Banks that offered payment deferrals to borrowers struggling through the coronavirus pandemic now face one key question: How many of these borrowers will make it through, and how many will default? The answer will determine the level of loan losses that U.S. banks ultimately have to absorb during the current credit cycle.
Second-quarter earnings reports will begin to provide some perspective, although analysts say it could be many months before there is full visibility.
Policymakers have encouraged banks to help customers hurt by the pandemic, and payments have been temporarily suspended on perhaps 7% of loan balances across the industry. Many deferrals involve fixed six-month or three-month periods, with the latter past or nearing expiration on the earliest forbearances. Tens of thousands of businesses have likely already closed permanently amid disruptions caused by COVID-19 and efforts to slow its spread.
Gary Tenner, an analyst for D.A. Davidson, said banks will probably conclude that some business borrowers have been irreparably damaged, and that some loans are not viable, as the end of initial deferral periods approach. However, he expects that the bulk of charge-offs will not register until the fourth quarter and into 2021.
"There's going to be probably some discovery towards the tail end of this deferral window," he said. But "there's probably going to be some lag to some of the discovery of those kind of situations." Moreover, longer deferral periods and extensions of expired ones will push off recognition of losses, Tenner said.
Timothy Coffey, an analyst with Janney Montgomery Scott, expects that second-quarter results will begin to indicate the bigger deferral picture. "I don't expect we're going to have a perfect view on how many of the deferred or modified loans are potential charge-offs," he said. "The tells will be: who have the banks decided to charge off right now? What percentage of modifications are those? What percentage of modified loans have been granted an additional 90 days?"
Overall, analysts anticipate that median charge-offs as a percentage of loans will jump 16 basis points from the first quarter to 53 basis points among a group of banks with more than $50 billion of assets, after registering no increase in the previous quarter. Consensus forecasts expect the increase to accelerate in the third quarter, and reach 1.06% in the fourth quarter and remain elevated into 2021. The pattern is roughly similar for smaller banks, with charge-off rates progressively ratcheting higher starting in the second quarter, though staying at lower levels than at large banks.
Loss provisions surged in the first quarter as the economic threat posed by the pandemic, and the prospect of massive amounts of delinquencies and defaults, came into focus. Analysts generally expect even bigger provisions in the second quarter — Wells Fargo & Co. said its allowance build would be "substantially higher" — as banks seek to establish reserves for lifetime losses under current expected credit loss accounting.
Reserving will accelerate as the nation's largest banks strive "to put questions about loss coverage behind them," Keefe Bruyette & Woods analyst Brian Kleinhanzl said in a June 30 note. For large regional banks, KBW analyst Brian Klock wrote in another note that he expects the bulk of the provisioning and reserve building to occur in the second quarter.
Consensus forecasts anticipate that provisions will remain high through at least the first quarter of 2021, although provisions would increasingly be devoted to replenishing reserves drained by charge-offs if analyst forecasts are accurate.
Some banks have already said that compensating for depletion from charge-offs will be a substantial component of second-quarter provisions.
In a presentation June 24, Banner Corp. said that "loss emergence has been light" in the second quarter, and "centered on small balance commercial loans." Nevertheless, the bank, which has $12.78 billion in assets, forecast charge-offs and impairments of $5 million to $7 million in the second quarter, a big jump from the first quarter, when recoveries exceeded gross charge-offs by $404,000.
Overall, Banner projected a second-quarter loss provision between $27 million and $36 million, up from $23.5 million in the first quarter. Management attributed $14 million to $17 million of the anticipated provision to downgrades in loan risk ratings, concentrated among loans that have been granted deferrals and extended to borrowers in sectors suffering first-order effects from the pandemic, such as restaurants and hotels.
Coffey said that Banner "is an example of a bank that's already being proactive in preparing for what they think could be sizable charge-offs later this year."
Analysts also say they expect the performance of loans with payment deferrals to depend in part on different approaches to modifications, with "some banks providing much more in the way of blanket deferrals, just for the asking, versus other banks that have pushed back much more on those requests," according to Tenner.
"I could make an argument for both approaches," Tenner added. Banks that have insisted on more collateral and upfront payments may be wise to have sought the additional protection. But for customers that are able to recover strongly, "a more generous level of approval of deferrals gets you through potentially this down period and perhaps saves a lot of those customers and businesses. And, over time, also reduces your losses."
Ultimately, credit costs remain dependent on the course of the pandemic, and how far new outbreaks go in choking off early signs of a fast rebound in economic activity.
"We don't know and the banks don't know," Coffey said.