Are there more cockroaches in bank balance sheets?

Zions Bancorporation surprised investors on its third-quarter earnings call with a $50 million charge-off on two commercial real estate loans. Regional bank shares fell six per cent almost at once. The loss revived an old Wall Street fear about credit. In banking a bad loan is rarely alone, and where there is one cockroach there are usually dozens more behind the wall.

The image was already in circulation. Earlier in the week Jamie Dimon, JPMorgan's chief executive, used it after his bank wrote off its exposure to Tricolor, the subprime car lender that collapsed in September amid allegations that collateral had been pledged more than once. On the same day as the Zions disclosure, Western Alliance said it had sued a borrower over alleged fraud. Two regional banks reporting borrower problems within hours was enough to turn a company-specific loss into a sector-wide sell-off.

Bad loans come in clusters

Credit models show that commercial real estate charge-offs tend to bunch together rather than rise steadily. With interest rates structurally higher and office occupancy falling, regional banks that extended maturities and loosened covenants, the practice known as 'extend and pretend', are running out of room. Once property values reset thirty to forty per cent below their original appraisals, refinancing defaults can pile up quickly.

The clustering has a mechanical cause. Commercial property loans are usually short relative to the life of the building, often five to ten years, and they are repaid by refinancing rather than from rent. A loan written at the peak of valuations and low rates can keep paying interest for years and then fail all at once when it matures, because a new lender will lend only against today's lower value at today's higher rate. Loans written in the same years mature in the same years, so losses arrive in waves.

The bank losses also followed the bankruptcy at the end of September of First Brands, a car-parts supplier whose heavy use of invoice financing and off-balance-sheet debt left its lenders, including a fund run by Jefferies, struggling to establish what they were owed. Together with Tricolor, it suggested that lending standards loosened during years of easy money are now being tested well beyond property.

The lesson of 2024

Regional bank investors have seen this pattern recently. At the end of January 2024 New York Community Bancorp reported a surprise quarterly loss, a large increase in loan-loss provisions tied mainly to office and rent-regulated apartment loans, and a cut to its dividend. Its shares collapsed, other regional lenders sold off in sympathy, and the bank needed a capital injection led by a former Treasury secretary within weeks. The loss itself was manageable. What spooked the market was the discovery that reserves had been set too low for a problem everyone knew existed.

Analysts check the reserves

After the Zions charge-off, bank analysts hurried to recalculate allowance for credit losses (ACL) coverage ratios across the regional lenders. If those banks have to raise loan-loss reserves to reflect impaired commercial property, net interest income and return on equity will suffer for several quarters.

The accounting explains why. Under the current expected credit loss standard, banks must reserve up front for losses they expect over the whole life of a loan. A bank that revises its expectations upward has to book the entire change in one quarter, as a provision that comes straight out of earnings. Regional banks, which hold a much larger share of their loans in commercial property than the biggest banks do, are most exposed to that kind of revision.

Who is most exposed

The pain is unevenly spread. Banks with heavy concentrations in downtown offices in cities where occupancy has not recovered carry the most risk, while those lending mainly on industrial warehouses, grocery-anchored retail or apartments outside rent-regulated markets have fared much better. Borrowers are exposed too: property owners who need to refinance face lenders that are now more cautious and charge more. Private credit funds and insurers, which have taken market share in property lending, are the likely buyers of loans that banks want to sell, at a discount.

The case against a wave

The strongest argument against the column's reading is that the Zions and Western Alliance problems look like fraud rather than the ordinary deterioration of property values. Fraud is idiosyncratic, and a bank that was deceived by a borrower is not necessarily one whose underwriting is poor across the board. Most regional banks reporting third-quarter results this month have shown stable credit metrics, and the Fed's rate cut in September, with markets expecting more, eases the refinancing burden at the margin.

Those points deserve weight. They do not dispose of the underlying problem, which is that a large volume of commercial property loans written at low rates is still coming due, and that the valuations behind them have fallen. Fraud tends to surface when credit tightens and money becomes harder to raise, so a rise in fraud cases is itself a symptom of a late-cycle credit market.

Signals to watch

The indicators are the rest of the regional banks' third-quarter results over the coming fortnight, particularly their non-performing and criticised loans, changes in reserve ratios, delinquency rates on commercial mortgage-backed securities, and the Fed's decision at the end of October. The Zions loss suggests that bad commercial property loans are starting to reach regional bank income statements. More lenders will probably report similar hits over the next few quarters, and the credit cycle looks to be turning against them. The banks most likely to disappoint are those with concentrated office books and thin reserves, and their shares will probably trade at a discount to the sector until they prove their provisions are adequate.