The Worst Loans Are Made in the Best Times: Credit Managers Lead the Fight Against Complacency
by Rita E. Garwood January/February 2018
With a record-breaking year on the books, the equipment finance industry has benefitted from a lengthy economic expansion. While it can be easy to relax into the false sense of security a period of abundance can bring, credit managers continue to exercise caution, keeping a vigilant eye out for the slightest negative signs or factors that may affect business.
In November, the National Association of Credit Management’s Credit Managers’ Index reported a combined CMI of 56.6, and its index of favorable factors jumped to the highest reading in several years (65.7). However, in December, the combined CMI took a step backwards to 54.2 and favorable factors plunged to 59.4. Despite this setback, both the CMI and favorable factors were up year over year.
“2017 was an excellent year from a credit perspective,” says Kevin Prykull, senior vice president and credit underwriting executive at PNC Equipment Finance. “Credit quality of new originations was solid throughout the year. Overall credit metrics remained strong, portfolio quality good and performance stable. It was one of best years that we have seen in a long time — all the things that credit managers like to see.
“Barring any systemic shocks to the economy, 2018 should yield similar credit results, with perhaps some modest deterioration. The exceptional credit performance experienced in the last several years is not sustainable in the long run or reflective of a typical mid-to-late phase economic cycle. So a slight deterioration in credit metrics in 2018 is anticipated and should not be viewed as a concern.”
“In 2017, Marlin saw credit metrics make a ‘return to normal’ for a healthy economic cycle,” says Lou Maslow, senior vice president and chief risk officer at Marlin Business Services. “Over the past several years, Marlin and the equipment leasing industry have enjoyed abnormally low delinquency and losses. We remain optimistic about the economy in 2018 and expect portfolio performance to be consistent with what we have seen during 2017.”
“The economy has been on a slow, positive trend for several years now, and I believe that optimism is currently outpacing the economic data to some extent,” says Scott McCann, senior credit manager of Bank Channels at Wells Fargo Equipment Finance. “The recent run-up in the stock market seems to be primarily due to the recent passage of the tax reform bill, which places pressure on political and business leaders to deliver stronger results in 2018 and beyond.”
More evidence of credit manager optimism in 2017 could be seen in the NACM sales category, which reached an almost record high of 68.3 in November before falling to 59.2 in December. Again, despite this drop, the sales category was an improvement from 58.6 recorded in December 2016.
“Notwithstanding the significant drop in December, we presume the optimism was based on expected economic expansion in 2018 with additional stimulus coming from tax reform which recently passed,” Maslowe says. “At Marlin, we anticipate significant growth in 2018 driven by increasing opportunities through our dealer channel as well as our existing customers.”
“Stable credit metrics and manageable portfolio quality have created a more competitive environment in equipment finance and for other capital providers,” McCann says. “As a result, we have seen more competitors enter the market, which has further pressured margins. I do not see this changing anytime soon, absent a major market-changing event.” According to the Thomson Reuters/PayNet Small Business Delinquency Index, delinquencies were down in 2017. Was this trend also experienced across the equipment finance industry?
“Wells Fargo Equipment Finance’s experience is consistent with the index,” McCann says. “Economic data is strong, but a geopolitical event, such as in North Korea or the Middle East, could change things overnight. Expectations are that delinquencies will grow next year, primarily because we are very long into the current cycle, and the trend has to change at some point. As the saying goes, ‘Each day that passes brings us one day closer to the next recession.’”
“Like all of our credit metrics, delinquencies remained quite good in 2017,” Prykull says. “We anticipate similar results in 2018. As mentioned previously, some slight deterioration to the exceptional results is expected.” “Marlin experienced an increase in delinquency in 2017 in part due to the maturation of new business verticals entered in the past few years as well as a return to more normal delinquency levels,” Maslowe says. “Overall, portfolio performance remains very satisfactory.”
