Bad loan term returns for banks trying to spot recession

If there isn’t enough banking jargon to blind you, it’s time to learn a new part of it: Welcome to the industry’s “criticized loan” era.

It’s a loan that doesn’t go bankrupt, or even default. But in a time when Wall Street is rocking at any sign of recession risks, especially from banks, it is picking up new currency. The loans criticized are those that show early indications of higher risk, such as a developer making payments but otherwise experiencing financial difficulty or a nearby office building This has lost a major tenant and needs to be replaced.

And they are rising, which is setting off alarm bells that have sent bank stocks down about 20% since early March, even as earnings from the sector are getting better than expected. Wall Street is watching Statistics on commercial real estate loans are close to close with indications that depositors are fleeing because of the higher interest rates paid by money market funds (question #1 about these funds). recent earnings call).

According to David George, banking analyst at Robert W. Baird & Co. is a way to get at least limited insight into the real estate downturn that many analysts predict will get worse before it gets better, because of a combination of Fears of an economic recession and slow return of workers to the office after Covid fueled expectations of a high vacancy rate.

“This is more subjective, but there are regulators in every bank,” he said. “Criticized loans can be paid or taken, but a loan can be disqualified because of its collateral.”

Not all banks disclose criticized loan growth in their income statements, and the definition of criticized assets is more flexible than categorizing whether a loan is delinquent or otherwise. alternatively “inefficient”, meaning that the loan has missed payments or is in breach of some other provision of the loan agreement. According to David Fanger, senior vice president of bond ratings agency Moody’s Investor Service, a bank’s quarter-end list of critical assets was built by the bank itself, under scrutiny by analysts. bank check.

The Federal Deposit Insurance Corporation’s guidelines for such loans say they should be singled out if “there are well-defined weaknesses that jeopardize the orderly liquidation of the debt. on one’s own, [including] the project lacks marketability, inadequate cash flow or… the project fails to meet economic expectations. They are characterized by the obvious possibility that the organization will suffer some loss if the deficiencies are not rectified.”

Bank earnings show modest growth in ‘criticized loans’

So far, first-quarter reports show only slight growth in criticized loans, even as they become the focus of attention at regional and national commercial banks. like american bank And Wells Fargo.

At Bank of America, criticized loans for office construction projects rose to $3.7 billion out of $19 billion in office loans. But office buildings account for only a quarter of the bank’s commercial real estate loans, and all CREs account for only 7% of the bank’s total loans and leases. So even that ominous-sounding number – 20% of office loans are at least likely to be shaken – represents less than 1% of total bank loans and leases. . Bank of America has set aside $900 million for potentially loss-making loans across all categories, a more authentic indication of near-term vulnerability.

“They were too reserved,” said George. “We can barely see the office [losses] more than 4 or 5 percent of office loans. They’ve got reserves for that.”

Wells Fargo, the nation’s largest commercial real estate lender, according to American Banker, did not disclose the extent of the lending criticized in its earnings report. A spokesman said in an e-mail that the figure would be in the bank’s quarterly Securities and Exchange Commission filings. Wells Fargo previously said its criticized lending to commercial real estate fell in 2022, but rose in the fourth quarter to $12.4 billion of a total of $155.8 billion in loans. .

Among the most detailed revelations are those from Bancshare Huntington, an area based in Columbus, Ohio with $169 billion in assets. Its criticized loans, which include all commercial loans and not just real estate, rose 5% to $3.89 billion. That included a $323 million loan upgrade to a higher risk rating and a $483 million payment, offset by $893 million in a new loan that was classified as “disappeared.” criticize”. The loans criticized represent just 3.5% of Huntington’s total loans and 13 times the total of 30-day overdue commercial loans.

Of Huntington’s more than $16 billion worth of commercial real estate loans, none are 90 days past due and only 0.25% of balances are 30 days or more past due. But the 30-day lag category grew from near zero by the end of 2022. How big is this problem? If all of the 30-day delinquency loans go unpaid and have to be written off, Huntington’s $602 million in quarterly earnings would drop by about 7%, or $41 million. The total of all loans criticized compared to the net income in 2022 is 2.13 billion USD.

Huntington’s chief executive officer, Stephen Steinour, told analysts on a recent earnings call: “Our credit quality remains top-notch. “Huntington is built to thrive in times like these.”

The story is similar among regional banks in general. PNC, the second-largest bank in the region, said criticized real estate loans now account for 20% of office loans, because the multi-tenant buildings it lends to are empty. about 25% and 60% of loans will be refinanced or repaid by the bank. by the end of 2024. But only 0.2% of office loans are actually past due. “For the foreseeable future, this (multi-tenant office) is our top area of ​​concern,” CFO Robert Reilly told analysts. PNC has a loan loss allowance of 9.4% of total multi-tenant office loans.

At the Cincinnati headquarters Bancorp Thursday Tuesday, 8.2% of office loans are currently being criticized, but that number represents about 0.1% of total bank loans. based in Cleveland keycorp said loans criticized accounted for about 2.8% of the total, up from 2.5% at the end of last year, but only 0.2% of loans were not paid on time.

Keycorp CEO Christopher Gorman said after the earnings report: “Credit quality remains good,” adding that the company has been reducing risk for a decade, including eliminating most of its assets. construction loans for office building developers. “We limit our exposure to high-risk sectors, such as offices, homes, and retail,” he told analysts on the quarterly earnings call.

There is an estimated $1.5 trillion in commercial real estate refinancing over the next three years, but Moody’s research shows that the portfolio is well diversified across banks, and follow a Recent analysis from CNBC Pro Using Deutsche Bank data, the concentration of CRE risk is smallest at the largest banks, where office loans make up less than 5% of total loans and average less than 2%.

For investors, it’s important to look at all the metrics together to manage their own risk, Fanger said. Many, even most, of the loans criticized will never turn into bad debt, he said, as they can be restructured or refinanced, or the office building’s collateral can be refinanced. sold to pay off some loans. But the striking new metric, which he says has been around for years, is the place to look for a version of what might happen in the future.

“There is a qualitative dimension to any assessment,” says Fanger. “We found it to be a useful measure of the direction the risk could take.”