Give Them Some Credit: Banks Not Too Relaxed

Quality Not Quantity

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It’s not yet clear if relaxed bank credit standards have set Northwest Arkansas lenders up for a hellacious reckoning. Loan charge-offs during the next several years will tell that story.

What is certain, lenders and borrowers agree, is mounting interest rate pressures, a local commercial lease-space glut and an ever-increasing number of banks and developers chasing deals mean something has got to give.

If that something’s not credit quality, the area will buck a national trend.

Credit managers surveyed nationwide in January by the Federal Reserve Board said that requests for easier credit standards are up. Half of the banks polled said they had reduced their spreads for commercial loans, and 25 percent said they had eased some factor used to rate risk.

Less fudging has been done in residential lending, the survey said, although there has been some credit quality creeping in that side of the business, too. Responses to a similar survey on commercial trends back in the fall were even more dramatic, according to the Fed’s American Bankers Daily newsletter.

That means more bankers are underwriting loans, particularly commercial paper, that they might not have in the past. It’s a trend Arkansas State Bank Commissioner Robert “Bunny” Adcock said could be a recipe for ruin.

Adcock, a 30-year banking veteran, said locally he’s most concerned about banks making a foray into Northwest Arkansas that might not fully understand the market.

“I see a lot of deals coming out of Northwest Arkansas, and it’s just a constant escalation of square-foot prices on land,” Adcock said. “I see the cost of projects that I consider awfully high, and where borrowers are asking for extremely low rates. They don’t want to put any money in the project or sign personally.

“… And I remember the 1980s. As a young banker in central Arkansas, I stood on the courthouse steps and watched properties being sold and banks taking substantial losses. My gray hair affects my judgment.”

Each bank has its own approach to risk rating, but every version includes a look at the three “C”s: credit, collateral and cash flow. Rob Brothers, president of Arvest Bank-Rogers, said when bankers talk about “eased” credit standards they mean a tinge of flexibility probably in just one of those areas. Banks, for instance, might finance projects at a higher loan-to-value ratio than previously if the borrower has great cash flow and pristine credit.

Or maybe a borrower’s debt-coverage ratio is slightly less. The industry rule of thumb on real estate transactions is bankers want borrowers to have $1.20 coming in for every $1 they’re borrowing. So if a client has great credit and collateral, but is “cash flowing” at only $1.15 to $1 instead of $1.20 to $1, then maybe the deal still gets considered. Maybe.

Ross Mallioux, executive vice president and chief lending officer of First Federal Bank in Harrison, said his institution managed to grow its loan portfolio 26 percent last year without sacrificing credit quality. Mallioux works out of a Fayetteville branch, one of 10 First Federal operates in Northwest Arkansas, but helps oversee lending bankwide.

The bank’s parent company is publicly traded First Federal Bancshare Inc. in Harrison.

“We’re not getting more stringent or relaxed,” Mallioux said. “We feel like we have solid underwriting that takes into consideration all of the factors. If you have a real strong compensating factor in one area, it can potentially compensate for a weakness in another. But we have a responsibility to our shareholders to maintain what we believe is adequate and responsible credit quality.

“So we look at the project, but not just the project. It’s the borrower, but not just the borrower. It’s the credit, but not just the credit. We look at the whole thing.”

Brothers said he believes credit standards overall are looser today than they were five years ago, but he doesn’t think Arvest has changed much. He said Arvest remains “watchful of the market, not fearful of it.”

“Where we never go as a bank is when all of those factors used to determine credit quality start to cave, all of the ‘C’s,” Brothers said. “We look at the broad picture, but when you start weakening in all of those areas that’s when there’s going to be trouble.”

Race for Returns

Since Spring 2004, three startup banks and two new-to-the-market institutions have pushed the number of local players in the two-county market to 24 and in the six-county market to 39. The latter takes in Benton and Washington counties plus Carroll, Madison, Sebastian and Crawford counties.

