What Commercial Loan Management can learn from the Stock and Bond Markets

RMA Journal, The, Feb, 2002 by Edgar M. Jr. Morsman

Promoting diversification, devising a rational policy that enhances value over the business cycle, making the effort to focus on the cash flow statement and explain wide variances to reported earnings, and reconciling the differences between reported earnings and taxable income are just a few lessons from the markets.

Mythology held that anyone who passed through the ancient city of Golconda in south-central India would become rich. During much of the last decade, stock market investors must have felt they had stumbled onto Golconda, although some tended to confuse a bull market with brilliance. The S&P 500 index rose 31% in 1997, 27% in 1998, and 20% in 1999. Many fortunes were made.

During 2000, the punch bowl was removed and closing time announced. The S&P 500 declined 10%, and in the first three quarters of 2001 it tumbled 21%. The rise and fall of the NASDAQ was much more pronounced. Many fortunes were lost.

By contrast, the bond market rallied as interest rates fell. That is, government and high-grade corporate issues rose. High-yield, lower-than-investment-grade bonds (formerly junk bonds) deteriorated as evaporating cash flows raised credit concerns. The spread between junk and Treasury yields has widened to a differential last seen in the recession of 1990-91.

The philosophy of stock and bond portfolios is found in the investment policy. In stock portfolios, the policy discusses such issues as investment style (for example, growth and value), sector (for example, health care, real estate, and technology), and delegation of authority. In bond portfolios, the policy covers such issues as credit ratings, duration, and liquidity.

A commercial loan portfolio's philosophy is set forth in the loan policy. However, significant differences between the commercial and securities portfolios make commercial policy difficult to standardize and the commercial portfolio difficult to manage.

* The commercial loan offers very little upside reward. Success is measured by getting your money back plus a little interest and maybe some additional business. When you help a customer improve, the dubious reward is often a lower interest rate.

* Specific types of desirable business are difficult to describe in a policy unless you are dealing with specialized industries, such as investor-owned commercial real estate. Consequently, good loan policy is an agreement between management, credit, and the line on what is to be accomplished within a target market, and it is reinforced by constant communication.

Despite these differences, commercial loan managers can learn much from the gyrations of the stock and bond markets in recent years.

* Volume is added by a costly marketing and sales effort, while disposal is often through workout. Don't we sometimes wish we could pick up the phone and place a trade order?

Diversification. Lenders cannot diversify away systemic risks, which are national or global events such as recession, inflation, and interest rate changes. However, they can and should diversify away nonsystemic risks, which are specific to individual firms--for example, strikes, product recalls, loss of patent protection, and lawsuits.

Diversification is called the one free lunch in stock portfolio management. A number of mutual fund managers in the technology sector ignored this truism and concentrated portfolios in faddish dot-coms. Returns were spectacular in a rising market (even a turkey can fly in a hurricane) and equally spectacular during the crash.

Concentrations have been the bane of commercial loan portfolios, and by now we should have learned to diversify by geography, industry, and individual borrowers. Losses in large, single credits have caused surprise increases in loan loss reserves and plummeting shareholder value while destroying the statistical predictability of the portfolio.

In fact, the stock market seems to assume that commercial portfolios are blind pools of unknown risk and accords them a reduced price-earnings ratio. In its all-industry composite earnings report for the third quarter of 2001, Business Week stated that return on equity was 7.5% and the P/E ratio as of November 1, 2001 was 39.

By contrast, the banking industry component enjoyed a higher ROE of 11.6%, but a lower P/E ratio of 18. Think of the wealth that would be created if we could just increase our P/E ratios to the average.

Risk and reward. Risk in stocks is usually defined as deviation from expected returns or volatility. A mathematical tool known as Beta measures the volatility of a stock or portfolio against some index such as the S&P 500. A Beta of 1.20 means a stock is 20% more volatile than the S&P 500.

Reward in bond pricing is a fairly objective process, whereby perceived high risk is heavily priced. The pricing spread over Treasury bonds rises slowly in the investment grades but then swings violently upward in the junk grades.

Commercial loan pricing tends to be more linear, that is, we overprice our better risks and underprice our riskier loans. A number of studies of the stock market have demonstrated that higher risk or higher Beta stocks have delivered more volatility but more total return over time as compensation.