Rising Yields Put Regional Banks to the Test
As the US Treasury yield continues its upward trend, commercial real estate distress risk is putting pressure on regional banks’ balance sheets. The higher borrowing costs are already affecting the stock market, with smaller bank shares falling by approximately 8.2% since late November.
The Risk of Default
The increasing cost of credit is making it more challenging for borrowers who purchased office buildings before the pandemic to refinance their loans. This, in turn, increases the risk of default, leaving regional banks vulnerable to higher losses on commercial real estate.
Unrealized Losses
According to Federal Deposit Insurance Corp. Chairman Martin Gruenberg, the surge in 10-year yields last year likely reversed most of the decline in unrealized losses on banks’ available-for-sale and held-to-maturity securities in the third quarter. Even with the recent rally in the market, the benchmark has risen by about 0.3 percentage points to around 4.58%, adding to the pain for lenders.
Commercial Real Estate Loans
Tomasz Piskorski, a finance and real estate professor at Columbia Business School, estimates that around 14% of the $3 trillion of US commercial real estate loans are underwater, rising to 44% for offices. Smaller lenders are more vulnerable to CRE defaults due to demanding lower down payments from borrowers than their larger counterparts.
Office Market Instability
The office market has yet to stabilize, and lenders are taking precautions. PNC Financial Service Group Chief Executive Officer Bill Demchak stated that the bank increased the reserves it set aside to cover soured office loans to 13.3%, up from 8.7% at the end of 2023.
Silver Lining
On the positive side, the declining cost of deposits, thanks to lower Federal Funds rates, helps stability. Steady deposit flows in the fourth quarter suggest that the odds are low that they could quickly be moved to other banks, reducing the risk that lenders have to sell underwater bonds.
Bank Fragility
Despite the positives, Tomasz Piskorski warns that “we are entering into a very precarious position” and “instead of escaping this area of bank fragility, we are moving toward an increasing area of bank fragility.” The incoming administration’s potential deregulation efforts may boost bank margins, but the rising borrowing benchmarks pose a significant risk to regional banks.
Corporate Bond Market
In other news, the corporate bond market is showing signs of life, with the six biggest US banks issuing corporate bonds or preferreds this week. The boom in electronic trading has made it cheaper to trade corporate bonds, enabling a wider range of investors to buy and sell large volumes of securities faster and more efficiently.
People on the Move
Paul Goldschmid, a former partner at King Street Capital Management, has launched his own long/short credit firm, Harvey Capital Partners. Goldman Sachs Group Inc. has promoted several key executives and combined teams to form a capital solutions group, recognizing the growing importance of private markets.
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