Fed Continues to Worry About CRE Lending

The Federal Reserve’s Board of Governors have made it clear that while they think the “banking sector remains sound overall,” there are problems, according to the November 2023 Supervision and Regulation Report. One of the troublesome spots they called out was bank lending to commercial real estate.

“The banking system remains sound overall. Banking organizations continue to report capital and liquidity levels above regulatory minimums,” they wrote. “Earnings performance has remained solid and in line with pre-pandemic levels, despite recent pressure on net interest margins. Deposit declines related to the March banking stresses have slowed. Loan delinquency rates remain low overall.

“However, delinquencies for CRE and some consumer sectors have increased from their low levels, and banks have increased credit loss provisions. Liquidity and interest rate risks also remain elevated for some banks, partially attributed to the increased funding costs and significant fair value losses on investment securities.”

CRE isn’t the only issue, but enough of one to be specifically called out. A factor is delinquency rates for CRE and consumer loans, which “increased slightly during the first half of 2023,” the report read. “For the largest firms, the CRE office loan segment showed the largest increase in delinquency rates.” Not terribly surprising.

The report pointed to bank sector credit rating downgrades from Moody’s and S&P. They both cited higher interest rates — which have for some banks resulted in their long-term bond holdings falling significant in value — and CRE exposure.

The Fed mentioned that even as loan delinquencies are low, larger banks are increasing their reserves against losses from lending. But more is going on than just that. Smaller banks are growing their CRE loan activity as large ones become more cautious and hold more cash, cutting lending. Although the Fed’s report looks more to big banks, those are the institutions that have the assets to more easily withstand a problem with CRE loans.

There are estimates that the fire sale on Signature Bank’s $33 billion CRE loan portfolio would drive prices below face value by 15% to 40%. Such a result at a time of limited price discovery would likely have an effect on loans and property evaluations more broadly. There are also waves of maturing office loans in major markets on their way between 2024 and 2026. CRE bank loan delinquency rates are already at a 10-year high.

“Some firms have indicated in public earnings releases that they expect increased loan losses, particularly within the office segment of CRE,” they wrote. “Supervisors, therefore, continue to closely monitor underwriting and loan quality. Recent efforts include a horizontal review to address exposures to potential deterioration in CRE markets.”

Closer banking regulation ultimately does have an effect on all banks, the more so for large institutions that face increased attention, but eventually smaller ones out of caution — or closings if things go bad. Remember that in 2010, 155 banks closed in the aftermath of the Global Financial Crisis. In the wake of the 1980s savings and loan crisis, 530 closed in 1989.

The potential for more disinclination of banks to take on CRE loans is there, and there probably isn’t enough nonbank lending to make up for it — especially as federal regulators are now planning higher supervision of them as well.