The hotel industry has been one of the hardest hit sectors of the economy during the pandemic. What does that mean for the banks that have lent money to hotels? And what methods are banks using to give hotels time to regain their financial footing?
- Banks Get Creative in Containing Hotel Credit Risk (American Banker)
- Bankers Don't See Economy Recovering Anytime Soon (American Banker)
- COVID-19 Market Updates & Resources
- Risk Levels & Bank Behavior During COVID-19 (Report)
Questions? Comments? Email Jim Young at firstname.lastname@example.org
Jim Young: Hi, and welcome to the Purposeful Banker. The podcast brought to you by PrecisionLender. We discuss the big topics on the minds of today's best bankers. I'm your host, Jim Young, Director of Content for PrecisionLender. And I'm joined again today by Dallas Wells, our EVP of strategy.
Apologies if our podcast these days is starting to seem a bit like Groundhog Day where, in our version, instead of I've Got You, Babe cranking up through the clock radio, I tell you that, "Hey, today our topic is going to be about, wait for it, risk." But that's where we are these days. Risk is the topic de jour. But we are going to shake things up a little bit here and go into a specific realm of risk today. And that is the risk involved with commercial deals for hotel chains. And the impetus of this comes from a familiar source, American Banker, and they recently wrote an article titled Banks Get Creative in Containing Hotel Risk.
And, Dallas, I've got to admit, I didn't need to see much more than the title of this one and get to the word hotel before I got a bit of a pit in my stomach, as someone whose only trip they've made during the pandemic, I went admittedly to an AirBnB because I wasn't really comfortable with a hotel. That gives you a little bit of context, but can you give us a bit of the lay of the land when it comes to the hotel industry right now, during the COVID-19 pandemic?
Dallas Wells: Sure. And it sounds like we can preface it by saying it's partially your fault.
Jim Young: My funds were not going to save the industry by itself, but go ahead.
Dallas Wells: Okay. Fair enough. I don't think this is going to come as a surprise to anybody, but commercial real estate in general is in trouble, but this particular area is really rough. So, a few stats from the American Banker article just right out of the gate, 4.8 million leisure and hospitality jobs have been lost since February. That number continues to climb. There are jobs coming back in other industries, but not that one. Occupancy in hotels is down 32% in that same time frame. And the sector could lose up to half of its revenue for the year. Every hotel deal out there, there is going to be very few of them that have the kind of debt service coverage to withstand losing half of their revenue, even when they can skinny down on staff and lots of the variable costs. The math just doesn't work and very few deals actually get stressed to that degree when they're being underwritten.
This is another one of those, just things that just couldn't have been predicted and didn't sit in anybody's credit risk model. What's interesting as you get more into the article and as you talk to a lot of banks, for some of them this is crisis mode just because they have a big enough exposure to this sector that it's potentially disastrous. And others, they just have a few of these sprinkled in to otherwise rock solid borrowers that they feel pretty comfortable with.
That's really what the article is talking about - kind of the strategies and tactics that some of these banks are using to try to work through these deals, essentially, all of which are problems or at least should be on the radar of banks as potential problem.
Jim Young: So, definitely problems. And I guess the question then becomes how long term is the problem here? Because as I started to think about it, this didn't feel like, say, if you're a bank that had a bunch of loans to, say, American textile companies in the mid '80s or newspaper chains in the last, I don't know, three decades. Sorry, personal aside there. Basically the hotel industry isn't going the way of Blockbuster Video, right? And I guess maybe this is... Can I make it more akin to, say, Ag loans during a drought? And is the way you deal with the risk maybe different when it doesn't appear the risk is permanent.
Dallas Wells: Yeah, I think that's fair. We're not talking about buggy whip manufacturers here. There is a real business and that business does come back. The "when" is the really hard part that nobody can get a handle on. This was something that in March and April as the shutdowns kind of rolled out nationwide, really worldwide, the expectation was is that this was a few weeks. And then, "Well, maybe it's a month or two."
And as things reopened, you have two things happen. Obviously, we have new spikes of the virus and those are happening. It's a very different experience in different pockets of the country. But then you also have the fact that even when things did reopen, consumers didn't come back everywhere and they didn't come back the same way as before. Still not a lot of travel and the hotel business continues to really struggle.