No matter how great a year can be, there are always sectors that fare better and worse than others. We asked the credit managers the proverbial question: which sectors are hot right now and which sectors warrant limited exposure?
Prykull would limit exposure to traditional brick and mortar retail, small, private liberal arts colleges, oil and gas service providers and any related exposure. “With the passage of tax reform and government support of infrastructure development, companies and equipment germane to such should benefit and attract capital and be worthy of additional extensions of credit,” he says, advising increased exposure in these sectors.
“We are being cautious with retail credits given the changing dynamics regarding online retailers versus brick-and-mortar operators,” McCann says. “The auto segment appears to be cooling off, and energy continues to be challenging due to volatile commodity prices. As for expansion industries, we continue to focus on several of our specialty verticals, including healthcare, food processing and certain segments of technology.” Contributions from the Capitol
The power shift in Washington caused a surge of optimism in early 2017, with the Equipment Leasing and Finance Foundation’s monthly confidence index reaching an all-time high of 73.4, but did that confidence translate into concrete results? If the most recent record-breaking ELFF monthly confidence index of 75.3 is any indication, the answer is yes. However, our panelists have different opinions on this topic.
“The recent tax law reform is a concrete result to materialize from D.C.,” Prykull says. “Tax reform should generally have positive financial implications for our lessees, encourage capital spending and favorably impact the equipment financing business.”
“Equipment leasing through November of 2017 enjoyed new business volume growth in excess of 5% according to MLFI, while Marlin’s new business volume grew more than 20%,” Maslow says. “There is little doubt that optimism in the business community about lower taxes and reduced regulation contributed to the growth.”
“I believe that while recent economic data, such as GDP growth in excess of 3% annualized in the two most recent quarters, are encouraging, much of the optimism is as of yet unfulfilled,” McCann says.
Many in the industry appreciate the Republicans’ mission to scale down regulations. The equipment finance industry has a wish list of myriad regulations it would like to curtail, but which changes would be most beneficial from the perspective of credit managers?
“Two regulatory requirements could negatively impact the equipment finance industry’s ability to serve its customers,” Maslowe says. “FinCEN’s [the Financial Crimes Enforcement Network] beneficial ownership rule is a significant concern given the lack of publicly available information on small businesses. The second is Dodd Frank Section 1071, which requires collection of demographic data about commercial borrowers. These two regulatory requirements will likely slow our industry’s ability to satisfy the financing needs of our customers and at the same time increase costs due to the increased time needed to satisfy these requirements.”
“Many of us in the industry would agree that we have spent considerable amounts of time and money in improving our compliance process,” McCann says, highlighting the efforts made toward Know Your Customer (KYC) Bank Secrecy Act (BSA)/Anti-Money Laundering (AML) requirements. “I do not believe there would be much support for reducing those regulations, but a smaller change around flood insurance would be helpful. Under the current rules, we have seen our ability to provide capital to many small business agricultural operators negatively impacted by the flood insurance regulation. This has a real impact on our customers and to some extent the broader economy.”
“Regulation of the financial services industry is not in itself a bad idea,” Prykull says. “However, the concern we have is a lack of clear guidance in interpreting and consistently applying these rules across the financial services industry to promote a level and fair playing field for all the participants and our clients.”
Another regulatory body, the Financial Accounting Standards Board, issued the final current expected credit loss standard in June 2017. How can credit managers prepare for implementation?
“Data quality is key,” Maslowe says. “I suggest that credit managers focus on making sure that historical portfolio data that will be utilized to model lifetime losses is clean and accurate. This will be necessary not only for loss modeling purposes, but also to satisfy future disclosure requirements.”
“As part of a large financial institution, our parent company is taking the lead on CECL for the organization at large,” Prykull says. “There is not much impact at the line of business level to any large extent, yet.” “We view this change as primarily an adjustment to accounting methodology, and therefore our credit practices and standards will not change,” McCann says.
