Flashing yellow: Rate hikes exacting a toll on banks' credit quality

Washington Federal branch in Boise, Idaho

Washington Federal, corporate parent to WaFd Bank, has reported consecutive quarters with net charge-offs after a nine-year stretch of net recoveries. Its nonperforming assets totaled 0.3% of assets, which was up slightly from the end of 2022.

In different circumstances, many financial institutions might envy the asset quality numbers Washington Federal in Seattle recently disclosed as part of its second-quarter earnings report.

According to the $22.6 billion-asset Washington Federal, nonperforming assets totaled $67 million on June 30, amounting to a modest 0.3% of assets. Here’s the rub, nonperformers totaled $44.6 million, or 0.2% of assets, at the end of 2022. At the same time, Washington Federal, corporate parent to WaFd Bank, has reported consecutive quarters with net charge-offs after a long, nine-year stretch of net recoveries.

“It is clear the rapid rise in interest rates is causing some stress for a limited subset of borrowers,” President and CEO Brent Beardall said in a Friday press release.

In a subsequent interview, Beardall said the emerging credit quality issues he alluded to in the Friday press release are distributed across WaFd’s portfolio. “The only borrowers who aren’t having problems are the ones with 30-year, fixed-rate mortgages,” Beardall said. “If you’ve got a short-term, variable-rate mortgage, you’re getting squeezed.”

Businesses are feeling extra pressure, since they’re grappling with elevated labor costs, along with the rising cost of credit, Beardall added.

WaFd CEO Brent Beardall
“The only borrowers who aren’t having problems are the ones with 30-year, fixed-rate mortgages,” said Brent Beardall, president and CEO of Washington Federal.

WaFd Bank

WaFd is not alone in seeing problem loans trend higher. Indeed, WaFd’s second-quarter experience — asset quality metrics that are solid overall but exhibiting signs of stress — is being writ large across the industry. 

Multiple banks that have reported second-quarter earnings noted concerns regarding credit quality. Unity Bancorp in Clinton, New Jersey, for instance, reported an uptick in nonperforming assets for the second quarter. Executives at Citigroup said they were girding for choppy waters ahead, forecasting increased loss rates in its giant credit card portfolio.  

Mercantile Bancorp in Grand Rapids, Michigan, reported slight, year-over-year increases in net charge-offs and nonperforming loans, though the numbers remain de minimis. The $5.1 billion-asset company’s lenders “remain highly engaged with our clients to identify potential problem loans at the earliest signs of distress and work collaboratively with clients to ensure that the issues are corrected and the risks to the bank are minimized,” President and CEO Bob Kaminski said Monday on a conference call with analysts.

“Mercantile is maintaining a close eye on borrower cash flows and ability to withstand both higher rates and a potential economic slowdown,” Hovde analyst Erik Zwick wrote Tuesday in a research note. 

This is a trend that community banks should expect to see throughout the second-quarter earnings season, experts warned. 

Ken Usdin, an analyst for Jefferies, wrote in a research note last week that he had modeled “steady increases in net charge-offs from higher rates and macro pressure.” 

While the economy has proved more resilient than expected, “we still see builds to quantitative [current expected credit losses] models and allowance-for-credit-loss ratios as the economy softens,” Usdin added. 

Commenting on Bank of America’s second-quarter earnings report Monday, David Fanger, senior vice president of financial institutions group at Moody’s Investors Service, noted widespread signs of credit-quality stress. “Asset quality indicators, although still mostly benign, are gradually weakening as the economy slows and the burden of higher interest rates affects more borrowers,” Fanger said. 

James Hughes, Unity’s president and CEO, said in a press release that an inverted yield curve, slower loan growth and tougher competition for deposits have created a challenging environment for banks. Indeed, the $2.6 billion-asset Unity reported $16.5 million in nonperforming assets on June 30, up from $9.1 million at year end 2022. For Unity, which reported second-quarter results on Friday, that figure amounted to 0.65% of total assets.

“Although Unity is not immune to this trend, we are in a strong position to face these headwinds,” Hughes added.

To be sure, community bankers have no reason to panic. The industry is coming off historically strong credit quality and appears well-positioned to weather a rise in problem loans. 

“Taken in its entirety, credit quality remains a positive differentiator for [WaFd],” Beardall said in the press release.

Most analysts, likewise, remained unfazed by the uptick in nonperforming loans. Jake Civiello, who covers Unity for Janney Montgomery Scott, wrote Monday in a research note that Unity’s credit metrics “remained a positive catalyst.”

Washington Federal reported net income of $61.8 million for the three months ending June 30, down 2% year over year despite continued contraction in its net interest margin and a notably higher allowance for credit losses, $9 million, compared to $1.5 million on June 30, 2022. The company was buoyed by net deposit inflows totaling $259 million, according to Beardall. “This is a continued reflection of the confidence our clients place in [us],” Beardall said.

Unity’s net income increased 2% year over year, totaling $9.7 million on June 30. The result topped Civiello’s estimate, prompting him to reiterate his “buy” recommendation and adjust his fair-value estimate of the stock upward by $2 to $29 per share.

Mercantile reported net income totaling $20.4 million, up 74% year over year. Year-to-date net charge-offs totaled $125,000, while period-end nonperforming loans amounted to $2.1 million, 0.05% of total loans. 


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