The, "How long?" is really the key question here and I think what bankers are really wrestling with. Some of the stats we've seen, and these are all over the place depending on where you find them and it's a number that's evolving in real time, but we've seen forbearance statistics for this particular sector in the 25 to 40% range, the number of these deals that are in some form of forbearance right now. And so, that is essentially banks saying, "Well, we know they can't pay us right now so we're just going to push pause on this thing and just wait." And that is not a permanent solution. And let's take the lower end of that.
Let's say it's 25%. If you have a meaningful book of these in your portfolio and a quarter of them are in some form of forbearance, what share of those are already bankrupt essentially? How many of them cannot come back already? Because if they come back, I think what everybody's realizing now, is whatever path the virus takes over the next few months, we are not coming back to 2019 occupancy levels anytime soon.
So it's really a matter of whatever the time frame, there will be some weaker links within the industry that don't make it. Some of the stronger ones that survive and they will end up picking up some of that slack and they'll do great, once we get to the other side of this, whenever is. But that's what banks have to figure out is who's who. Who's going to make it and who's not?
Really what the time is, the time factor is determining how deep that cut line is. How many of those in your portfolio are not going to make it? What some of these banks with big exposures to this are starting to wrestle with is, "How aggressive do we start to be in recognizing the extent of that? And maybe should we start realizing some of those losses now, so that they don't pile up and we have to realize them all next quarter, next year, two years from now?" Whenever that kind of big tidal wave hits of, "Okay, now it's time to actually make good on all those losses."
That's the discussion we're starting to hear. That's what you see some hints of in this American Banker article is banks trying to find the best way they can to give these operators time to survive while, at the same time, trying to be realistic about the fact that some of them are just no longer solvent.
Jim Young: All right. The way you answered that one may change a little bit the way I ask the next one. And it also is, I should say, a little bit what you're talking about points to another American Banker article that was kind of some of the context for this, which is Bankers Don't See Economy Recovering Anytime Soon. Boy, that headline really just doesn't leave much to the imagination, does it?
I wanted to look then at some of the specific tactics you're talking about and one of them was Western Alliance Bank. It's about a $30 billion bank out of the Phoenix area. And I'm going to ask you another one of those dumb banking layman questions here. I'm going to quote this directly. "They're offering clients several options for deferrals. Some schedules are set for six months, others can stretch over a year. But in all instances, Western Alliance is requiring borrowers to advance several months of loan payments."
So, this is the dumb layman question part here. If you're a hotel and you're saying, "Listen, I can't make my payment right now so can you defer them for me for six months to a year?" How do you have money to make advanced payments on the loans that you're just asking to be deferred?
Dallas Wells: Yeah. Good question. And there is a couple different ways mechanically that banks can go about that, but we'll just use a general description of it to cover those. How these typically work is the bank and the borrower are coming to some sort of agreement where they're saying, for example, "Let's make it so that you don't have to make payments for 12 months, but we want you to go ahead and kind of pre-fund three months, six months worth of payments. So, that is sitting essentially in escrow here at the bank and we will draw those for those payments. But you don't have to come up with any more cash for some period of time." What they're doing is some version of a solvency test. The issue we just talked about of who can make it and who can't?
Who's really on the verge of going out of business and who actually has some cushion and can make it? And they are simply proactively looking at the inflows and outflows and saying, "This isn't sustainable. And so, let's match the debt schedules to the revenue that's coming in so that this thing is stable and it's not just continuing to bleed month after month for some undetermined amount of time." It's partially to see kind of who still has some liquidity, some stability. And also there is a human element to this too. Which of these operators actually believes that they are viable on the other side and is actually willing to write a check and put some more cash into it? It's a way to share the risk on this. And it's essentially the bank saying, "If we are going to put some of our capital on the line and ride this out with you, we want you to put some of your capital on the line and ride it out with us and let's share this risk. And let's both agree that we're going into this together and kind of hold hands and jump in."
Sometimes that liquidity doesn't actually exist in the business. So, what you're actually asking is for an owner to come out of pocket. It mentions in other places in the article, a lot of times if there is not actual liquidity there, because of what you just asked. If they're to the point now of saying, "We can't make payments," maybe they have already exhausted the liquid resources. Sometimes it's tying other collateral in. That could be other business assets. Sometimes it's an owner's home. It really is saying, "We want you to fully commit to this. And if you do, then the bank will too." It's a combination of a crude but effective solvency test and making sure that the humans on the other side of the transaction are equally invested as the bank is and making sure that it comes out right.
