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Soaring Loan Deferrals Offer Near-Term Relief But Will Bring Billions In Losses

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Soaring Loan Deferrals Offer Near-Term Relief But Will Bring Billions In Losses

Loan deferrals across the banking industry's loan books are in the high single-digits and could require many institutions to build reserves considerably to cover future losses.

The Coronavirus Aid, Relief, and Economic Security Act, passed in late March, permitted financial institutions to avoid classifying loan modifications related to the COVID-19 pandemic as troubled debt restructurings and accordingly require them to test for impairment. While small banks appear to have used deferrals the most, we estimate that deferrals made up 7.2% of the industry's loans at the end of the first quarter, based on disclosures from nearly 150 banks aggregated by analysts from Raymond James, Janney Montgomery Scott, Compass Point Research & Trading and S&P Global Market Intelligence.

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It seems likely that many of those deferred loans will move to nonaccrual status once the six-month forbearance period provided through the CARES Act ends, since borrowers opted for modifications for a reason. Several banks such as Bank of America Corp. have noted that 40% of borrowers taking advantage of the deferrals continue to pay interest on the credits, suggesting that not all the credits will end up in default. However, other large institutions such as JPMorgan Chase & Co. note that 20% of credit card customers asking for forbearance have asked for additional help.

Janney Montgomery Scott analysts estimate that 40% of loan deferrals could move to nonaccrual status once the forbearance period ends. Banks will likely impair loans that move to nonaccrual. Keefe Bruyette & Woods analysts estimate that losses on deferrals could reach 10%.

In our analysis, we assumed that 30% of deferrals will become nonperforming and then would incur a loss given default just shy of 55%. That assumption was based on banks' loss experience from 2007-2009 and a Federal Deposit Insurance Corp. study on loss given default on assets at failed banks during the Great Recession. If that occurred, losses on deferrals would reach $128 billion, or roughly 7.5% of the industry's tangible common equity at the end of the first quarter of 2020.

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We assumed that the deferral and loss experience would be different across asset groups. Publicly traded bank disclosures show that smaller community banks have offered deferrals to their customers in the high double-digits. The level of forbearance declines as banks get larger and stood at just 3.20% among the nation's largest banks. However, loss given default has historically been lower among smaller institutions and was estimated to be slightly below 40%, leaving their potential loss content on comparable footing to larger regional banks that have not used deferrals as often.

Reserve levels at larger regional banks more than covered the amount of potential losses on loan deferrals on their books, while reserves are estimated to stand at just under 60% of deferrals at institutions with less than $1 billion in assets. But most small banks have not yet adopted the Current Expected Credit Loss model, which required institutions to reserve for future losses across the life of their portfolios. The new accounting methodology led to a sizable increase in reserves in the first quarter.

While deferral practices appear quite different when comparing large and small banks, the experience across regions appears much more similar. Deferrals appear highest in the Southwest, with an estimated 10.2% of loans in deferral. The West and Northeast followed closely with 10.1% and 9.7% of loans in deferral, respectively. Banks in the Southwest could record the largest losses on deferrals relative to their equity as well, with potential losses equating to 13.0% of tangible common equity in the first quarter.

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Just how large losses are will depend on the shape of the economic recovery and underwriting practices at a given bank, but it seems hard to debate that deferrals likely carry more risk than many other loans. The KBW analyst team has also tracked the capital at risk from the surge in deferrals by adding them to the numerator of the Texas ratio, which measures the risk of bank failure. The historical Texas ratio compares a bank's nonperforming assets and loans 90 days or more past due to its tangible common equity and loan loss reserves. A ratio of more than 100 indicates a higher risk of failure since the amount of assets at risk exceeds the capital and reserves on hand.

KBW's modified Texas ratio adds deferrals to nonperforming assets since they also put capital at risk. Given the sizable amount of deferrals across the industry, particularly among smaller institutions, the estimated, modified Texas ratio exceeded 100% among banks with less than $1 billion in assets. The modified Texas ratio for the industry aggregate was 48.7% in the first quarter.

Looking across regions, the modified Texas ratio appeared to be the highest in the West at 71.2%. The ratio was the lowest in the Midwest at 40.9%.

During the upcoming second-quarter earnings season, banks should offer more insight into the amount of deferrals they have offered and behavior of borrowers receiving relief but the ultimate risk the credits pose likely will not be realized until later this year.

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For our latest outlook for the U.S. banking industry, including credit quality, please click here.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.

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