The US markets were rocked by a series of failures in regional banks over the last month.
The US Federal Reserve and FDIC moved quickly to try and limit the damage, protect deposits, and prevent contagion from spreading to other banks.
On the face of it, they seem to have done a good job and we haven't seen a run on other US banks.
However, investor confidence couldn’t be said to have been restored, judging by this chart, which plots the S&P Regional Bank ETF (SRE), its 50-week Moving Average, in green, and the price of troubled lender First Republic (FRC) in red.
The ETF remains more than -20% below the moving average and is down by -28.0% over the last month, and shows little sign of wanting to bounce.
Why might that be?
A common factor among US regional banks is their high exposure to Commercial Real Estate or CRE loans, especially in the office sector, which itself has been hit hard by the pandemic and the associated shift to remote working.
What are CRE Loans?
Commercial real estate loans are loans that are secured against income-producing properties such as office buildings, shopping malls, hotels, and apartment complexes.
These loans typically have longer maturities and higher interest rates than residential mortgages historically they were often refinanced or sold before they matured.
According to Bank of America, US regional banks account for 68% of outstanding CRE loans, much more than their mega-cap banking peers.
Of the $270 billion of bank CRE loans set to mature this year, about $80 billion, or around 30%, are backed by office properties.
This poses a significant risk for regional banks, office vacancy rates have soared and office values have declined due to lower demand and economic uncertainty.
Poor risk management
Rising interest rates have also exposed some regional banks' poor management of interest rate risk. Some banks have invested heavily in long-term bonds that lost value when interest rates rose.
While others had funded their long-term CRE loans with short-term deposits a strategy that became more expensive when rates rose.
This created what’s known as a “duration mismatch” which resulted in a squeeze on net interest margins, capital ratios and in some cases solvency.
The most prominent example of this was Silicon Valley Bank (SVB), which collapsed on March 10 after selling a bond portfolio at a $1.8 billion loss. the bank than failed to raise enough capital to meet regulatory requirements or to find a buyer for the business.
SVB was one of the largest lenders to the tech sector and had $209 billion in total assets at the end of 2022.
Other regional banks that have faced similar troubles include Signature Bank, which failed on March 12 after a run on deposits; First Republic Bank, which received a multi-billion dollar lifeline from other banks and is exploring strategic options.
The failures and near-failures of these regional banks raised concerns about the stability and resilience of the US banking system, especially among smaller institutions, that rely heavily on CRE lending but which may not be able to hang on to their deposit base.
Is the fire out?
The Federal Reserve took steps to calm depositors and investors, such as providing emergency liquidity, increasing deposit insurance limits, and conducting stress tests.
However, some analysts warn that more challenges lie ahead for regional banks that are heavily invested in the office market.
Fitch Ratings expects further declines in lower-quality office values, driven by higher vacancies and lower rents due to what it called structural changes in office space utilization.
Bank of America predicts that CRE loans could be the next domino to fall in the economy, owing to a credit squeeze and a raft of upcoming loan maturities.
This chart, below Chen Zao, the Chief Global Strategist at Alpine Macro, shows the sharp decline in the value of office-focused real estate investment trusts, verus the wider REIT sector.
And the exposure that intermediate and small regional banks have to the sector, compared to their mega-cap competitors.
Is this a car crash thats unfolding in slow motion?
It certainly has the potential to cause further problems for regional banks whose finances are already stretched. If those lenders are unable to refinance their commercial real estate customers then they will have to look elsewhere for finance or perhaps sell off property during a downturn in the cycle and presumably do at prices well below face value.
In turn that could drive down the value of other properties, that act as security or collateral against other CRE loans, and we could end up with a vicious circle.
The chair of the Federal Reserve Jay Powell said recently that the collapse of silicon valley banks and others “are likely to result in tighter credit conditions for households and businesses, which would, in turn, affect economic outcomes."
Some in the market have taken that to mean that the Fed expects a credit crunch, at some point this year.
If thats the case, then the central bank will be exploring its options.
One thing it could do to ease the pressure on regional banks and their CRE loan books would be to allow the banks to pledge those loans as collateral, against which they can borrow from the central bank.
That wouldn’t solve the underlying economic issues in the banking and office sectors, but it would likely buy both groups some much-needed breathing space.
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