Commercial banks have fallen from grace among home builders far and wide—and for good reason. How hollow the refrain: “We are relationship bankers; our goal is to develop long-term relationships.”
Home building is by nature capital intensive. Yet, equity is too costly to meet all of builders' capital needs. With leverage—debt—the returns required by builders and their investors can meet risk-adjusted hurdle rates. Public builders access public debt primarily, layering in commercial bank capital as they need it. Public debt is long term, less restrictive, but more expensive—in nominal terms—than bank debt. Private builders use commercial bank debt as their primary source of capital. Bank debt is comparatively short term, highly restrictive, and less expensive in nominal terms.
So, have commercial banks abandoned home builders? What will it take for them to begin lending again? And, if they are to return, when?
The beauty of a market-based economy is that it corrects. The bad news is markets tend to overcorrect. Markets resemble a pendulum: Over time, it settles in the middle. The bank lending pendulum is swinging back gradually.
Have a look at second-quarter earnings of major financial institutions. Stronger bank earnings resulted from lower loan losses. Still, new concerns prevailed about lower future earnings due to shrunken loan portfolios.
Bank of America stock prices fell 9 percent after exceeding consensus earnings expectations thanks to deteriorating revenue trends. BOA noted an increase in the contraction of its commercial bank portfolio in the second quarter from the first quarter. BOA CEO Brian Moynihan told The Wall Street Journal on July 22: “As we look on the loan demand side, it continues to remain weak as the consumers continue to delever. There's no loan demand because there is no demand for the [client's] products.”
Former president Bill Clinton, speaking to a group of financial planners in Boston recently, indicated banks are sitting on cash reserves that the economy would benefit from were banks to lend at a normal rate. Howard Atkins, CFO of Wells Fargo, also told the WSJ on July 22: “We believe credit quality has indeed turned the corner.” Improved credit quality positively impacted many lenders' second-quarter earnings.
Banks make money lending money. The demand for loans has remained sluggish, and loan portfolios are shrinking, foreshadowing a negative impact on future earnings. Banks' lending will self-correct such that higher-risk lending generating greater revenue and profitability will again return to lenders' portfolios to offset shrinking loan portfolios.
Melissa Hicks, Texas Capital Bank's division executive responsible for home building lending, indicates banks covet commercial and industrial (C&I) lending in an attempt to rebuild loan portfolios and improve their revenue and profit outlook. The problem, Hicks says, is C&I lending is fiercely competitive, leading to weak pricing power. As C&I lending competition overheats, “this will force the market (banks) to come back to real estate,” Hicks asserts.
Banks will “slowly put their toes back in the water” of residential construction lending, she says. For one, they need to fully understand the impact of the Financial Regulatory Reform legislation. Once banks understand the new legislation and gain comfort with a return to residential construction lending, Hicks believes the pendulum will “overnight swing hard” toward home builders.
While the correction of markets is painful because of their tendency to overcorrect, they eventually find equilibrium. As they do, AD&C lending will once again return to home building.
Jamie Pirrello is CFO of Sivage Homes and its San Antonio division president. Contact: [email protected].
