Credit-quality pitfalls that bankers should watch in 2023

December 29, 2022 11:42 AM

Fears are simmering that inflation (and aggressive interest rate hikes to fight it) could push the economy into recession in 2023. Historically, the combination has indeed caused economic turbulence.

The Federal Reserve this year lifted rates multiple times. Collectively, they marked the biggest increases since the early 1990s. A resulting downturn would pose elevated credit risks for banks. During recessions, borrowers are more likely to default on their loans.

To be sure, the vast majority of banks posted continued solid credit quality with third-quarter earnings, and many said they expected more of the same with four-quarter earnings reports in January. But executives are paying closer attention to potential threats as the industry moves into the New Year.

Against that backdrop, here are four areas bankers and analysts are watching with some trepidation.

Small-businesses vulnerabilities

Analysts say small businesses are more exposed to soaring inflation and rapidly rising interest rates than larger companies. Owners of small operations tend to work on narrower margins and may struggle to absorb rising costs if their customers pull back on spending in 2023.

This, in turn, could make it more challenging for businesses to repay existing loans.

Robert Bolton, president of bank investor Iron Bay Capital, said that optimism is waning in areas of the country where populations are stagnant or in decline. He suspects that, should small-business loans sour in coming quarters, it would likely begin in these areas.

"The level of caution is more pronounced when you get away from the more vibrant cities," Bolton said.

Empty offices

Expiring office leases and an enduring shift to remote work could pinch landlords and leave them poorly positioned to make loan payments in the year ahead.

More than 240 million square feet of office leases — about 10% of the U.S. market — is expected to expire in 2022, according to data from the real estate services company Jones Lang LaSalle.

As lease agreements culminate, more businesses are expected to scale back on office space, given that more of their staffers are working from home since the onset of the pandemic. Other tenants may demand lower rents, according to the data analytics firm Trepp.

What's more, soaring inflation is affecting labor and travel costs, giving companies added motivation to trim real-estate expenses and leaving more landlords to grapple with rising vacancies.

"Does the shoe drop on credit quality? That's hanging out there across the industry," said Jacob Thompson, managing director at Samco Capital Markets.

Hotels: Renewed trouble ahead?

Vacationers are staying in hotels at near pre-pandemic levels, and business travel for conferences and meetings regained momentum this year. Banks that serve the hospitality industry report sound credit conditions — marking a rebound from the slump that hotels waded through amid the onset of coronavirus outbreaks.

Still, the pandemic demonstrated that business travel is particularly vulnerable in a downturn. With the shift to remote work and the rise of virtual events, bankers say businesses could quickly pull back on travel to save money in a recession. Hotels and resorts could endure another round of pain as a result.

In a sharp downturn, consumers would delay vacation plans, too.

"We'd almost certainly see significant stress in hospitality … in a deep recession," said Michael Jamesson, a principal at the bank consulting firm Jamesson Associates.

Susceptible consumers

American consumers held strong this year amid a sturdy job market. The U.S. economy consistently added jobs throughout 2022.

However, worried about a recession that could drive job losses, banks with big consumer books — including Wells Fargo in San Francisco and JPMorgan Chase in New York — boosted loan-loss provisions in 2022 to prepare for potential consumer loan losses in the year ahead.

Banks are focusing on areas such as credit cards and adjustable-rate mortgages, where higher interest expenses could overburden borrowers.

Consumers themselves are bracing for harder times. The University of Michigan's Index of Consumer Sentiment produced a reading of 59.7 in December. That was far below the year-earlier level of 70.6.

Sentiment "remains relatively weak," said University of Michigan economist Joanne Hsu, director of the index.