Another bank, Arkansas State Bank, was acquired in 2004 by out-of-market institutions (Liberty Bank of Arkansas in Jonesboro and Russellville Bancshares), which have re-branded and continued its operations. And at least two more banks have said they plan to open Northwest Arkansas branches this year.

Mark Mizelle, president of Liberty Bank’s Rogers-Bentonville market, said Liberty is obviously trying to grow its market share but it won’t do so at the expense of asset quality. Mizelle, along with other local Liberty leaders Doug Lynch and Howard Hamilton, was hired during last year’s acquisition for his knowledge of the area market.

Mizelle moved to Northwest Arkansas with Arvest and later joined Regions Bank for three years.

“Local banks are underwriting a lot more prudently than a few years ago,” Mizelle said. “They’ve gotten to know some developers and who does things the right way. Lenders who have been in the market for a while are risk rating appropriately and underwriting deals appropriately.

“Liberty Bank can do the sized deals I’m used to doing and it’s not just trying to grow for the sake of growing.”

An accurate total for commercial bank loans made in any local market is hard to come by, mostly because of the way the Federal Deposit Insurance Corp. segments its data. To take a stab at part of that segment for Northwest Arkansas, bankers said, consider the just value of local commercial building permits alone.

Their value for the 12 months ended in February, with one month of incomplete data for Springdale, totaled $175 million. Collected by the University of Arkansas’ Center for Business & Economic Research, the data includes Fayetteville, Springdale, Lowell, Rogers, Bentonville and Siloam Springs.

If at least 90 percent of those deals involved bank financing (bankers said the figure is probably higher), then more than $157 million in local commercial projects got bank financing from somewhere last year. It’s hard to know what percentage of the loans came from banks with physical locations in the area, but the consensus is it’s the lion’s share.

And that’s just in commercial development and doesn’t include traditional business financing.

Cash Flow Concerns

According to The Reed Report’s 2004 year-end commercial edition, 17 percent of Class “A” and Class “B” office space surveyed in Northwest Arkansas was vacant. Real Estate Market Data Inc. in Springdale compiles the report, which in December included 4.7 million SF of space, for local bankers.

Bentonville properties alone accounted for nearly 70 percent of the vacant space. The rest of the local cities, the report said, are closer to national occupancy rates. So, the race to build office space for vendors to Bentonville-based Wal-Mart Stores Inc. hasn’t worked out for everyone.

Maybe the most telling detail in December was that eight Bentonville office buildings totaling 125,000 SF remained totally vacant, including seven buildings that were brand new. So what bank funding was provided for any of those deals must have been done without any pre-lease requirements.

Forget about asking for that now, said prominent developer Collins Haynes, a principal at Haynes Ltd. in Rogers with more than 500 acres of commercial property along the Interstate 540 corridor. As a major developer and, from time to time, a significant local borrower, Haynes said if anything, the market glut has intensified area bank-credit standards.

He said even newcomer lenders taking on bigger loans are now asking that the deals be backed with more existing properties and pre-leased space. Bankers are also making up margin and front-loading their risk by assigning a point or two at closing.

“If you don’t have a proven track record you’re not going to get the loan,” Haynes said. “There’s too many things working against you. The cost of land is going up and construction costs are rising, but lease rates are pretty much a constant from say $15.50 to $19 per SF.

“Particularly in office space for [Wal-Mart] vendors, they are going to be looking to pay $17 to $19 per SF, and that’s the end of the story. They know it’s out there and you have to be able to develop product at that price.”

Come Bets

If local bankers are rolling the dice on risky credit, they haven’t crapped out yet.

Financial and anecdotal bank data filed quarterly with the FDIC — such as net loans, allowances for loan losses, past due loan schedules, non-bank real estate holdings and charge-offs — can be used to make inferences about the quality of bank loan portfolios.

None of area’s locally based banks appeared to have charge-offs or non-current loans greatly in excess of normal cycles. In fact, data collected by the FDIC, albeit statewide, shows improved returns and reduced loan losses for Arkansas banks during the last five years.