The Impact of Technology
Technology has transformed the way we live and work, and headlines about artificial intelligence appear in the news every day. How has technology changed the process of risk management, and what could AI developers create to enable credit managers to be more efficient and productive?
“The fundamentals of credit evaluation and adjudication have not really changed during my more than 38-year career within the equipment finance industry,” Prykull says. “However, the change in technology has dramatically impacted the speed and quality of how we underwrite, adjudicate and manage credit. Such effect has been most dramatic with smaller-sized transactions with the advent of automated credit scoring to approve credit and with behavioral scores and modeling to manage the small ticket portfolio. Artificial intelligence will add a whole new dimension to the discipline of credit underwriting and portfolio management in the future, particularly within the larger-ticket environment.”
“Technology and the availability of internal and external data have significantly changed risk management since the beginning of my career in the 1980s,” Maslowe says. “Technology and data have facilitated the development of sophisticated credit models that help decision small ticket applications in an accurate and cost effective way. Loss forecasting with accurate PD’s and LGD’s is another risk management activity that has benefitted from technology enhancements. Artificial intelligence offers the potential to update credit models constantly based on changing portfolio performance and dynamics.”
“Technology has had a huge impact and will continue to do so,” McCann says. “Tools such as predictive data are helpful in making decisions on small homogeneous loan types, but are difficult to apply to middle market and larger credits. AI has its positives, but again I see it having limited application, as there is no substitute for the judgement of a well-trained, experienced credit professional.”
Charting a Course for 2018
New Year’s Day can provide a fresh start, but when you’re coming off a fantastic year, the pressure can mount. We asked our panelists about their primary goals and anticipated challenges of 2018.
Prykull says, in many respects, the goal for his team is to stay the course and adjust accordingly. “We need to be ever vigilant in recognizing any negative signs or factors that may impact the business, new originations or the portfolio at large. With an anticipated level of stable credit quality, our focus can be on process improvement and underwriting efficiency in 2018, along with emphasis on portfolio management.”
“Our primary 2018 credit management goals are to further enhance our credit scorecards and auto decision rates, strengthen our Enterprise Risk Management program and prepare for CECL,” Maslowe says. “As is typically the case, our greatest challenge has to do with managing ambitious goals with resource constraints. Fortunately, our team is up to the challenge.”
“We are focused on several objectives in the near term,” McCann says. “A couple that come to mind are continued credit discipline given the highly competitive environment and new talent development, which is critical to managing generational turnover as it occurs in all areas of our business.”
Prykull agrees that talent management in credit is a vital concern. “With the graying of our credit experts within the industry, developing and retaining solid underwriting and credit talent is essential for our future. Talent management matters not only for our entry level staff, but also for our mid-career and top-level leaders.”
But the worry that keeps Prykull up at night is complacency. “The prolonged period of exceptional credit results is not sustainable. We still operate within a cyclical environment that impacts the equipment finance industry. We need to remain ever vigilant and detect the slightest shift in factors that may impact our portfolio. We need to rapidly adjust and alter course on originations, which is never easy to do in such a benign credit environment. As credit folks like to say, the worst loans are made in the best of times.”
“In the near-term, I remain focused on making sure that we are taking maximum advantage of Marlin’s growth potential by ensuring that our underwriting focuses on optimizing risk-reward, while also keeping a close eye on portfolio performance trends,” Maslowe says. “Longer term, I remain concerned about a recession in 2019-2020 and the impact that the still-intense regulatory environment will have on Marlin’s business as we grow past $1 billion in assets in 2018.”
“The only sleep issues I have are when the coyotes are howling in the neighboring marsh,” McCann says. “Seriously, I sleep well knowing that we have a strong credit culture at Wells Fargo that appropriately balances sound risk management practices with serving our customers’ financial needs. That said, the length of the current economic expansion has naturally bred some complacency toward risk, so the challenge is to maintain discipline during ‘the good times,’ especially in the face of robust competition.”