PPP Update
The PPP program opened up on Monday of this week, and the race between banks began to process applications. We hear that the program is originating around $30-60 billion a day in loans, and the SBA is pro-actively trying to ensure that the funds are dispersed fairly amongst lenders of different sizes. Last night at 5 PM, there was $90 billion authorized, which represented 2.5 days of volume. That would suggest the program will reach capacity sometime next week. We believe the allocation for the banks between $1-50 billion has been spoken for, although those banks can use the general allocation. There is no known mechanism to take returned money, through either lenders failing to close these loans or borrowers returning the money, and inject back into the availability.
Now those lenders are dealing with ever-changing guidance from the Small Business Administration and the Treasury Department.
Smaller banks were pleased with the agencies’ decision Wednesday to block lenders with more than $1 billion in assets from using the SBA’s E-Tran portal over an eight-hour period that evening.
Still, some expressed frustration with a requirement to complete a form that has yet to be distributed to lenders. And the decision to scrutinize large-dollar loans, without guidance on what will be reviewed, has also left many bankers scratching their heads.
Methinks the lady doth protest too much. The PPP program is a massive bonanza for banks, allowing them to both generate much needed fee income (which should be used to pad loan loss reserves), and keep struggling borrowers from defaulting on their other loans. This publication is almost always on the side of the banks, but enough with the complaining. SBA has done a remarkable job guaranteeing a more than 20-fold increase in their yearly lending capacity in less than 30 days.
Many of the public and large companies that received these loans have returned the money, including the Los Angeles Lakers, Potbelly, Ruth’s Chris Steak House, and Shake Shack. Treasury Secretary Steven Mnuchin warned companies as well that they could face criminal liability if they could not certify that they were facing economic injury, giving those companies until May 7 to return the funds. They also announced an audit on all loans over $2 million. Mnuchin and SBA Administrator Carranza made a joint statement Tuesday:
“We have noted the large number of companies that have appropriately reevaluated their need for PPP loans and promptly repaid loan funds in response to SBA guidance reminding all borrowers of an important certification required to obtain a PPP loan. To further ensure PPP loans are limited to eligible borrowers, the SBA has decided, in consultation with the Department of the Treasury, that it will review all loans in excess of $2 million, in addition to other loans as appropriate, following the lender’s submission of the borrower’s loan forgiveness application. Regulatory guidance implementing this procedure will be forthcoming.”
If Congress had simply followed existing SBA rules regarding eligible borrowers, than none of these companies would have gotten the money. On some level, one can’t blame companies from accepting free money, providing it isn’t done fraudulently.
We talked to one bank CEO in Minnesota who brought up an interesting issue with these loans. He said they are treating these like construction loans, making sure that only eligible expenses (i.e., payroll, rent, utilities) are dispersed. He told us, “We don’t want to be stuck with 1% loans – we want to make sure we get the forgiveness.” We suspect that the loan forgiveness expected by both the lender & borrower will not meet expectations, industry-wide. Bankers need to make sure that they are on top of their borrowers in a couple of months to make sure these loans get forgiven.
Main Street Lending Program Update
In response to the public input, the Board decided to expand the loan options available to businesses, and increased the maximum size of businesses that are eligible for support under the program. The changes include:
- Creating a third loan option, with increased risk sharing by lenders for borrowers with greater leverage
- Lowering the minimum loan size for certain loans to $500,000; and
- Expanding the pool of businesses eligible to borrow.
Under the new loan option, lenders would retain a 15 percent share on loans that when added to existing debt do not exceed six times a borrower's income, adjusted for interest payments, taxes, and depreciation and other appropriate adjustments. This compares to the existing loan options where lenders retain a 5 percent share on loans, but have different features. Under all of the loan options, lenders will be able to apply their industry-specific expertise and underwriting standards to best measure a borrower's income. In total, three loan options—termed new, priority, and expanded—will be available for businesses.