Dan Dykema, CEO of ANB Financial N.A. in Bentonville, knows a thing or two about trying to grow a bank in Northwest Arkansas. He started ANB in 1993 after Worthen National Bank in Little Rock bought out Bentonville’s First Bank and displaced him along with a lot of customers.

A decade later, Dykema’s hip-minded, technology-savvy banking organization is, somewhat to his chagrin, part of the establishment. But he remembers having to pound the pavement.

Dykema said realistically, there’s probably a little bit of local credit quality relaxing. It’s more frequent, he said, when a bank is starting from zero and trying to reach a critical mass. Even then, he said, banks don’t typically charge off bad loans for three years so it might take awhile to evaluate a new bank’s risk rating.

“I don’t think relaxed standards are rampant,” Dykema said. “And the guys starting the three new local banks, Joe Mills, Jerry Carmichael and Gary Head, they know their customers here well. I doubt they will have to bend over backwards to get business. It’ll be harder for the people who are bringing folks in from other areas.”

Dykema said credit standards have changed dramatically in the last 25 years on everything from the length of mortgage amortizations to seven-year car loans and 110 percent home equity loans. Better technology and customer demands are the biggest factors behind the shift, he said.

“I’ve never studied it, but I will bet you that even though the [credit] standard might be a little less, I don’t know that it’s resulted in any greater charge-offs. Margins are just less, and lending itself has gotten more sophisticated,” Dykema said.

Niche Lending

Carl Grimes, a broker/owner at Sunbelt Business Advisors of the Ozarks in Fayetteville, said his clients have definitely seen disparities in what passes for strong credit from one bank to another. Sunbelt, which has offices in Fayetteville and Springfield, Mo., brokers mergers and acquisitions of businesses.

Grimes was recently helping one Rogers retail-business owner position his company for sale. The $1.5 million business, which keeps $500,000 to $600,000 worth of inventory, needed to be refinanced and receive a line of credit in the interim.

The owner met with one local bank that Grimes said, “ran him around the tree 15 times.” In the end, Grimes said, he believes some banks in Northwest Arkansas are so leveraged into real estate lending they don’t care if they do any business lending or not.

“The first bank didn’t arrange a line of credit like the said they would,” Grimes said. “They wanted security way above the business and mortgages on two homes plus a certificate of deposit. So our client went across the street to one of the new banks. They sat down, structured the loan perfect for him and they didn’t require all the collateral the other bank did.

“It was nothing more than two lenders looking at the same deal differently. It had nothing to do with the management or credit of the business.”

Grimes said as interest rates rise, all banks will be re-evaluating their credit standards.

Bob Taylor, president and CEO of Chambers Bank of North Arkansas, said his commercial boutique routinely does a “shock analysis” that analyzes the impact of rising rates.

“You can write good loans today, but if they’re adjustable-rate loans they might be bad tomorrow,” Taylor said. “Your borrower may feel comfortable at 7 percent, but if rates go to 9 percent, can they withstand that rate? We do a shock analysis for that very reason.

“We want to know if we do a loan at 6 percent, how that customer is going to stand at 8 percent. We try to keep that debt coverage ratio at $1.25 to $1 or even higher.”

Taylor said most commercial property developers include rate escalation clauses in their lease agreements so that when rates go up, the cost is passed on to renters. His bank had loans of $193 million at December’s end but had already grown that figure to $200 million by April.

“We probably keep $30 million to $40 million in the pipeline at some state of loan approval or lending,” Taylor said. “Now we’re typically shorter-term lenders, but our past dues continue to be good. Our foreclosures continue to be low and so we’re not seeing those kinds of weaknesses in the market yet.”

Grimes agreed that in the end, Northwest Arkansas’ risk tolerance will come down to relationships and a strong understanding of the local market.

“What did [former U.S. Speaker of the House] Tip O’Neill say, ‘All politics are local?’” Grimes joked. “Well, my gut feeling is all lending is local.”