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Equipment Leasing & Finance
Executive Perspective

Welcome to Chaos

Chris EnbomWELCOME to CHAOS for those running equipment finance companies! Underneath all of the headlines of the growth of equipment finance portfolios over the past few years and the health of the industry, the equipment finance industry is facing significant structural issues requiring fast reactions from its leaders. In this article, I explain several of the problems facing industry participants.   

Bank Balance Sheet Stress   

When both short- and medium-term interest rates were low, depositors had little incentive to search for alternatives to short-term bank deposits. For many years now banks have enjoyed high amounts of deposits yielding little or nothing, and there has been a huge amount of cash in the economy especially during Covid, when government spending was high and overall consumer spending low. 

As rates have quickly moved up, depositors have searched for alternatives to cash such as government securities and other instruments providing higher yields.  

At the same time, the underlying loan portfolios of banks are comprised primarily of medium- and long-term loans against commercial and residential real estate and other individual and commercial loans. Most of the loans were fixed rate, and at rates between 1.5% and 4%.  

With treasury and SOFR rates suddenly increasing, and interest-free deposits leaving many banks, there is a squeeze from three directions…less funds to lend, higher cost of funds and suddenly a portfolio of loans that has considerably less value in a higher-rate environment.  

Banks either need to raise equity capital, charge very high rates to attract new deposits or shrink. Many are being forced to choose the third option, having to either sell or run off “non-core” divisions. Additionally, due to the less stable nature of deposits in the current environment, bank regulators are looking much more closely at the balance sheets, policies and procedures of banks, resulting in more conservative lending practices. 

There are considerably less aggressive sources of wholesale syndication, and selling portfolios and transactions to banks has generally become more expensive, especially for riskier transactions. 

Expect more changes in the bank sector, with banks either exiting the business, scaling back, selling portfolios or merging.

The equipment finance industry is facing significant structural issues requiring fast reactions from its leaders.

Inverted Yield Curve   

This chart shows, in simplified terms, the effect of the recent yield curve moves on the margins of an independent equipment finance company. For the past 20 years, with a normal yield curve where short-term borrowing costs were lower than long-term borrowing costs, many independent equipment finance companies and banks borrowed utilizing short-term indexed rates such as one-month SOFR and lent fixed-rates. Others did partial hedging (I assumed 50% hedged in this graph), and some hedged most or all of the portfolio. In this graph example, I assumed that the finance company borrows at a 100 basis point credit spread and it costs 60 basis points to hedge over 5-year treasuries. I also assumed that the portfolio has an average yield of 350 basis points over 5-year treasuries. In reality there are other rate dynamics at play for companies that hedge, but the general point is to show that the 300 to 500 basis point spread enjoyed from borrowing short and lending “long” has been considerably squeezed in the recent rate environment, even to the point where companies who did not use more sophisticated hedging of the inverted yield curve last year are having considerable difficultly making money.

Where Do You Get Money? 

With the exception of the securitization market, which has remained active and liquid for finance companies, funding is becoming increasingly scarce and expensive. Independent and captive equipment finance companies with very strong balance sheets will always attract capital, but lending spreads are going up, covenants are tightening and many bank wholesale lenders are starting to exit relationships during renewal times due to their own balance sheet and regulatory stress. Capital is becoming much more expensive and scarce for many companies. 

Other Concerns 

Over the past couple of years as Covid waned, package shipping volumes fell and fuel prices rose, class 8 trucking has been under considerable stress. Additionally, used class 8 prices were artificially inflated during Covid due to supply chain issues, and those prices have now plummeted. We are starting to see some similar stress in used values of construction and other equipment. The lack of room for error in portfolios due to low margins, the increased scrutiny on institutions and a concern that portfolio stress and charge-offs will increase are adding to an already cloudy situation. 

Alas, there is room for optimism. Yield premiums have been too low for many years, and we may at some point see some higher spreads—especially for riskier assets. Where there is chaos there is opportunity, but it can be painful for most in the industry as we get through the pain. 2023 has been hard to navigate. I expect 2024 will be equally “interesting.” Put your seat belt on.  



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