(Bloomberg) -- US Treasury yields have trended up since late last year, and commercial real estate distress risk is straining regional banks’ balance sheets again.
Stocks are already reacting to the higher borrowing costs. Smaller bank shares have fallen about 8.2% since late November after the 10-year Treasury yield began trending up. The risk of default by borrowers who bought office buildings before the pandemic sent values plummeting also increases when the cost of credit rises.
“Rising long-term yields certainly leave the banking system more fragile in the short run, if more profitable in a base case economic scenario,” said Steven Kelly, associate director of research at the Yale Program on Financial Stability.
A surge in 10-year yields last year likely reversed most of the decline in unrealized losses on banks’ available-for-sale and held-to-maturity securities in the third quarter, Federal Deposit Insurance Corp. Chairman Martin Gruenberg said in a Dec. 12 speech. Even after this past week’s rally after better-than-expected inflation data, the benchmark has since risen about 0.3 percentage points to around 4.58%, adding to the pain for lenders.
If borrowing benchmarks remain high, regional banks risk higher losses on commercial real estate because borrowers will struggle to refinance, said Tomasz Piskorski, a finance and real estate professor at Columbia Business School. He and fellow researchers estimate about 14% of the $3 trillion of US CRE loans are underwater, rising to 44% for offices.
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Smaller lenders are more vulnerable to CRE defaults after demanding lower down payments from borrowers than their larger counterparts in the run up to the interest-rate hikes that began in 2022. Now that office and multifamily values have crashed, the lenders have less of a buffer before taking losses.
The office market has yet to stabilize “which is why we remain concerned and remain well-reserved,” PNC Financial Service Group Chief Executive Officer Bill Demchak said on an earnings call this week. The bank increased the reserves it set aside to cover soured office loans to 13.3%, up from 8.7% at the end of 2023, although it’s a small proportion of their overall book.
On the plus side, the declining cost of deposits, thanks to lower Federal Funds rates, helps stability. Steady deposit flows in the fourth quarter suggest that the odds are low that they could quickly be moved to other banks, reducing the risk that lenders have to sell underwater bonds. Duration risk is also reducing as the securities move closer to maturity.
For now, “investors are a little less concerned about the unrealized losses, because it doesn’t look like there’s going to be forced sales like there was with Silicon Valley Bank,” said Scott Hildenbrand, head of depository fixed income at Piper Sandler.
Terry McEvoy, a bank analyst at Stephens Inc., concurs. The firm has met at least 30 bank investors in recent days and it was not a major area of discussion or concern, he said. The incoming Trump administration may also boost bank margins through deregulation, said Piskorski at Columbia Business School.
Still, with borrowing benchmarks trending up even as the Fed cuts interest rates, “we are entering into a very precarious position” and “instead of escaping this area of bank fragility, we are moving toward an increasing area of bank fragility,” Piskorski said.
Week In Review
The six biggest US banks issued corporate bonds or preferreds this week, after posting results. Issuance could pick up in the coming sessions thanks after yields have fallen, following an inflation report that implied that price increases may be coming under control.
It’s never been this cheap to trade corporate bonds, thanks to a boom in electronic trading that’s enabling a wider swathe of investors to buy and sell large volumes of securities faster and more efficiently.
The first loan this year to fund a leveraged buyout arrived on Thursday, with JPMorgan Chase & Co. supporting Silver Lake Management’s purchase of Endeavor Group Holdings Inc., the talent agency and controlling investor in WWE and the Ultimate Fighting Championship.
China Vanke Co. rebounded from record lows in credit markets, as people familiar with the matter said the distressed developer had previously told some creditors it had enough cash prepared to repay a local note.
Repeat corporate bankruptcies in the US are running at the fastest pace since 2020, as some companies still can’t recover even after slashing debts.
Software maker Databricks Inc. clinched more than $5 billion of financing from lenders including Blackstone Inc., Apollo Global Management Inc. and Blue Owl Capital Inc. in its largest debt raise to date.
At least eight major distressed Chinese firms, including a China Evergrande Group unit, are set to defend themselves in court cases relating to their debt problems over the next two weeks, in one of the busiest stretches ever for such hearings.
Blackstone’s flagship private credit fund withdrew a planned $500 million investment-grade bond sale expected to price Tuesday due to administrative delays.
Goldman Sachs Group Inc. pulled out of a $1 billion deal to help Ecuador refinance debt, due to internal risk-management controls.
Altice France’s creditors are demanding the return of shuffled assets and a say in future board appointments as part of negotiations with the company over its €23.7 billion ($24.4 billion) debt pile.
Prospect Medical Holdings Inc., once an active buyer of cash-strapped hospitals, filed for bankruptcy after struggling with debt piles and soaring costs.
On the Move
Paul Goldschmid, who was one of the longest-tenured partners at King Street Capital Management before leaving the $26 billion hedge fund firm last year, announced on LinkedIn the launch of his own long/short credit firm, Harvey Capital Partners.
Goldman Sachs Group Inc. promoted several key executives and combined teams to form a capital solutions group, a move recognizing the growing importance of private markets. Pete Lyon, global head of the financial institutions group and the financial and strategic investors group, and Mahesh Saireddy, global head of mortgages and structured products, will lead the new group.
Lloyds Bank has appointed James Brown as managing director, head of leveraged finance & project finance syndication. Brown joins from Mizuho in London where he led the leveraged debt capital markets business for five years.
Ares Management Corp. promoted finance industry veteran Kevin Alexander as co-head of alternative credit. He’ll work alongside current co-heads Keith Ashton and Joel Holsinger.
Banco Bilbao Vizcaya Argentaria SA has hired UBS Group AG’s Americas head of structured credit and sustainable credit products, Estanislao Fidelholtz, as a managing director and head of its structuring team for credit solutions in the US.
Man Group has consolidated its European and US CLO groups into a global syndicated loan business. Portfolio managers Joshua Cringle and Jonathan Newman will lead the new platform from the US with capacity to issue CLOs.
Credit investor SC Lowy Financial HK Ltd. has laid off several staff members, according to the company’s chief executive officer, as the firm pivots away from trading public securities and toward private credit.
--With assistance from Greg Ritchie and Rheaa Rao.
