Loan Modifications Ramp Up At Regional Banks As They Begin Realizing Property Value Drops

Regional banks are beginning to feel the squeeze of the weakened office market, even as larger institutions are facing fewer troubled loans.

The average bank with $100B or less in assets modified 0.32% of its commercial real estate loans in the first nine months of the year, a jump from the 0.1% of modified loans through the first half of the year, according to a report from Moody’s. 

It’s a small but significant increase that comes as financial regulators have increased their scrutiny of banks' commercial real estate loan books.

Property owners typically seek modifications when facing repayment or refinancing issues, and an uptick in their usage at smaller lenders signals those institutions are facing more exposure to commercial real estate credit risk.

Smaller lenders and regional banks typically took lower down payments on loans in the years leading up to the interest rate hikes that began in 2022, leaving them more exposed to a sudden drop in property valuations.  

“Extensions of loan maturities and payment deferrals continue to be the most common forms of loan modification offered by banks as well as the largest by volume,” according to the Moody's report. 

Still, smaller banks are outperforming their larger peers. The average midsized bank modified 1.93% of loans in the first nine months of the year, while the largest banks averaged 0.79% loan modifications. The pace of modifications has slowed in recent months at all banks except those with assets under $100B, according to Moody’s. 

“We expect the pace of loan modifications will continue to slow in the fourth quarter following the Federal Reserve's 25-bp rate reduction in November and 50-bp cut in September,” the report’s authors wrote. 

Large financial institutions have been more aggressively writing down assets in their portfolios — although many analysts, including the Federal Reserve Bank of New York, suspect they aren't cutting values deeply enough — and setting aside cash to pay for what are seen as inevitable losses. 

But regional banks have been slow to adjust to shrinking valuations, according to Bloomberg, and the uptick in modifications on the smaller side of the lending markets could be a signal that the banks are beginning to catch up to their larger peers. 

The office sector is still finding its footing in the pandemic's wake, and the asset class has borne the brunt of a broader decline in values. Office CMBS delinquencies, by far the most stressed CMBS sector, have more than doubled in the past year and reached 11.2% in November.