Early cracks start to show in banks' commercial loans

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Move over, deposit costs. The health of commercial borrowers is now a major source of hand-wringing among bank investors.

Problems in business loans have risen in recent months as companies that were in a weak financial position have started closing up shop. The environment remains relatively benign, and few analysts expect the credit worsening to get nearly as dire as it did after the 2008 financial crisis.

But it's clear that the starting gun has gone off in what analysts call "credit normalization." Bank loans were unusually healthy during the pandemic, but now more commercial borrowers are running into trouble, and bankers are starting to write off soured loans.

Some bankers have described the issues as "one-off" problems with specific borrowers, rather than anything indicating broader stresses in their loan portfolios. But investors worry those isolated events will start piling up next year. The difficulty in gauging which banks will face more trouble is prompting many stock buyers to stay away from the sector as a whole.

"The problem that a lot of these investors are facing right now is that it's hard to get your arms around credit quality and how the banks are going to perform in a worse credit environment," said Andrew Terrell, a bank analyst at Stephens.

During this year's third quarter, net charge-offs rose to 0.11% of average loans at the regional and community banks that Stephens covers, up from 0.04% a year earlier. Those numbers include both commercial and consumer charge-offs.

U.S. consumers experienced stress earlier than businesses, as inflation, high interest rates and depleted savings caused some to fall behind on their credit card payments. At many credit card issuers, charge-offs are nearing or have already surpassed pre-pandemic levels. 

Regional banks have been relatively insulated from consumer pressures since many of them have smaller consumer books. But worries over their commercial real estate portfolios persist, and their non-real-estate loans to commercial borrowers are starting to turn, even if problem loans remain at mild levels.

One recent corporate bankruptcy caused some tremors. Mountain Express Oil, a Georgia-based company that distributed oil to hundreds of gas stations, had gotten a $218.5 million loan from a group of banks. But the oil distributor filed for liquidation, and the banks involved in the loan now say they're unlikely to recover any of the money they lent. That's a tougher pill to swallow than a reorganization bankruptcy, where some recovery is likely.

The 100% loss rate was unexpected and added to investors' usual wariness of banks' participation in syndicated loans, said Chris McGratty, an analyst at Keefe, Bruyette & Woods. Unlike loans directly to businesses, syndicated loans leave banks at a distance from the borrower, which means they have less control when things go south. Losses tend to be larger and less predictable.

In their third-quarter earnings calls, the CEOs of affected banks said the Mountain Express Oil issue was a one-time event. And they expressed confidence in the rest of their syndicated loan exposures.

Other than that one loan, the balance sheet at First Horizon "continues to perform very well," CEO Bryan Jordan told analysts last month. The Memphis, Tennessee-based bank led the Mountain Express Oil syndicated loan.

Concerns over the oil distributor's bankruptcy were understandably "magnified," since it followed a long period where investors didn't have to worry much about the health of bank loans, KBW's McGratty said.

"There's going to be a normalization process — it's well underway," he said. "It's still fairly good, but the trend is moving against us."

Nowhere is that trendline clearer than in the trucking sector, which is in dire financial straits after booming during 2020. Consumers spent big on furniture, electronics and appliances as they stayed home during the pandemic. But they rapidly shifted toward travel, entertainment and restaurants as the world reopened, causing a crisis for trucking companies that suddenly had less inventory to ship.

The trucking giant Yellow Corp. filed for bankruptcy in August, part of a bloodbath that's taken down decades-old companies.

A large concentration in trucking loans appears to have been behind the failure of a small community bank in Sac City, Iowa — the fifth bank failure this year. The bank was tiny, with just $66 million of assets, but regulators had previously dinged it for being too exposed to trucking and shut it down because of "significant loan losses."

Trucking loans likely make up a far smaller share of total loans at many other banks, which can get in trouble with regulators for being too exposed to any one sector. But any loan losses in one area lower the cushion they've built up to absorb troubles elsewhere.

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Other commercial sectors don't appear to be undergoing that kind of pain, said Stephens' Terrell. But within various industries, some companies that were already struggling are suffering as high interest rates take a toll.

"When times are really good, you've got air cover to restructure anything you want," Terrell said. But as the cycle turns, the "weakest operators go first."

Bankers say they're keeping a close eye on their commercial real estate portfolios, particularly office loans. Occupancy rates in office buildings have fallen amid the rise of remote and hybrid work. Banks are stashing away reserves in case those loans go bad and are marking more CRE loans as "nonaccrual" credits, according to the ratings firm Fitch Ratings.

Any problems will likely "disproportionately weigh on regional banks, which have relatively higher CRE exposure," Fitch analysts wrote in a note this week.

"However, banks are generally well positioned to absorb further 'normalization,'" they wrote.