Since the Great Recession, Bank of America (BAC 0.17%), one of the largest commercial lenders in the country, has been going about a strategy that CEO Brian Moynihan calls "responsible growth." This refers to growing the balance sheet with disciplined loan underwriting so the bank can ride out any economic downturns.
In the fourth quarter, Bank of America reported a big step up in commercial net charge-offs, which represents debt unlikely to be collected and a good indicator of actual loan losses.
The increase comes as banks are bracing for what could be difficult economic conditions later this year. Is the sharp uptick in commercial loan losses a red flag? Let's take a look.
Putting the number in context
In the fourth quarter, commercial net charge-offs rose to $158 million, which is up $97 million or 159% from the third quarter. Commercial loans include small business, commercial real estate, commercial and industrial, and commercial lease financing. It's a somewhat notable jump when you consider that commercial net charge-offs really haven't moved much over the last year.
But in the grand scheme of things, credit quality is still quite healthy and near historic lows. Net charge-offs totaled just 0.11% in the bank's commercial portfolio, and the commercial net charge-off rate has averaged 0.51% since 2007.
Image source: Bank of America.
Conditions are normalizing
While loan quality is still extremely healthy, I do think management is starting to see cracks in certain areas, notably commercial real estate. Bank of America noted that in Q4 commercial criticized loans increased by about $1.6 billion. Criticized loans are those that aren't necessarily delinquent yet but that have a higher chance of becoming delinquent, so they can be a good indicator of what's to come.
Bank of America CFO Alastair Borthwick noted that about $1 billion of that $1.6 billion increase in Q4 was associated with office buildings, which have come under scrutiny as the pandemic has accelerated remote working, which looks like a trend that is here to stay.
Companies are likely going to downsize or get rid of office space if they don't really see a need for it, especially because it can be a big expense. Borthwick noted that the loans are still performing, but the bank wants to stay on top of it and get ahead of any problems.
Borthwick also noted that the office portfolio has very strong underwriting with 55% loan-to-value ratios, which means the customer borrowed 55% of the appraised property value and should have sufficient equity in the property. Borthwick also said that 75% of the bank's office portfolio is class A, which means very prestigious buildings with above-average rents. Office buildings also only make up about $15 billion of the bank's total commercial loan book, or about 2.5%.
Is this a red flag?
I definitely wouldn't tell investors to completely ignore some of these trends, especially when you think about office buildings, as remote work doesn't seem like a fad.
But credit quality is still quite healthy across the bank and near historic lows. The criticized loans also seem to be well underwritten, and it's good to see management already thinking conservatively.
A more severe recession could make things worse, but loan losses are going to move higher at some point because they are simply too low right now. At this point, I have no reason to doubt management and still like Bank of America's stock long term.