Jim Young: It was interesting because it got ... They sort of had two different reactions to it. One of which was an analyst saying like, "Man, I've never seen anything quite like that before." And then you had another one, which was a CEO, I think of Bank United, who basically said kind of what you said, which is, "Yeah, this is basically, essentially, yeah, putting up some more collateral, essentially. A different sort of guarantee for a loan so it really isn't that unusual." So, which is this? Unusual or just another variation on time-tested lending techniques?
Dallas Wells: Yeah. That's kind of workouts 101. There is nothing all that unusual about the tactic itself. I think what the analyst was probably referring to of it being so unusual, is Western Alliance has kind of systematized it. Typically, these workout things are deal by deal, case by case. You've literally got humans kind of sitting across the table from each other, hashing this stuff out. And Western Alliance has almost made a program out of it, of saying like, "Here's your menu of options. Pick which one works." And they've taken some of the human element and some of the decision making out of it because it's just a program.
I think that tells you the level of different levels of exposure between those two banks. One saying, "Yeah, we just come to the table and figure it out. It's deal by deal." And the other one is saying, "We got a bunch of these and we just want to systematically take an approach to buy time for all of these operators and we'll kind of sort out the winners and losers later."
Jim Young: All right. And then to add, again, one more curve ball to this sort of thing. What we're basically talking about here again is trying to find a way to buy some time for hotels to figure this out. And I guess, then the question is, again, I mentioned that other article where Bankers Don't See Economy Recovering Anytime Soon. And what we were talking about Western Alliance was six month deferrals and a year deferrals and that sort of thing. And I guess what I'm wondering is this... In some ways, what Western Alliance is doing sounds, "Wow." Like one analyst said, "I've never seen anything quite like it." But on another way it sort of seems like, "Is it enough?" Or do you basically approach these sort of things when it comes to recessions and that sort of thing and forbearance with, "We're going to deal with this six to 12 months at a time and then revisit it six to 12 months later."
Dallas Wells: Here is the hard part about debt restructuring. There is kind of the temporary solution and then there is eventually a permanent solution. We're in that stage now where we don't yet know the distinction between the two. And so, most banks are still, "Let's take temporary measures." But that full balance of that debt is being carried forward. Even if we kind of turn off the vig for awhile, you still owe us that money. If an industry, or even let's back it down to an individual borrower, if an individual borrower's revenue, kind of true run rate when things do normalize, whether that's six months from now or five years from now, if it normalizes at 80% of what it was when that debt was put in place, it can only support 80% of the debt. That's how the math will eventually filter through, is 80% of the income, 80% of the revenue, that's 80% of the value. The debt has to be adjusted down accordingly.
So, the question is who eats the 20%? And that's what banks are looking for now with some of that additional collateral. Eventually, what this starts to look like in some workouts is they say, "Okay, we are reducing the amount of exposure that we're going to have to you. You need to write us a check for the difference for that 20%." Well, a lot of them just can't do that. Then the banks are eventually going to have to write down portions of that and then figure out, "Is the rest of that debt salvageable at that lower amount? Do you foreclose on this thing and just get out what you can?"
Those are the kind of ugly permanent solutions where you figure out, there is kind of three outcomes. Either the business can eventually service the original amount of debt. Number two, the business can service some lesser amount of debt and we have to figure out who comes up with the difference. Or the bank decides that the best outcome is, "We just foreclose. We just flush this thing and we can recover more of what is owed to us that way, by just selling the property." Of course, when you're looking at an industry wide issue like this, who wants to buy a freshly foreclosed on hotel? Even the secondary repayment sources... And this is what happened during the financial crisis. You had a lot of deals that were leveraged up pretty darn high.
And so, then you had housing developments that, "Okay, we foreclosed on it. Now we own this." It was going to be developed into 2000 homes north of DFW. Guess what? Every bank in town has some property like that. It's all for sale. And the people who would buy it would be your real estate developers, who are all filing bankruptcy or bleeding cash. So, that's why these things are so cyclical and why banks pay so much attention to how much exposure do you have to any given sector, any given industry. It's because of things like this.
That's the work that has to be done over the next couple of years. The second article you mentioned, that's why you hear some real concern from bankers. There is real pain to be dealt with here, and it doesn't happen right away. This is the part that I think, for whatever reason, always seems to surprise market analysts, economists, is this stuff just takes time to filter through the banking industry. It takes time for the losses to kind of be realized and to show up. There are losses. They will be realized over the coming quarters and years. And there will be some banks that see some massive pain from this.
