A Ticking Time Bomb for US Banks

A Ticking Time Bomb for US Banks


By Samantha Barnes, International Banker


The global commercial real estate (CRE) sector is now under severe pressure as interest rates remain elevated across much of the world. This is no more apparent or systemically important than in the United States, home to the world’s biggest commercial property market. And with a massive wave of property debt maturing over the next three years, speculation is mounting that the US banking sector could succumb to another major crisis should CRE loan-default rates climb to unmanageable levels.

At about one-quarter of the average lender’s assets and a whopping $2.7 trillion of aggregate bank assets, CRE loans represent a substantial share of the total US banking system in 2024. And with many of those loans issued at rock-bottom rates during the low-interest environment of the previous decade, borrowers’ ordeal of repaying their CRE loans at today’s sharply higher rates is placing immense strain on American lenders as they seek to avoid selling loans at significantly discounted prices.

To compound matters for CRE lenders, moreover, factors such as the slowing economy and strong post-pandemic preference for remote- and hybrid-working arrangements have not only further contributed to the sharply rising distress within the US CRE market but have also proven considerably bearish for US commercial property prices. According to Green Street’s Commercial Property Price Index (CPPI), which captures the prices at which US institutional-quality CRE transactions are currently being negotiated and contracted, commercial property prices fell by 7 percent over the past year and by 21 percent since their March 2022 peak.

It should not be surprising that the total value of delinquent loans tied to commercial properties such as malls, offices and industrial units was estimated at a whopping $24.3 billion last year, more than double the $11.2 billion registered in 2022. According to data firm MSCI, meanwhile, more than $38 billion of US office buildings are now threatened by defaults, foreclosures or other forms of distress—the highest amount since the fourth quarter of 2012. And the Mortgage Bankers Association’s (MBA’s) “2023 Commercial Real Estate/Multifamily Survey of Loan Maturity Volumes”, published in mid-February, found that 20 percent ($929 billion) of the $4.7 trillion of outstanding commercial mortgages held by lenders and investors will mature in 2024, a 28-percent increase from the $729 billion that matured in 2023.

The stress that such alarming figures are having on the banking sector is now eliciting serious concerns. As reported by the Financial Times in February, for instance, filings from the Federal Deposit Insurance Corporation (FDIC) revealed that US banks currently hold $1.40 in reserves for every dollar of delinquent commercial real estate loans, which is significantly lower than the $2.20 recorded a year ago and the lowest level in more than seven years.

What’s more, the average reserves at JPMorgan Chase, Bank of America (BofA), Wells Fargo, Citigroup, Goldman Sachs and Morgan Stanley fell from $1.60 to $0.90 for every dollar of commercial real estate debt on which a borrower is at least 30 days late. This means that delinquent CRE loans, which tripled to $9.3 billion for the six big US banks over the last year, have now surpassed the amount of reserves being held at those banks to cover them, which could prove hugely problematic should those loans end up in default.          

Many believe the situation should be manageable at current levels for the biggest banks. Wells Fargo, for example, recently confirmed that its CRE-loan strains are largely confined to the office sector and that it has set aside enough reserves to absorb charge-offs after large builds. But while CRE accounts for around 11 percent of the average loan portfolio of a big US bank, that exposure soars to 21.6 percent for small banks, such that more severe problems could befall smaller and regional US lenders as they face higher risks of write-downs.

Indeed, S&P Global Ratings warned in late March that regional lenders could see their asset quality and performance eroded by the stresses in CRE markets and that increases in modified loans and loan maturities “may foreshadow a decline in asset quality and performance”. The credit-rating firm lowered its outlooks on five such regional banks—First Commonwealth Financial (FCF), M&T Bank, Synovus Financial, Trustmark and Valley National Bancorp—as the five lenders have “some of the highest exposures” to CRE loans among the banks it assessed.

Having recently analysed about 4,000 US banks, moreover, consulting firm Klaros Group found that 282 banks, most of which are smaller lenders with less than $10 billion in assets, face two distinct threats in the form of commercial real estate loans and potential losses tied to higher interest rates. “Most of these banks aren’t insolvent or even close to insolvent. They’re just stressed,” Brian Graham, co-founder and partner at Klaros Group, told CNBC. “That means there’ll be fewer bank failures. But it doesn’t mean that communities and customers don’t get hurt by that stress.”