Additionally, businesses with up to 15,000 employees or up to $5 billion in annual revenue are now eligible, compared to the initial program terms, which were for companies with up to 10,000 employees and $2.5 billion in revenue. The minimum loan size for two of the options was also lowered to $500,000 from $1 million. With the changes, the program will now offer more options to a wider set of eligible small and medium-size businesses.
The Board recognizes the critical role that nonprofit organizations play throughout the economy and is evaluating a separate approach to meet their unique needs.
- Underwriting emphasis appears to be heavily weighted towards the company condition prior to COVID-19. Any other loans with the same borrower at the originating lender must have been pass as of 12/31/2019. No “asset-based” lending, these loans must cash flow based on 2019 EBITDA
- Treasury is now making the equity injection in to the SPV with a $75 billion investment
- Loan purchases will cease on September 30, 2020, and the program will be operated by the Federal Reserve Bank of Boston
- Combined programs are now $600 billion, which is less than the initial $1.2 billion. However, according to Chairman Powell during his press conference yesterday, he is not worried about capacity.
- These loans cannot be subordinated to other debt; i.e., no piggyback structures that put the government in worst collateral position than the non-government involved loans
- Only eligible for-profit US businesses established prior to March 13, 2020 with 15K employees or less, 2019 annual revenues of $15 billion or less
- Loans based on LIBOR, and no payments of P&I for the first 12 months of loan, although interest will be capitalized. Under MSNLF, the loans will be amortized over the remaining 3 years after the first year. Under the other two programs (MSPLF & MSELF), 15% for the first two years and then a balloon payment at maturity
- For MSNLF & MSPLF, the Borrower pays 1% to the SPV, and on MSELF, the fee is 75 basis points
- Compensation, stock repurchase, and capital distribution restrictions follow the rules of the CARES Act, but dividends can be made for S-corps in order to cover the tax obligations
- Only US depository institutions are eligible, but non-banks may be added later
There’s a lot to digest. Chairman Powell’s news conference had some additional tidbits about the program. His press conference covered a lot of other topics, but he did say that “we only make loans to solvent entities with the expectation that the loans will be repaid.” So, while our characterization of these loans as “workout credits” is not inaccurate based on where these companies are at the time of the origination, the Fed fully expects to be repaid. Additionally, he said that the program should be operating “fairly soon.”
Michael Iannaccone of MDI Investments had some additional comments on the program as he has been in regular dialogue with the Fed. He commented:
While the above terms are generally more favorable compared to the loan products available on the open market the lack of forgiveness will be hurdle for most board rooms and management teams. There are also the limitations or restrictions on dividends and other operational metrics. These need to be considered in a cost-benefit analysis. This non traditional financing needs to be reviewed alongside a company's complex capital stack, including mezzanine financing, traditional bank debt and revolving credit lines.
Ultimately, the MSNLF lending program offers a necessary avenue to mid-sized businesses that are in a liquidity crunch but are relatively healthy and have some assurance they can continue bouncing back as we move through economic uncertainty created by the pandemic.
Overall, we now know far more about this program than we did a few weeks ago. This appears to be a great outlet for banks to help good borrowers currently operating under financial stress. We still believe lenders will be concerned about potential repercussions (i.e. buy me back at par!) if these loans go sideways, as the nature of these loans are risky since they will not likely cash-flow based on current operations. Companies with strong balance sheets appear to be the ideal candidates.
More Powell
Chairman Powell’s news conference yesterday was one of the most revealing Fed news conferences or interviews we’ve seen. We are mostly paraphrasing, but here is what we took away from his remarks.
- Rates will stay at near-zero rates as far as the eye can see. But, he did mention that low rates can only do so much.
- Fed wants to preserve the flow of credit in the economy
- They appear to be slowing down their purchases of Treasuries and Agency-backed securities.
- Fed is going to take a wait and see approach going forward regarding further asset purchases
- Fed can’t lend to insolvent companies or make grants. But they intend to do it to the absolute limit of their powers. Perhaps, that is why they declined to provide liquidity to the mortgage servicers.