You're hearing that from the bankers. You're hearing this from some of the consultants out there. Accenture has been talking a ton about credit risk. BCG has been talking a ton about credit risk. I'm not sure that we fully know yet how ugly this is going to be for banks, but it's bad. And that's kind of... Real estate is the most obvious place that it's landing. That's where, in the survey, that's one of these American Banker articles, the sector that banks are worried about most is CRE, then C&I, then consumer. So, depending on what your exposure is, what CRE first means is a lot of community and regional banks are the ones that are going to take the brunt of this. This is not the big guys and it's not a lot of the credit unions. This is commercial banks, a billion to 10 billion to 20 billion, that just have a ton of this kind of stuff on their books. It was solid before. Now, a lot of it's not and we just have to figure out how much, in the meantime. Some rough seas ahead for a lot of those banks.
Jim Young: Absolutely. I'm going to throw in one off the books question here, based off of what you just described.
We have talked in the past about a tactical sort of way of banks becoming sort of experts in certain industries. Becoming very good at like, "Hey, you guys get really good at becoming healthcare lenders," or that sort of thing. Is this sort of thing though, maybe a cautionary tale about that. Let's say I opened up a commercial boutique bank in which I basically specialized in lending to hotels and I was really, really good at that. I'm toast if that's all I've got or 90% of what I've got it. Like I said, we've made that argument in the past to be fair that, "Hey, this is a good way to get market share and to provide a service. When your money's as green as everyone else's, your expertise matters." But if you had someone come to you now and say, "Hey, listen. I'm thinking about doing sort of an industry specific commercial lending operation." Would you say, "No."
Dallas Wells: Good question. And I think there is always that trade-off, the risk versus reward trade off. And even for banks that have specialized in things like this, and there is a few that have done if you're going to specialize in things like hotels or some other higher risk, higher leverage... Some industries are just more cyclical than others. Some are more defensive and some are not. What you've seen is banks like Live Oak, who specialized in their early days in a few super specific industries. They specialized in some that were not super cyclical and they used SBA. So, they shared the risk of some of that stuff. And also, you can specialize in an industry without necessarily having to specialize in the type of deals on your book. If you specialize in healthcare, you should still have a mix of real estate and equipment and operating loans and lines of credit and personal stuff to those doctors, and wealth management.
And so, you can still diversify the sorts of stuff on your balance sheet. Also, this goes kind of beyond the loan portfolio where, given what sort of risk or concentrations you might have in the lending area, that's going to cause you to do different things on the deposit side of your balance sheet. And it's going to cause you to do different things with the rest of your asset base. What we see is some banks who specialize, they have kind of a high profit, high growth loan book. And so, their loan to assets, they keep a little lower. They carry a fairly big securities portfolio and it is agency and treasury debt. It is super low risk based capital, essentially zero credit risk, and they use that to kind of balance their overall risk profile.
But all of that stuff is kind of where the fancy math comes from for doing risk adjusted returns and for measuring economic capital that way. You're measuring some of the correlations of those things. You're measuring some of the risk variance between the different types of assets on your books. Especially for the larger, more sophisticated banks, those things should show up in some of your stress testing of, "Do we have too much exposure to something like this?"
The banks I worry about are the billion dollar banks that just grew a ton of real estate because that's what they were good at lending into. And it was what they could specialize in and grow really quickly and they didn't do some of that stuff to offset that risk or to balance that risk. Those strategies are never something that you take on in a vacuum. They are really effective. They can be really profitable. But they have to be part of a big picture balance sheet strategy that fits with that. The kind of classic real estate construction community bank that funds itself with broker deposits and kind of runs everything super hot and high growth and highly leveraged, those are the banks that fail through every one of these cycles. And there is going to be some more of those. They're going to look slightly different than the ones that failed last time, but there is going to be some of those. That's why you can't kind of put all your eggs in one basket that way, not across the whole balance sheet.
Jim Young: Gotcha. Okay. Well, that will do it for this week's show, Dallas. Thanks again for coming on.
Dallas Wells: Yep. Thanks, Jim.
Jim Young: All right. And thanks so much for listening and now for our usual few friendly reminders. You want to listen to more podcasts, check out more of our content, you can visit the resource page at precisionlender.com or head over to our home page to learn more about the company behind the content.
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