Low oil prices aren’t the only factor stressing energy loans these days; federal bank regulators are put­ting the squeeze on oil and gas debt portfolios by amping up critical classifications of senior secured loans made by energy lenders. And banks are crying foul.

It’s guilt by association, they claim. That is, association with junior unsecured debt.

Syndicated bank loan portfolios are subject to review by the Shared National Credit program, an interagency organization with shared oversight by the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency. Agent banks and participating banks are bound to the classification bestowed on a particular loan by the SNC, and are forced to comply with the accompanying requirements attached to those classifications.

In April, in its semi-annual risk assessment report, the OCC sent a shot across the bow of energy banks, putting on notice their credit underwriting practices for oil and gas portfolios as a top priority. “Where indicated, examiners will … assess banks’ actions to assess, monitor and manage both direct and indirect exposures to the oil and gas sector, given the recent decline in oil prices and the potential for a protracted period of low or volatile prices.”

Essentially, energy loans are in the crosshairs for extra scrutiny. Since April, energy bankers have indicated that the number of energy loans receiving a “substandard” or “doubtful” rating has effectively doubled from last year, a record number, per one banker.

Why do loan grades matter?

“They matter because it governs how much capital the bank must hold against the loan,” said Steve Kennedy, executive vice president and head of energy banking with Amegy Bank. A normal loan in good standing might require 8% to 12% reserve capital, but “the capital required to be held against a problem loan might be double that. It’s very expensive to have a lot of problem loans in the portfolio.”

Loan grades also matter because a substandard or below rating reduces flexibility in how a bank can handle individual client loans.

“These loan classifications impair a bank’s ability to respond and try to assist an affected company in getting through a difficult time,” said Dennis Petito, managing director, head of North America energy coverage for Credit Agricole. The increased tendency of regulators to downgrade energy loan classifications “could have unintended consequences,” he said.

Banks vs. junior debt

Regulations, per se, haven’t changed for energy lenders, just the perspective of the oversight regulators.

“The big disconnect right now between how banks are reviewing their loans and how the regulators have viewed the loans is with regard to the junior debt,” said Kennedy.

Typically, a bank will evaluate its senior debt against the collateral, and in some cases may view the senior debt as protected, even if the junior debt behind that loan causes the client to be overlevered. In such a scenario, the bank’s exposure would be adequately covered by the value of its collateral. Yet the federal reviewers have begun to take a different tack. In a world of sustained lower oil and gas prices, the SNC has tended to view overleverage by a company as a problem for both the junior and senior debt.

As such, “they’ve assigned basically the same grade to the senior debt as they would to the junior debt. Their thinking is, if a company needs to go through a bankruptcy process, you don’t know what a bankruptcy judge might do relative to collateral and cash flow. They believe there is a risk of loss any time the total debt is too high,” Kennedy said.

Petito takes exception to that assumption. “As an asset class, the bank reserve-based loan is a very safe asset class.”

The history of loss by experienced reserve-based lenders is “virtually nil,” he said, less than 5% over time. “There have been few instances where banks have suffered loan losses on their primary reserve-based portfolio. It suggests the banks are pretty darn good at what they do.”

Experienced reserve-based lenders would have had a sensitivity case of $50 oil starting in 2015, simply because the consultants were pointing to that scenario, he said. “We certainly did. While the market has proven weaker than any had anticipated, clients that have adequate liquidity and reasonably unlevered balance sheets can weather this rough patch. However, the banks will have to show patience and give them time to work through it.”

Downside scenarios currently are being run at the low-$30s oil price level to assure the loan pays out.

Jim McBride, a former banker who now consults with energy companies, bolsters the bankers’ position. “Generally, additional debt behind the bank debt is unsecured, or is subordinated, and can’t force collection until the bank is paid off.”

Additionally, most loans are syndicated among 10 to 20 banks, almost all with internal engineers that review the loan value, said Petito.

“You have a lot of experienced eyes looking at any given transaction, none of whom wants to lose money for their institutions, and empirically they’ve been very good at it. You would expect the regulators would recognize that history, and allow the banks to continue to support their clients.”

The banks need to have the latitude to do what they do best, he said. “We’ve seen more situations where credits have been downgraded than there should be.”

Typically, credit rating agencies such as Moody’s or S&P—not government regulators—should be concerned about the general creditworthiness of a company, Petito said. “One would expect the bank regulators should be concerned about the assets that the banks have on their books, which tend to have a much better outcome in troubled times, than what unsecured creditors experience during those same times.”

Layers of debt

The SNC’s heightened scrutiny may be a sign of the times, however. Where in the past oil and gas operators have taken on junior debt as a temporary bridge to another event, such as bringing on more asset value, more equity, or to a sale, the trend in recent years of historically low interest rates has led to operators layering on additional leverage. These financial instruments include high-yield debt, second liens and term B loans, an effort to keep pace in a higher-ante shale environment.

“It has become more of a permanent part of a company’s capital structure today,” noted Kennedy.