- Fed worried about persistent unemployment
- Fed not worried about the national debt right now
Kudos to Mr. Powell for being honest and forthright, and largely avoiding the opaque “Fed-speak” popularized by some of his predecessors.
Credit Update
Many people are asking our opinion on the state of problem assets at banks, and how much workout assets will expand. We believe the Great Recession is a reasonable base case. Using the Quarterly Banking Profile reports, we can give you some idea.
As of the 12/30/2019 Quarterly Banking Profile, total problem assets at banks stood at $217 billion. We calculate this figure by adding up 4 call report categories, including Loans and leases, 30-89 days past due, Noncurrent loans and leases, Restructured loans and leases, and other real estate owned. At the peak of the Great Recession, this figure stood at $658 billion. By this measure, there would be a 3-fold increase in problem assets if we reach the prior peak.
Prior to the Great Recession, problem assets reached a low point of $113 billion in the first quarter of 2006, and ultimately great at nearly a 6-fold increase. So, banks are entering this crisis with twice the level of problem assets. $217 billion is certainly manageable, but banks have more problems entering this crisis than they did in 2008. But, banks are far better capitalized today than they were in 2008, although they will likely need to raise some capital. Minneapolis Federal Reserve Bank President Neel Kashkari said the big banks should raise $200 billion in capital. It is reasonable to assume many banks will need to raise capital.
We think about a 5-fold increase in problem assets seems like a reasonable base case, although it could certainly be much worse. Every bank should consider their current workout portfolio and model whether they have the capacity to handle a 5 to 10-fold increase in workout assets. As we have told you all, we have resources to help banks manage this influx, through both loan sales and workout management.
However, we do not expect to see much of an increase in workout assets until later in the year. This is largely due to the “free forbearance” language of the CARES Act. From March 1 of this year, and the earlier of December 31, 2020 or 60 days after the national emergency ends, a financial institution (see Section 4013 of the CARES Act) may elect to:
“suspend the requirements under United States generally accepted accounting principles for loan modifications related to the coronavirus disease 2019 (COVID-19) pandemic that would otherwise be categories as a troubled debt restructuring; and suspend any determination of a loan modified as a result of the effects of the coronavirus disease 2019 (COVID-19) pandemic as being a troubled debt restructuring, including impairment for accounting purposes.”
This is an extraordinary concession, and it remains to be seen how banks will use this relief. Banks are required to keep track of these modifications. Christopher Marinac, one of the best bank analysts we know, had some interesting thoughts. Chris, Director of Research at Janney Montgomery Scott LLC stated:
“It will take a good three quarters for reality to be acknowledged. Some borrowers were thinly capitalized and certain businesses are living paycheck to paycheck, like some households. The sooner the banking system realizes who has trouble, the better off we are. The problem is all of us have a heart and we don’t want to force people out of business. The forbearance helps, but it expires in six months. What has to happen is Banks build reserves and it’s going to be a multi-quarter process. My sense is that you can’t trust the problem loan data – its bogus. I understand why Banks are pushing out problem recognition, but it is temporary.”
“May is a critical month. If we get things open in which June can be a real month, than maybe it will be up and running. This allows us to work us out of a ditch. Coming out of the last financial crisis, the SEC required companies to provide real risk grades so we know today what is rated pass, watch, special mention, substandard, etc. We have the classification system, it’s just not updated now. You can’t tell me a hotel loan is a pass rated credit at March 31st, 2020. The banks are disclosing their modifications in their investor presentations, but nearly all of these are rated Pass credits. As forbearance expires, I expect several loans become criticized, but not classified.”
Anecdotally, we are hearing massive increases in restructured loans. One of our clients told us that 43% of their commercial real estate portfolio is under a modification. Another client told us that 25% of their consumer borrowers took advantage of a 60-day forbearance option. It remains to be seen whether these loans are temporarily troubled, and will return back to normal status when the forbearance period ends. But, it is highly likely that you will see massive increases in problem loans in the fourth quarter of this year.
