'Some Financial Institutions Will Fall': Concerns Rise About Bank CRE Loan Portfolios

Months of economic despair wrought by the coronavirus pandemic may lead to a wave of bank defaults as a worsening pandemic has already started prompting local governments to issue new lockdown orders, which could stall the economic recovery.

The stress of troubled loans is mounting, especially among the country's midsized and community banks, as government support propping up businesses at the start of the pandemic has evaporated. Four banks have already failed this year, including two since the start of October, according to the Federal Deposit Insurance Corp.

“We're starting to see strain in the financial system,” CCIM Institute Chief Economist K.C. Conway said. “The Fed has not really forced the banks to recognize what's going on in commercial real estate.”

Conway's evidence of financial system stress is percolating in the Texas Ratio, which measures the value of banks’ nonperforming loans compared to their total asset value plus loss reserves. The higher the number, the more trouble there is. And when banks reach a ratio of 100% or more — or their resources are outstripped by their outstanding troubled loans — they typically fail.

RBC Managing Director Gerard Cassidy and other analysts created the formula to evaluate problem banks in Texas in the 1980s. Today, the Texas Ratio is one of the standards analysts use to evaluate the health of banks.

The Texas Ratio of all U.S. banks had been on a steady decline since the end of the Great Financial Crisis, when it topped 27%. By the end of 2019, the nationwide Texas Ratio had fallen to 6.8%. But it has gone up this year, rising to 7.1% at the end of the third quarter. Conway expects it to rise more in the coming months.

“I think we're on the verge, really, of a big uptick in bank failures,” he said.

More troubles with commercial real estate loans could chill the lending markets next year, putting the brakes on commercial real estate activity. Banks hold half of the $4 trillion in outstanding commercial real estate debt this year — levels that exceed those prior to the Great Recession, Conway said.

“Banks have the biggest piece of the CRE debt pie that accounts for half of all CRE debt,” Conway said. "As goes CRE, so too will the banks."

On average, five banks fail each business year, according to the FDIC. There have been only three years in which no banks failed since 1933, including 2018. When a bank fails, it is taken over by the FDIC, which sells the assets to other solvent banks or takes over operations itself.

The only major bank with assets of $1B or more that has a Texas Ratio of 50% or more is Beal Bank USA in Las Vegas at 54.33%. In January, The Wall Street Journal reported that Beal Bank foreclosed on a $384M mortgage on the Texas headquarters of JCPenney. Owners of the property were planning to redevelop the 1.8M SF facility and campus with new retail and a hotel.

Of the top 100 banks by asset size, five banks have Texas Ratios over 20% this year: American Express National Bank, Popular Inc., TIAA Bank, Sallie Mae Bank and FirstBank Puerto Rico, according to data compiled by BankRegData.

While the credit crunch during the Great Recession prompted some huge bank failures, experts say many institutions entered this downturn with loans buoyed by stronger underwriting standards.

But mounting troubles in the CMBS market are a harbinger for what the banking industry could face next year, Conway said. Delinquencies spiked to the highest level in the 16 years of Fitch Ratings tracking in July. Troubled loan rates moderated throughout the summer, but Fitch reported Nov. 6 that new delinquencies hit $3.2B, outstripping the $2B in loan resolutions.

Troubled bank loans are clustered in the retail and hospitality sectors, which have been disproportionately impacted by the pandemic.

Community and midsized banks are demonstrating higher strain in the Texas Ratio. They also are the lifeblood of commercial real estate lending, holding 62% of outstanding CRE bank loans, according to a 2019 Milken Institute report.

Banks with assets between $10M and $100M have roughly a third of their loan portfolio tied up in commercial real estate lending, according to Morningstar.

"Small and mid-size banks generally depend more on CRE loans because they typically lack the broad range of products and services that larger banks have,” DBRS Morningstar officials wrote in a report this week. “Additionally, these banks tend to have stronger knowledge and relationships within their local markets and feel obligated to participate in the development of their communities, which inevitably requires CRE financing.”

In September, Federal Reserve Chairman Jerome Powell raised concerns about the health of smaller banks.

“Smaller banks are going to probably bear too much of the burden here,” Powell told a House of Representatives committee Sept. 22. “They have more exposure to real estate and to smaller businesses, which are probably more vulnerable, and have less resources to deal with this sort of stress.”

With coronavirus hitting record infection levels all over the country, some governments have begun reinstating restrictive measures and lockdowns. Illinois Gov. J.B. Pritzker announced plans to restrict indoor dining in bars and restaurants, to restrict indoor gatherings to people in the same household and outdoor gatherings to 10 people, according to The New York Times. Maryland Gov. Larry Hogan is requiring bars, restaurants and nightclubs to shutter by 10 p.m., and limiting the capacity of businesses and other organizations to 50%, according to The New York Times.

