Loan Portfolio Optimization and the Perils of Complacency

Monitoring the Continuing Progression of Credit Risk

Here we explore the need for fine-tuning every lender’s commercial loan portfolio for optimal credit risk while balancing growth objectives, regulatory compliance and borrower demand with safe and sound credit management.

This paper addresses the following:
• Rising commercial lending delinquency concerns
• Potential risks in upcoming CRE loan maturities
• Industry and regulatory concerns for 2024
• Mitigating risk through independent loan and portfolio reviews
• Introduction to MBL Risk Analytics

Your commercial loan portfolio is a living, continually changing entity. Bank and credit union commercial loan portfolios are compilations of living expectations and covenants that, left unmonitored, may exceed risk tolerance limits, erode liquidity and trigger institutional failure.

Lenders make credit decisions based almost exclusively on present facts, historic performance trends, and financial projections. In other words, we bet the future on past events or projections. To be clear, after the commercial loan has been funded, boarded, and all the documents have been neatly filed away, things change.

Life goes on. People change. Priorities change. Environments change. Repayment capacities change. While the business owner continues to focus on what she or he does best, the world continues to evolve. Political, economic, environmental, state and local events are fluid. Competition, human resources and other increased costs of doing business trigger operational changes that impact the borrower’s ability to service the debt. In other words, credit risk does not stop when the loan docs are filed.

Credit risk continues to change and independent loan portfolio monitoring – the ongoing evaluation and analysis of a financial institution’s loan portfolio - is no less important than the everyday monitoring of an individual’s investment portfolio to proactively identify and manage risks.

In most cases, the original loan documents include loan covenants – minimum financial performance standards – that the borrower must meet not just at the onset, but during the term of the loan in order to maintain good standing and minimize risk to the lender. However, as time goes on, covenants and other performance requirements become forgotten or more and more difficult to fulfill and, without a continuous, proactive independent loan and portfolio management process, lenders may not be aware of a borrower’s failure to comply with those performance standards until they are in default. Effective loan and portfolio management enables timely, proactive steps that can be taken by both lender and borrower to avoid default.

Why is this important now? 
Commercial real estate loans delinquency is heading in the wrong direction. Delinquency rates for mortgages backed by commercial properties increased during the fourth quarter of 2023, according to the Mortgage Bankers Association’s (MBA) latest commercial real estate finance (CREF) Loan Performance Survey. “Ongoing challenges in commercial real estate markets pushed the delinquency rate on CRE-backed loans higher in the final three months of 2023”, said Jamie Woodwell, MBA’s Head of Commercial Real Estate research. “Delinquency rates jumped to 6.5 percent of balances for loans backed by office properties and to 6.1 percent for lodging-backed loans.

Delinquencies for loans backed by properties remain elevated for multifamily and industrial property loans both increased marginally…many properties and loans still face higher rates, uncertainty about property values and – for some - changes in fundamentals.” For many commercial real estate borrowers, interest rate adjustments built into their current loan structure will result in a heavy financial burden in 2024.

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