The Federal Reserve has a history of sweeping mounting loan problems under the rug – until the rug gets pulled. The S&L crisis in 1989, which struck at the heart of the savings and loan industry, is one case. The budding subprime mortgage crisis that led to the full-blown financial crisis of 2008 – which former Fed Chair Ben Bernanke repeatedly denied would happen – is another.

Enter current Fed Chairman Jerome Powell and the budding commercial real estate loan crisis.

It’s been a year since the Silicon Valley Bank meltdown triggered a regional banking crisis.

And we are on the brink of another one. Let me explain.

You may have seen the headlines about New York Community Bancorp’s (NYCB) recent 60% stock plunge. Its shares hit a new low before rebounding the morning Moody’s downgraded its credit rating to junk status.

Let me put that in context. Because you might not know that NYCB took over $38 billion of Signature Bank’s assets after it failed last March.

You see, that purchase made NYCB bigger. As a result, NYCB popped into a higher regulatory category – meaning it had to have more capital set aside in case of a financial emergency.

Only it doesn’t. That’s why its mounting recent commercial real estate (CRE) losses mean it could eat through the capital it does have. Hence, Moody’s downgrading its rating on February 8.

Let me unpack that further. At its recent earnings call, NYCB reported $252 million in losses for Q4 2023, mostly in CRE. That’s mainly because the office vacancy rate in New York City hit 17% at the end of 2023. That’s a record high.

Higher office vacancies mean less money coming in to pay for commercial office real estate loans. That causes delinquencies or defaults in payments. Throw in the fact that rates have been higher due to the Fed’s tightened policy, and it accelerates budding problems with paying loans.

Unfortunately, this is a growing trend across many major U.S. cities.

Chicago, San Francisco, and Houston are all facing rising office vacancy rates above 20%.

That means associated CRE values are falling, and loan payments aren’t getting paid. And that plagues regional banks in those cities and other cities where office vacancy rates are rising.

The harsh reality is this. As long as rates stay high, regional banks will face more problems with CRE and other loans. They don’t have the luxury of diversifying assets like larger banks do to ride out such storms.

Plus, according to Goldman Sachs research, roughly $1.2 trillion in commercial mortgages are due to mature in 2024 and 2025. They might be rolled into new mortgages at higher interest rates. Or, if borrowers can’t afford that, it forces sales in underlying properties. This also means less money coming into loans as payments. So, this problem isn’t going away anytime soon.

The Fed’s Demolition Project

The Fed began raising rates in March 2022. Since then, regional banks have faced mounting challenges.

But I’d like to highlight the key reasons and the connection between tighter Fed policy and problems in the banking system.

  1. Higher Interest Rates. More expensive money leads to a decrease in borrowing and lending activity. When rates rise, it’s more expensive for individuals and companies to get and pay interest on loans. As a result, credit demand for loans drops.

  2. Increased Cost of Borrowing. On top of reduced loan demand, regional banks have faced higher borrowing costs. As rates rise, banks need to pay higher interest to depositors, which cuts into their profit margin. So regional banks need to raise interest rates on their loans, making them less attractive as opposed to larger banks that have greater access to the Fed for money they borrow.

  3. Liquidity Challenges. Regional banks use short-term funding to meet their financial obligations more than larger banks. That liquidity can come from deposits or borrowing from the Federal Reserve. When rates rise, it’s more expensive for them to access this. The resulting liquidity crunch can cause problems in meeting their financial obligations.

Regional Banks in the Eye of the Fed Policy Storm

Regional banks focus on the financial needs of individuals and businesses in certain geographic areas. (National or international megabanks such as JPMorgan Chase or Citigroup have a broader scope).

That means any economic or financial event impacting the area can have an outsized effect on related bank loans. That’s what happened with NYCB.

But the problems in the regional banking sector today are not confined to one area. They are a net result of higher loan costs driven by higher interest rates and faltering commercial real estate.

That’s why we are seeing their stock prices hit across the country.

So while the media focused on the share price collapse of New York Community Bancorp, numerous other banks are trading at or near their lowest levels in two years.

It’s not a pretty picture in the regional bank arena, whether for banks operating in many states or a few…

U.S. Bancorp, the parent of U.S. Bank, is the 5th largest bank in the U.S., with about $663.5 billion in assets. It operates in 28 states. Its stock has shed 30% of its value in the past two years.

KeyBank is the 22nd largest bank in the U.S. with $186 billion in assets. It operates in 16 states. And its stock has lost 50% of its value over the past two years over the same issues.

Zions Bank stock has lost about 42% of its value since the Fed began raising rates. It has a high concentration of commercial real estate exposure relative to the amount of capital it holds. And it has high office space exposure.

Small regional banks have felt even more intense pain. First Foundation Inc., the parent of First Foundation Bank, has seen its share price plummet by 70% in two years. It operates in California, Nevada, Florida, Texas, and Hawaii.

Broader Commercial Real Estate Turmoil

Now, small banks account for nearly 70% of all CRE loans outstanding in the U.S. That figure includes loans made by these banks and loans they purchased from larger banks.

As Fitch Ratings notes, “Banks with less than $100 billion in assets possess higher CRE concentrations than their larger counterparts.”

That’s why losses in that category “could result in the failure of a moderate number of smaller banks.”

It gets worse. According to MSCI Real Assets, about $85.8 billion of U.S. commercial property debt was distressed at the end of 2023. And there’s an additional $234.6 billion of debt in potential distress.

Commercial property prices are down 21% from their March 2022 peak. And within that sector, office prices showed the biggest drop – falling by 35%.

Banks hold $441 billion of commercial property debt coming due this year out of a total of commercial property loans coming due of $929 billion, And about $234 billion of that maturing debt held by banks is securitized in CMBS, collateralized loan obligations, and asset-backed securities.

Fitch reported that if commercial property prices decline by approximately 40%, losses in CRE portfolios could ignite the failure of a “moderate number” of predominately smaller banks. Some regional banks could be forced to sell loans at a loss or increase provisioning for losses.

Careless Powell

It’s easy not to care about things like regional or local bank failures when you’re breathing the rarefied air of power and job security. Maybe that’s why Fed Chair Jerome Powell didn’t bat an eye when asked about the commercial real estate market’s impact on banks.

“It feels like a problem we’ll be working on for years,” he told CBS in a 60 Minutes interview. 

He admitted that “it’s a sizable problem.” Then he said it was a “manageable one” and confirmed it was more likely to impact smaller or regional banks.

Gee, thanks, Jerome. Last June, a few months after the collapse of Silicon Valley Bank, then the second largest in U.S. history, Powell said he was keeping an eye on CRE and ramifications on the U.S. banking system. And yet, here we are – with so many measures of loan stress rising.

Now, his use of the word “manageable” was interesting to me. It’s like all Fed Chairs use the same song lyrics. That was the same term Treasury Secretary (and former Fed Chair) Janet Yellen used in her testimony to the House when asked about brewing CRE problems.

This was during one of two testimonies she gave that week – one to the Senate and one to the House – on the U.S. banking system.

She downplayed CRE risks. She told the House Financial Services Committee on February 8 that she was concerned about stresses in CRE but that the situation was “manageable.”

As I said earlier, I don’t trust Fed or former Fed officials when they say things are manageable or not really problems. Especially when it comes to loans and banks. Not when the data suggest otherwise.

That’s why I suggest you avoid investing in any regional banks for now.



Nomi Prins
Editor, Inside Wall Street with Nomi Prins