The result is an abundance of highly levered operators caught in a pinch with depressed margins. Never before has the industry been so levered with junior debt. “We’ve never had a downturn this significant where we’ve also had so much use of junior debt,” Kennedy said.

“The energy industry was growing quite a bit because of the shale revolution, and it consumes a lot of capital,” said McBride. “The banks have provided or arranged for a lot of that capital, and I’m sure the increased scrutiny came from the growth of lending into the energy sector.”

Were energy lenders too lenient? “Banks were generally using about a $70/bbl price deck when crude was $100. We thought that was conservative then, but today it doesn’t look so conservative.”

The fallout

A substandard grade cuts two ways: It requires the bank to keep more capital in reserve against the loan, approximately double the amount for a loan in good standing, and the bank loses its flexibility in working through a cash-flow crunch with the client.

“We’re having to use more of our capital in our loan-loss reserve to support that loan,” Amegy’s Kennedy said. Instead of a 10% equity piece for a healthy loan, where 90% of the loan is funded by deposits, the equity side for substandard and below loans is closer to 20%.

“As you might imagine, it affects the way a bank views the loan going forward. It would also affect the bank’s willingness to expand the loan facility at some point. All of these things have a very real effect.”

For instance, a bank might “dial back” the amount it is willing to lend to the energy industry, scrutinizing a company’s debt exposure more critically as that debt becomes more expensive in light of the risks and costs involved.

“As more capital is being held against these loans, banks are assessing what are the true costs of that senior debt when a company also has a large amount of junior debt,” Kennedy said.

“We might have reservations” on future loans, Credit Agricole’s Petito acknowledged, “because if the SNC classifies that loan, then we’re subject to internal criticism and substantially higher capital costs. Now we’ve got a higher exposure to a classified company than would be considered acceptable.”

As such, “you might see pre-emptive activity on the part of banks that might otherwise be willing to extend additional credit, if they think it could get rocky.”

Hands tied

A second concern is reduced flexibility to work with a client. A bank might have a difference of opinion with the grade placed on a loan, “but the challenge is, once that credit becomes criticized,” said McBride, “the bank’s ability to work with that client is less flexible than it was before the credit was criticized.”

Depending on the client’s situation, a bank might be willing to relax a lending standard to help a client through a rough patch, Petito said, “but when they do that and the reaction is to lower the classification of the loan and put it in a different asset class, it could hamstring the ability of the institution to be responsive to the client, although it might be a legitimate way for the bank to help that client.

“There are lots of situations short of bankruptcy in which banks can assist a company in getting through a liquidity crisis with the expectation that it then normalizes its capital structure and gets back on track.”

Companies with temporarily high debt-to-EBITDA ratios due to depressed oil prices, but that are able to live within cash flow, are probably going to be all right, Petito predicted. “But if a company like that happens to get classified as substandard, then it’s going to be tough for banks to continue to support it.”

McBride noted that following the financial crisis in 2008, the American public demanded more government oversight of banks. Particularly in lieu of the mortgage default crisis, “regulators don’t want to be accused of being asleep at the wheel” this time, he said.

Before the downturn in the price of oil, the average bank had less than 5% of its loans as having issues that were criticized or classified, and now the average bank may have loans that are criticized and classified of 20% to 30% of their portfolio, estimated one banker.

Those aforementioned unintended consequences, per Petito, could be companies being forced to sell assets they would prefer not to sell at a time when the value of those assets are low, or companies being forced to merge with other companies.

Coming together

But along with the record number of energy loans classified as substandard, comes a record number of bank appeals of those classifications. “It’s a good time for the two parties to get together to discuss this and get on the same page,” said Kennedy. “We don’t want to overreact.”

In September, regulators called a meeting in Houston with nine energy banks to address concerns and determine if any changes to their approach to grading senior debt is warranted. Kennedy participated in that meeting, which he believes is unprecedented, and deemed the result refreshing and cooperative. “They aren't trying to tell anyone how the cow ate the cabbage.”

Rather, the regulators are “making a concerted effort” to determine if the current way energy companies capitalize themselves with various forms of debt warrants a change in the way the regulators view senior debt in relation to other forms of debt. The outcome of the discussion is yet to be determined, “but their approach was commendable.”

In fact, many of the energy banks’ appeals have been granted, it was revealed in the meeting.

“It’s important to concentrate on situations that are truly overleveraged and truly present some risk of loss to the bank,” Kennedy said, “and not overreact in the other situations where the leverage is too high, but the banks have enough coverage to be patient and allow some time for those situations to be resolved.

“I hope in the coming months we’re able to determine exactly where that line is,” he added, “where banks and regulators can agree that in some cases the bank debt would not be treated as overleveraged if the bank’s senior loan is well-covered by the collateral value and its cash flow.”

But do energy loans deserve higher scrutiny in a world of sub-$50 oil?

“The quality of these loans has gone down in every energy bank,” Kennedy confirmed. “That’s a reflection of what’s happening in the industry. We just have to recognize the effect of the market on these loans. The risk hasn’t changed—the risk ­­­was always there—but now we’ve realized one of the downside scenarios. We’re experiencing that stress test right now.”