Ratings Downgrades Loom For U.S. Regional And Smaller Banks Exposed To Commercial Real Estate

Commercial real estate loans outstanding have grown slightly over 100% in a decade. CRE borrowers took advantage of the incredibly low interest rates, an economy recovering from the Global Financial Crisis, and banks that in too many cases were less than diligent in underwriting loans. Presently, the amount of commercial real estate loans, as a percent of banks’ total loans, has grown to being slightly higher than it was in the last quarter of 2007. This worries me.

The party at the low interest rate buffet trough eventually ends in tears. We are now in a global environment of much higher interest rate environments. This means that even if the Federal Reserve Bank and other key central banks around the world pause their rate hikes, rates do not just suddenly decline. CRE borrowers will face higher borrowing costs when they must refinance in the foreseeable future.

Unfortunately, banks that are smaller than the Globally Systemically Important Banks (G-SIBs) are more vulnerable in the continued deteriorating commercial real estate environment. Banks that are $100 billion in assets are less diverse by geography and by business lines; hence, they depend more on their net interest margins. As the default rate of commercial real estate loans rises, this will pressure banks’ liquidity and earnings.

In a report released May 24^th by Fitch Ratings, data shows that for banks that are $100 billion dollars or less in assets, commercial real estate loans are a much bigger percentage of total capital than they are for banks over $100 billion in assets. Johannes Moller, Director at Fitch Ratings explains that “U.S. regional and small banks with meaningful commercial real estate concentrations could experience negative rating pressure if portfolios deteriorate, particularly those with more exposure to office markets constrained by weaker occupancy.” According to Fitch Ratings, “most concentrated CRE exposure is held on balance sheets of smaller banks which are not rated by Fitch, limiting our visibility into lender-level credit quality for the broader ~4,700 banks in the U.S.”

Commercial real estate loans are heterogeneous. Banks are the largest lender in loans to the office market. According to Fitch Ratings data, banks hold about $720 billion in outstanding office loans.

Moreover, some parts of the commercial real estate sector, such as offices, have been adversely affected by COVID. Office occupancy rates are far from being at 100% due to a good number of professionals being able to work remotely at least part of the time if not the whole week. Fitch Ratings analysts explain in their report that “assuming a hypothetical stressed loss rate of 20% for these loans (about double the 9.8% average nine-quarter loss rate for CRE per the 2022 severely adverse DFAST), this results in about $145 billion of cumulative losses, or 8% of the sector’s $1.76 trillion of tangible common equity, which banks should be able to absorb over time as they work through their maturities and renewals.” The phrase ‘over time’ troubles me. How long? And when defaults start happening, this could well lead to market volatility.

Another key reason to watch CRE loans is that a significant amount of loans underwritten in 2018 and a few years prior to then are due this year. Interest rates are much higher than they were in those years. We are about to find out how good banks’ underwriting standards were in those years. Given that 2017-2018 were years of deregulation and a bank friendlier tone from former Federal Reserve Vice Chair of Supervision Randal Quarles, I have my doubts.

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