Casualties are already emerging. New York Community Bancorp experienced massive losses on its CRE loans, leading to almost $6 billion wiped off its market value, a $2.7-billion loss being reported in the fourth quarter of 2023 and a downgrade by Moody’s to “junk” status. And Pennsylvania Real Estate Investment Trust (PREIT) warned in November of its inability to make around $1.1 billion in debt repayments, prompting its second Chapter 11 bankruptcy since 2020 a month later. However, some commercial borrowers are taking actions to avoid or exit bankruptcy. To its credit, a comprehensive restructuring, which has involved slashing $835 million in debt from its balance sheet, saw the owner and operator of mall retail space exit from its bankruptcy status in early April.

Nonetheless, these deteriorations are signs of things to come, with more stresses and failures expected over the coming months and years that could well plunge the US banking sector into yet another crisis. A working paper published in February by the National Bureau of Economic Research (NBER) analysed the exposures of US banks to distress from their CRE loans during the Federal Reserve’s (the Fed’s) monetary-tightening cycle beginning in early 2022. It found that in the wake of recent property-value depreciations following higher interest rates and rising adoptions of hybrid-working patterns, about 14 percent of all loans and 44 percent of office loans are in “negative equity”, whereby their current property values are less than their outstanding loan balances. Should interest rates remain elevated and property values fail to recover, loan-default rates might reach—or even surpass—the levels seen during the 2007-09 global financial crisis (GFC).

Depending on the magnitude of defaults that transpire, the resulting banking-sector stress could ultimately trigger a wave of failures among lenders. At a default rate on CRE loans of 10 percent, for instance, the paper contended that US banks would experience an aggregate loss of some $80 billion, while raising the default rate to a worse scenario of 20 percent resulted in $160 billion of total losses. The NBER paper also noted that around one-third of all loans and “the majority of office loans” may encounter substantial cash-flow problems and refinancing challenges due to the more than doubling of debt costs resulting from the aggressive monetary tightening and substantial increases in credit spreads that have transpired.

“If such CRE loan distress would manifest itself early in 2022, when interest rates were low, not a single bank would fail, even under our most pessimistic scenario,” according to the paper. “However, we show that the large decline in banks’ asset values following this monetary tightening of 2022 has significantly eroded the banks’ ability to withstand adverse credit events.” As such, the authors warn of an increase in the insolvency risks of a “substantial set” of US banks, with an additional 231 banks with aggregate assets of $1 trillion under the 10-percent CRE loan-default rate scenario estimated to have mark-to-market (MTM) asset values below the face values of all their non-equity liabilities. Under the 20-percent default-rate scenario, that number rises to 482 banks, with aggregate assets of $1.4 trillion.

The prevailing high-rate environment also means that refinancing loans will remain expensive for CRE borrowers, and even more so with many banks now seeking to lower their overall CRE exposures. “Banks have tightened underwriting standards over the past year across a range of household and business loans, and they may continue to tighten further this year,” the FDIC’s 2023 annual report noted.

The Federal Reserve’s vice chair for supervision, Michael S. Barr, also confirmed in a speech given on February 16 that regulatory supervisors are closely focused on banks’ CRE lending in several ways, including “how banks are measuring their risk and monitoring the risk, what steps they have taken to mitigate the risk of losses on CRE loans, how they are reporting their risk to their directors and senior management, and whether they are provisioning appropriately and have sufficient capital to buffer against potential future CRE loan losses.”

As the following chart from the Federal Reserve Bank of St. Louis shows, US commercial banks have continued to amass CRE loans on their balance sheets in substantial quantities, with the latest reading for March at a whopping $2.985 trillion. This is 0.34 percent more than the previous month and 3 percent more than a year ago, implying the ongoing continuation of a long-term upward trend despite the widely known risks emanating from the commercial property sector.

Last June saw the FDIC, along with the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System and the National Credit Union Administration (NCUA), issue anInteragency Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts, a “principles-based resource for financial institutions to consider when engaging with borrowers experiencing financial difficulties”.


Originally Appeared Here

About Caroline Vega 228 Articles
Caroline Vega combines over a decade of digital strategy expertise with a deep passion for journalism, originating from her academic roots at Louisiana State University. As an editor based in New Orleans, she directs the editorial narrative at Commercial Lending News, where she crafts compelling content on commercial lending. Her unique approach weaves her background in finance and digital marketing into stories that not only inform but also drive industry conversations forward.