At first glance, the answer to the question 'have US regional bank stocks emerged from their crisis' is: not really.
First, much of this is an index-driven rotation trade. As investors switch out of the ‘magnificent seven’ tech stocks for smaller-cap names, the index lifts all boats. And it is far from clear how many investors understand the specific balance-sheet exposures and credit issues they are gaining exposure to from the large number of US regional banks they’re buying at the index level.
However, some investors are buying regionally banks specifically, either individual names or through S&P Regional Banks Select Industry KRE Index. This seems to be driven partly by the belief that a more-likely victory for Donald Trump – and his new vice-president pick of JD Vance – would usher in a benign regulatory environment for bank M&A. But also, the banks’ losses in their accumulated other comprehensive income (AOCI) bond portfolios are now falling – certainly on the shorter-dated notes in these portfolios – as they’ve been running off.
The Fed’s recent stress test found that banks could sustain a 40% fall in valuations of CRE assets – but it was applied only to the largest 31 US banks
Add to this the expectation of US rate cuts – which will help reduce the underwater position of these portfolios (even if only modest cuts are expected) – and the outlook for the sector certainly looks better.
But let’s not forget a key element of the 2023 regional banking ‘crisis’: these firms’ exposure to commercial real estate (CRE). Risks in this asset class haven’t reduced over time and could be growing, just as investors are rushing into the sector.
The US Federal Reserve’s recent stress test found that banks could sustain a 40% fall in valuations of CRE assets – but it was applied only to the largest 31 US banks.
The concentration of CRE loans is much, much larger within smaller regional banks, where there hasn’t been widespread systemic stress analysis. Among these firms, there has also been a noticeable absence of statements from senior management over their CRE exposure.
Bankers and lawyers who are active in CRE have been saying – off the record – that some regional banks are now trying to offload CRE exposures as ‘extend and pretend’ strategies run out.
Bruising
US banks have been very keen to make these disposals or end credit arrangements amicably, and thereby avoid painful price discovery for the industry. Where this has not been possible, it has been bruising. For example, the recent forced sale of 1740 Broadway in Manhattan saw all but the top-rated triple-A debt tranche of a securitized $308 million financing wiped out.
Single-asset deals are obviously riskier than those backed by portfolios of properties, but the fact that the lower five tranches were wiped out shows just how severe the price reduction on the asset was.
The Fed’s H8 banking data is a blunt and opaque tool to examine CRE banking exposures, but its trends are instructive. US banks’ CRE exposures have been falling since May 8. Even after the collapse of SVB last March, these portfolios had continued to rise consistently, although at a lower rate. The H8 data shows that US banks’ lending to CRE construction began to fall in March too.
So it is no surprise that John Murray, Pimco’s head of private CRE credit, who has a very good view into banks’ CRE debt strategies, told Bloomberg in June that he thought the "real wave of distress is just starting”, with banks selling their best assets first.
He said his team have been opportunistically buying good assets at stressed prices and he forecast more regional banking failures ahead.
The increasingly negative outlook for CRE will likely present him with good opportunities in the coming months, but those buying up regional bank stocks may well regret their precipitous entrance into a sector with potentially uncapped CRE risks.
