Evening Brief – 12.19.23
Not Out of the Woods
The fierce rally in the equity markets since the end of October has catapulted most sectors out of their recent doldrums, financials being one of the most notable.
While there are compelling reasons to own financials, including a more positive economic outlook and falling interest rates, there are still obstacles that must be overcome before the regional bank sector can begin a longer-term advance.
Hundreds of billions of dollars in client deposits have recently flowed out of regional banks’ accounts into money markets in search of higher rates. In addition, the Federal Reserve injected liquidity into the system during the pandemic, and regional banks purchased hundreds of billions of dollars in low-yielding long-dated US Treasuries, resulting in significant unrealized losses on their balance sheets, which is still a problem for them.
Moreover, regional banks still have more than $1.5 trillion in commercial real estate loans on their books, all of which are scheduled to be refinanced over the next three years. These institutions are also struggling with tighter regulatory standards and more stringent lending criteria in the aftermath of the March banking crisis.
It’s difficult to argue with the Fed’s recent dovish pivot, which has fueled a massive short-covering rally on the belief that consumer and business lending will see more favorable borrowing terms, but the commercial real estate refinancing predicament confronting regional banks remains a clear and present danger.
The concern is certainly on the mind of the FDIC. On Monday, the bank regulator released a Financial Institution Letter titled, Managing Commercial Real Estate Concentrations in a Challenging Economic Environment.
The letter, authored by Doreen Eberley, Director Division of Risk Management Supervision, noted that “recent weaknesses in the current economic environment and in fundamentals related to various CRE sectors have increased the FDIC’s overall concern for state nonmember institutions with concentrations of CRE loans.”
The FDIC expressed its concerns about bank exposure to Construction & Development (C&D) loans, citing massive credit losses during the 2008 to 2013 banking crisis. “Banks currently engaged in C&D lending could be affected by weaknesses in the current economic environment and real estate fundamentals,” the letter read.
“The FDIC continues to be concerned that institutions with concentrated CRE exposures may be vulnerable to real estate downturns and is reminding such FDIC-supervised institutions of the importance of ensuring that credit risk management practices are strong.”
One could argue that the current surge in regional bank stocks is a perfect opportunity to take profit. Of course, taking on the Fed is challenging, but there are lingering issues within regional banks that could impede top- and bottom-line growth in the future.