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Navigating the Liquidity Crisis

By: Chris Nichols

The liquidity crisis in the capital markets has presented community bankers with both an opportunity and a challenge in the second half of 2007.

In this environment, where credit is tighter and many non-banks have been sidelined, community bankers have a unique opportunity to capture business because finance companies, conduits and many larger banks are now hamstrung by lower liquidity. As a result, community banks have a better chance of winning loan business and at wider margins.

However, this opening in the marketplace comes with higher risk. To capitalize, community bankers must better understand loan structure and value, while at the same time, place greater emphasis on risk management.

Impact of less liquidity

Prior to the end of July 2007, many large banks, finance companies and broker-dealers established single-purpose companies to originate long-term, fixed-rate loans that they would fund using a combination of warehouse lines and commercial paper. Once funded, loans would be securitized and sold to investors around the globe. Because of the spillover effect to liquidity caused by the subprime residential mortgage market, both short-term and long-term credit spreads have increased to their widest levels since the mid-1980s. In the process, these loans are no longer profitable ó not due to credit but due to the cost of liquidity.

Community banks are under no such liquidity constraint. They can readily tap their balance sheets to expand long-term lending, particularly in the area of commercial real estate. Currently, established commercial real estate projects continue to perform at near-historical low loss rates. Given the problems in the capital markets, it is highly likely that the problems with liquidity will start to impact credit and cause greater losses in general commercial lending. This contagion should not be widespread, which has presented community banks an excellent opportunity to increase loan growth. Commercial loans that were being priced at Libor + 80 bp back in June 2007 are now at Libor + 1.50 percent and are expanding to the Libor + 2 percent-range.

Evaluating risk

The opportunity obviously comes at a risk. Because a well-structured, long-term loan is more profitable than a construction loan on a risk-adjusted basis due to higher discounted cash flows, the added risk is often worth it on a quantitative basis. That said, before a community bank embarks on a campaign to increase market share in this area, management should ensure that its bank has the ability to safely expand its portfolio.

To achieve that objective, itís vital to have the experience to underwrite not just collateral but also a propertyís cash flow. In addition to understanding the cash flow on the base case, shocked scenarios must be run for the individual loans and the entire portfolio. Banks should also be guided by a loan pricing strategy and model that quantify the risk with the latest available information. Ascertaining the latest probabilities of default, prepayment speeds and loss given defaults on a potential loan is also crucial. Without a disciplined loan pricing strategy, many community bankers will misprice risk and inefficiently allocate capital and resources.

Bankers must also feel comfortable with loan structuring components and use them to their advantage. Leveraging prepayment penalties, securing more granular credit covenants and swapping long-term interest rate exposure to a floating return is mandatory for banks looking to be competitive.

Finally, banks need to ensure they have adequate monitoring capabilities so that ongoing portfolio management can be enhanced. Receiving and analyzing rent rolls, maintenance expense, property valuations, default/recovery rates and management will alert banks to problems before they occur. Loan origination and portfolio management is one of the most important elements of banking. Yet, far too many banks fail to utilize a quantitative approach.

For community bankers in the West, a more aggressive loan origination strategy, coupled with enhanced risk management, can grow net income and ROE. Bankers who increase their underwriting capabilities, utilize a loan pricing model and structure loans to optimize long-term profit will grow earnings despite a slowing market. Bankers who sit pat will end up putting their institutions and their shareholders at greater risk for the future.

Chris Nichols is CEO of Banc Investment Group, the broker-dealer subsidiary of Pacific Coast Bankersí Bank. He can be reached at 415-399-5800 or cnichols(at)bancinvestment.com.

Copyright October-November 2007 Western Banking (BankNews Publications)


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