Small Banks Have Big CRE Risk? Really? | Bank of America Update

March 25, 2024 | Premium Service | Updated | It’s one year since the bank formerly known as Credit Suisse started to wobble after several embarrassing losses, resulting in a forced marriage to advisory behemoth UBS AG (UBS).  A year later, UBS is still trying to offload the largest servicer of legacy private-label residential mortgages in the US, Select Portfolio Servicing. SPS had about $150 billion in unpaid principal balance on over 800,000 loans at the end of 2023.

SPS was acquired by Credit Suisse Group AG (CS) in 2005. With the June 2023 acquisition of CS, UBS is now the parent company of SPS. Apparently another auction is in process for SPS focused on private servicers. As before, UBS is trying to get par for servicer advances on the delinquent private label loans in the portfolio, advances that are in some cases 15 years old. Several bankers that have looked indicate to The IRA that 60 cents on the dollar is closer to fair value for the SPS default advances. 

It’s a comment on the current state of the markets that so many conversations in the credit begin around 60 cents on the dollar. Like the value of a house or condo in FL that is not covered by hazard insurance on the property. And the power is turned off, meaning no A/C. The walls are already growing.

Our friend Nom de Plumber asked what happens when a conventional or government guaranteed loan which is no longer protected by property casualty insurance on the house. The answer is that the servicer of the loan is in violation of the Guide from Fannie, Freddie or Ginnie. The GSEs can probably waive the insurance requirement temporarily, but Nom de Plumber asks the obvious question: who takes the loss on the uninsured house when it is destroyed by a hurricane? The servicer.

Small Banks Have Big CRE Risk? Really?

Another favorite topic of conversation when it comes to discounts from face value is commercial real estate. Over the past several months, a number of members of the media have decided that the commercial real estate (CRE) concentration ratio is the key factor in determining a bank’s exposure to loss on moribund office properties. It's easier for the generalist reporter to seize upon a single metric instead of spending time to actually understand the issue.

Naturally, the media narrative says that small banks have more problems than large banks in the $2.5 trillion in total CRE exposures. In fact this is not true and shows a considerable lack of nuance on the part of occasional visitors to the world of banking. Small banks have bigger percentage concentrations than large banks, but the big banks have far larger risk exposures in dollar terms.

A small bank may have a CRE ratio over 300, but if you don’t count those buildings that are “owner-occupied” - that are not rentals but where the business is located in the building - the CRE ratio drops to slightly below 200. The owner occupied properties perform better, needless to say.

The CRE concentration ratio was added to the regulatory disclosure at the behest of the FDIC after the 2008 financial crisis, but as Bill Moreland of BankRegData notes in a must-see video posted last week, the ratio is not as useful for assessing large complex banks compared with community banks. So while the CRE concentration ratio is useful for predicting future problems with smaller community banks, it does not illuminate current problems facing larger banks right now. Bill's video is below.

We have noted over the years that most of the top-five banks have less than half of total assets actually deployed in banking, while the remainder is for trading, capital markets and other non-banking activities. In addition, the regulatory data does not distinguish between performing loans and loans that have been modified by the bank into a troubled-debt restructuring (TDR).

As Moreland notes, you need to add non-performing loans to TDRs to begin assembling a true picture of the bank’s asset quality. The CRE concentration data from FDIC also includes some unsecured exposures. The table below from BankRegData shows the concentration ratios by asset size. The ratios look gnarly, but the banks below $10 billion in assets are really small and they tend to own small loans.

Go above $50 billion in assets and the banks start to change and have significant trading and investment advisory activities. Thus the large banks have low CRE concentration ratios, but very large dollar exposures. Moreland notes that most of the largest banks such as Wells Fargo (WFC), Bank of America (BAC) and U.S. Bancorp (USB) already have non-performing CRE loans in mid-single digits or higher today.

Source: BankRegData

"Since higher is worse there is a continued media focus on the 'impending risks to the community bank' community," notes Moreland. "I've tried to explain to them that they are focused on a potential issue, rather than a current actual issue, but 'our Editor doesn't want that story' is the response. We should not get to focused on what may happen in CRE a year from now and focus instead on what is happening today. The storm is here for CRE."

Moreland notes that if we add non-performing CRE loans to TDRs that are still considered "performing" by credulous auditors and regulators, then WFC's defaulted CRE exposures really are well-above 6% already and climbing. Other large banks show similar levels of morbidity on CRE loans, but nobody in the Big Media wants to talk about this because the equity managers who buy size via passive strategies will be very disappointed.

The other issue at work here is not simply TDRs, but the broader tendency to formally or informally modify delinquent loans to avoid default. In the world of residential mortgages, for example, a compromise with creditors has become the first, second and even third option in the servicer waterfall post-COVID.

In commercial credits as well, loans that have been extended on previously contracted terms or placed on interest only usually indicate a distressed debtor that has defaulted in all but name. The lender is slowly becoming the owner of the distressed asset. This is why the sharp correction up in loss given default on bank multifamily assets in 2021 and 2022 was significant. When you see lenders taking 100% losses on a secured 60 LTV commercial mortgage, that's a red flag.

Given these caveats, how are consumers and investors supposed to tell good banks from bad? Our rule of thumb is to compare cash losses vs total assets and tangible Tier 1 capital.  Thus when we’ve written about the substantial net credit losses of Goldman Sachs (GS), the remarkable fact is that the losses of this investment banking group are above the losses of Main Street depositories when compared with the total consolidated assets. Indeed, the GS net loss rate is above the Peer Group 1 average for the top 130 banks.

Source: FDIC

Update: Bank of America

When we try to convey the magnitude of the under-performance of Bank of America (BAC) compared with other banks, one of the first relationships we show is net interest income. JPM had $3.875 trillion in assets at the end of 2023, but BAC had $3.1 trillion or 17% less. Yet BAC generates 40% less net interest income than does JPM. This is a fundamental and striking indictment of CEO Brian Moynihan, yet the big media remains mostly silent.

Source: FFIEC

While JPM has astutely managed its duration risk over the past five years, BAC has not, leaving the bank with a 10 point operating deficit vs JPM. Below we can see the components of earnings and how the net income of BAC compares with the average for the top 130 US banks.

Source: FFIEC

As you can see in the table above, BAC is tracking below the average income for Peer Group 1. Why? First we start with overhead expenses equal to 2.11% of total assets, then add interest expense of 2.32% for a total of 4.4%. The bank's return on earning assets is only 4.48%, thus BAC is underwater on earning assets and is literally surviving on non-interest income.

Source: FFIEC

With an efficiency ratio in the mid 60s, BAC is not that far off the Peer Group average of 61, but the degradation of industry efficiency in Q4 was broadly felt by all banks. BAC already has lower than average operating expenses, although compensation per head now averages over $180k. Yet it is in the areas of credit that BAC has some of the biggest challenges. Simply stated, JPM and USB have higher net losses but they also have higher net income.

Bill Moreland notes that as of year-end 2023 BAC had commercial NPLs and "performing" TDRs equal to more than 8% of total CRE loans. That is a big number. But the overall credit situation at BAC is poor and getting worse across all asset classes. The net losses disclosed by BAC and the other large banks at the end of Q4 2023 are significantly understated if we include "performing" TDRs in the calculation. We expect to see reported net loss rates for most US banks move higher in Q1 2024 and the balance of the year.

Source: FFIEC

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