Global demand in 2021 is expected to remain below pre-COVID levels, especially if there are more regional lockdowns. Recovery in the broader economy, combined with Biden administration commitments to clean energy, will drive recovery in the oil and gas sector. Yet a commitment to clean energy may mean additional taxes on oil and gas consumption.
Domestic oil production is only marginally feasible at the $50-per-barrel range at which it’s been priced during the pandemic, and the future of shale oil is particularly uncertain. Overcapacity will place pressure on market participants. Oilfield services and refineries may face greater pressures than the industry as a whole. Natural gas demand is expected to decline in 2021, driven by lower demand in the electric power sector.
Mixed Retail Prospects
Retail is more of a mixed outlook. Small businesses in the consumer retail space have suffered significantly, lacking online sales capabilities and having less capital and reserves to survive a prolonged recession. Businesses relying on in-person sales have not operated at full capacity since March 2020, but businesses with robust digital sales capabilities have benefitted from the lockdown-driven shifts in consumer spending practices.
This remained true during the 2020 holiday season, when in-store sales declined significantly as the coronavirus resurged. Moving into 2021, online retail may stabilize, but brick-and-mortar retail will continue to feel the effects of lockdowns and social distancing requirements. The National Retail Federation expects greater investment in supply chain security and reverse logistics technologies as a result of the supply chain disruptions experienced in 2020.
Beyond COVID, lenders will feel the impact of regulatory changes. Although the changes may not directly affect creditworthiness, they will affect the cost of lending.
One example of this is the Financial Accounting Standards Board’s Current Expected Credit Loss (CECL) standard. Although CECL was scheduled to take effect in January 2020 for large public companies, the CARES Act provided those firms the option to delay CECL implementation until the end of the year. For companies that took advantage of that option, CECL requirements took effect in January 2021. Implementation was postponed until January 2023 for smaller public companies, private companies, and nonprofits.
Industry observers expressed significant concerns regarding the impact of CECL after member testing of credit loss estimation models indicated that CECL would increase procyclicality. Greater procyclicality exacerbates economic downturns, causing the downturns to be more severe and to last longer. It also increases the cost and decreases the availability of credit, especially for non-prime borrowers or those seeking longer-term loans. Based on estimates from banks that were early adopters, CECL has resulted in higher credit loss reserves for lenders with substantial portfolios of consumer or longer-term loans. Changes in economic scenarios due to the lingering effects of the pandemic may intensify this impact. The new standard is also expected to increase the volatility of loan loss reserves, income, and capital.
A Challenging Year for Lenders
In short, the credit outlook for 2021 is turbulent. Lenders will face challenges related to economic conditions, borrower health, and regulatory changes. Some of the challenges related to the economy and distressed borrowers will be specific to particular credit sectors or will vary by geographic region. Others will be widespread. The impacts of the pandemic may persist for several years. To prepare, banks should assess their staffing and systems for capacity and skills to handle rising workout volumes, evaluate adequacy of customer due diligence in prior PPP lending, and determine whether their capital and liquidity positions are strong enough to meet their needs.