Philadelphia has instituted similar measures, including closing gyms, limiting the capacity of retail stores to five people per 1K SF and halting indoor dining.

The Coronavirus Aid, Relief, and Economic Security, or CARES, Act helped financial institutions by allowing them to delay identifying and reporting troubled debt — concessions made to financially strapped borrowers — until the end of the year. Concerns that loans could face trouble after 2020, though, prompted both the American Bankers Association and the Independent Community Bankers of America to petition Congress to extend these deadlines into 2021 and beyond, American Banker reported.

"The problem, in a sense, is that these are temporary measures. Without playing politics here, I don't know what's going to happen,” Oxford Economics Head of U.S. Macroeconomics Gregory Daco said. “The stress is there, and it's palpable.”

Ten banks with $10M or more in assets currently have ratios of 90% or higher, and seven are well over 100%, including northern Maryland-based Cecil Bank, with a ratio of 181.78% of its $200M in assets, according to DepositAccounts, a division of Lending Tree.

Cassidy, the inventor of the Texas Ratio, sounded the alarm about those financial institutions in April.

“Although the Texas Ratio is low for all of the top 20 U.S. banks today, we anticipate that as the impacts of the pandemic continue, we will see the ratio increase,” Cassidy wrote in a blog post. “Smaller banks with a significant volume of high-risk loans will likely have the most credit troubles; it is likely that some of them will likely exceed a ratio of more than 100 during this credit cycle, and [may be] vulnerable to potential failure.”

Banking leaders have been airing concern in recent weeks; banks reported the largest percentage increase in charge-offs for bad loans since 2010, quadrupling their reserves set aside for loan losses, the Washington Post reported. The Federal Reserve plans to unveil the results of its latest banking stress test by the end of the year.

“I don't see any way of avoiding a great deal of pain in the commercial real estate market in 2021. It's almost inevitable,” former Independent Community Bankers of American President Cam Fine told the Post this month. “My friends at the Federal Reserve and the FDIC are becoming increasingly uncomfortable with what’s going on in the commercial real estate world.”

Some finance professionals say the conservative underwriting standards following the Great Recession in the banking industry are paying off in this downturn.

“Regulations in the reserves are multiples higher than what they were, and banks are much more capitalized than they were the last time,” said Patterson Real Estate Advisory Group partner Ken Grimes, a commercial real estate debt broker. “We haven't seen any sort of wholesale pullback from lenders.”

Financial institutions have begun to raise the amount of capital they are setting aside for bad debt, known as a debt service coverage ratio, from 1.38% last year to 1.59% as of the third quarter, according to a recent CBRE report. When banks have to reserve more capital for debt, they have less to make loans.

“Loan underwriting has become more conservative in the current [risk-averse] lending environment. Average [loan-to-value ratios] for permanent commercial and multifamily loans fell in Q3 to levels not seen since the Global Financial Crisis,” CBRE Global President of Debt & Structured Finance for Capital Markets Brian Stoffers said in the report.

A greater challenge for banks may be what exactly to lend to, JLL Debt & Loan Sales Platform Leader Gerard Sansosti said. While multifamily and industrial remain favored asset classes, there is only so much supply available.

Lenders have almost entirely pulled back from retail and hotel lending, and other institutions are cautious about office deals, especially as companies evolve in their use of work-from-home.

“We have lots of lenders saying to us, 'Where should I look?'” Sansosti said. “With the amount of liquidity in the market, and if you take out two main food groups, you have to find somewhere to put it. I think that will be a bigger challenge for the banks.”

News of the potential for a successful vaccine that could begin inoculating the population next year has sent both stocks and optimism higher in recent weeks.

“Given the news about the vaccines, I would say that we're probably likely to see less uncertainty as we move forward than there certainly has been over the last several months,” Woodwell said.

Renewed optimism coupled with low interest rates should help both borrowers and lenders through the next few months, especially with some expectation that President-elect Joe Biden's administration could push through another stimulus bill, Daco said. And even with a wave of bank failures, Daco said he doesn't expect those levels to reach anywhere near the apocalyptic ones seen during the Great Financial Crisis. 

“I suspect if you start to see a wave of smaller financial institutions failing, the Fed will intervene by expanding or modifying the terms of its emergency lending programs to essentially preserve credit access,” he said. “That doesn't mean some businesses will not go down, that some loans will not be paid. And some financial institutions will fall.”