Fed Unintended Consequences May Put More Pressure on Regional Banks

The Federal Reserve, looking at the most recent economic news, has been getting more concerned again about inflation. It’s signaling is having the likely unplanned result of putting regional banks under more pressure over CRE loans, even though the Fed and other agencies have said that the banking system is fine.

One escape route that regional banks have used — an insurance-like maneuver — is becoming harder to get, according to Reuters, adding to the strain the banks have been feeling. But a finance and banking expert and academic told GlobeSt.com that the concern may be overblown.

In a Tuesday speech to the Florida Bankers Association, Fed Board of Governors member Michelle Bowman noted “progress on inflation” over the last year. But recent Consumer Price Index and Producer Price Index moves “suggest slower progress in bringing inflation down toward our 2 percent target,” she said. “We had also seen signs of the labor market coming into better balance, but recent strong jobs reports—including upward revisions to employment growth—show a continued tight labor market.”

These are signs that, over time, could lead the Fed to postpone or even reduce the number of rate cuts — exactly what regional banks don’t want to hear because of CRE loan portfolios.

So long as rates stay up, many landlords face maturation of their loans and the need to refinance. Interest rates have a few effects. The most direct is to make it harder for owners to afford a new loan, which is a risk factor for the previous lender seeing a timely payoff. Another is that higher interest rates depress transactions and make it harder for many owners to get the price they want, and so they withdraw a property from market and wait, which buyers want a good deal. Prices come down, lowering property valuations, which undermine the value of the loan.

“Since the bank collapses last March, some regional lenders have sold billions of dollars of loans to private investors to reduce risk and shore up liquidity,” reported Reuters. “Some have also bought insurance against risk of loss on loan pools from investors to free up precious capital.”

The name of the strategy is a credit risk transfer, or CRT, according to says Rebel Cole, Lynn Eminent Scholar Chaired Professor of Finance at FAU and a former Federal Reserve economist.

According to a 2020 publication of the Structured Finance Association, CRTs “involve the transfer of credit risk of all or a tranche [part] of a portfolio of financial assets.” The buyer typically owns a portfolio of assets — corporate loans, mortgages, or other types of assets. The seller could be a bank, insurance or reinsurance company, trust, or private capital source. The seller has the revenue stream from the CRT and the buyer has insurance against loss. It’s a concept similar to credit default swaps in bond trading.

However, with property valuations down 25% to 30%, money sources are pulling away from this practice because of the increased risk. Reuters wrote that one person involved in insurance on bank portfolios said regional banks will have to be prepared for “high double-digits in yield for insurance on CRE loans.”

Without the insurance as a hedging mechanism, regional banks may find themselves holding assets that have become toxic, increasing the potential of worried depositors moving their money to other institutions and leaving regulators wondering if a bank will remain solvent and if it needs to be shut down.

But Cole, who checked some bank filings, said that he’s “highly skeptical of the story.”

“Bank OZK reports zeros for the amounts of credit default swaps,” he tells GlobeSt.com in an email. “Flagstar sold ($213 M) more CDSs that it purchased ($51 M). There may be a handful of regional banks that are doing this, but it certainly is not pervasive.”

He sent a list of 158 banks, each with more than $10 billion in assets, and the number of credit default swaps bought and sold. Only 20 had either bought or sold some swaps.

“Regional banks may well be selling off chunks of their performing CRE portfolios to reduce exposures, but the are only nibbling at the edges, based upon changes in their reported exposures on the quarterly call reports,” Cole adds.