yachtworld regulator 28

These 28 regional and community banks exceed regulators' threshold for high commercial real estate concentration risk: here's what's really at stake.

• Analysts are struggling to predict which banks will be affected by high CRE exposure.
• Some of these loans will absolutely go bad, said Todd Baker. 
• Regulations allow banks to have their own risk-rating systems.

Where there's smoke, there's usually fire. But where banks' exposure to commercial real estate is concerned, locating that fire may be difficult.

Rising interest rates quickly increased the cost of borrowing for investors in commercial real estate, including offices and multifamily homes. Higher rates also meant a riskier asset class for investors. For Michael Barr, the second vice chair of the Federal Reserve, the office segment is most at risk, largely due to the rise of remote work. This means banks with elevated exposure to commercial real estate loans are also at risk — a situation Fed chair Jerome Powell described as "sizable" but "manageable."

So who exactly will take the hit? New York Community Bank put the question back on investors' minds this week as it scrambled for cash after announcing an unexpected quarterly loss, partly due to commercial real estate loans that soured. As analysts scramble to pinpoint where the pressure is building, they're saying some of the most readily available data may not provide an immediately satisfactory answer, but it could provide clues as to where to look.

"It's the parlor game now to try to figure it out by looking at the call reports and the SEC reports to try to get a sense of who, if anyone, is under reserved," said Todd Baker, a senior fellow at the Richman Center for Business, Law and Public Policy at Columbia University. "Because the question here is not, 'will some of these loans go bad?' They absolutely will. The question is, are the bank reserves and capital adequate enough to deal with a significant downturn in their portfolio?"

A call report, a quarterly statement that shows a bank's balance sheet and more, isn't comprehensive enough to determine the actual risk a bank could be exposed to. It doesn't reveal details such as borrowers' track records, said Mark Hillis, a former chief risk officer for commercial real estate at JPMorgan.

This report is also a lagging indicator: an ongoing review may not show that things have deteriorated much further, said Clifford Rossi, the director of the Smith Enterprise Risk Consortium at the Robert H. Smith School of Business, University of Maryland.

"By the time you're looking at that call report data, it's kind of like looking up at the stars," Rossi said. "That star has already probably blown up billions of years ago and you're seeing stale data."

Varying risks

According to the Mortgage Banker's Association, $929 billion in commercial real estate loans is due to mature in 2024, with $257 billion in multifamily and $206 billion in office.

Smaller banks faced further pressure after Silicon Valley Bank, Signature Bank, and First Republic Bank collapsed. Business deposits exceeding the FDIC's insured limits moved to larger banks or money markets. Meanwhile, rising interest rates meant smaller banks had to offer higher yields to keep and continue attracting deposits, Baker said.

There's also varying concentration risk: the largest banks with commercial real estate exposure are more diversified, meaning that any losses won't be as devastating, Baker said.

Within the dreaded office category, location and quality matter for defining risk. Older class C spaces are at amplified risk of default than higher-end class A buildings due to higher operating costs from outdated systems, rehab requirements, and lack of conversion options to residences, Hillis said.

Historically, multifamily had been a low-volatility asset class. But expensive debt due to rising interest rates, rent control laws, and environmental laws have considerably increased operating costs for landlords and their risk of default, Hillis noted. As some of these loans begin to roll over, requiring renewal in a high-interest-rate environment, some landlords may have trouble affording them.

Who defines risk?

In interpreting various regulations, one of the issues is that banks have their own risk-rating systems. It isn't until regulators examine the bank that they conclude whether that system is adequate or needs adjustment, said Hillis. The Basel III endgame proposal would change this by setting a standard risk-weighting system rather than allowing banks to define it. It would also require banks to increase their capital to offset risk, Rossi noted. The downside of this proposal is that it could pass the added costs to depositors and borrowers, Rossi added.

More experienced FDIC examiners are typically assigned to larger and more complex financial institutions. Less experienced examiners are often assigned to smaller banks. And while many smaller banks can be incredibly well run, they may not have adequate talent to address an increasingly complex risk environment, Hillis said. Additionally, banks can set their underwriting standards with different risk levels, which aren't readily transparent externally. Some can be more risk-averse and approve loans that other banks rejected, he added.

"It's word of mouth," Hillis said of how analysts sometimes pinpoint the risk-averse banks. "Sometimes it's borne out in terms of performance over time. But because we haven't had a real downturn, it hasn't really borne itself out in terms of losses. You'll probably see it in this commercial real estate cycle. You'll see higher levels of losses that will be driven by a variety of factors. One would be looser underwriting."

A bank's internal risk management function works with the business division to create risk metrics that are recommended to the board. But risk management is often set aside and not looked upon as an equal partner, Rossi said. Banks get into trouble when weak governance practices allow the business areas to dominate the risk-taking discussion. And Board members don't always have direct risk experience to ask the right questions and challenge management.

"I worked for Countrywide Bank, which is no more. I worked for Washington Mutual, which is no more. I worked for Citigroup, which almost was no more," Rossi said. "You can point to any excessive risk-taking; I am absolutely convinced, having looked at this, not just in my own experience, but looking at what happened over the course of last spring or any bank failure, you'll ultimately be able to put your finger on some sort of lapse in risk governance that led that institution to taking on excessive risk beyond what they should have done."

How regulators look at risk concentration

A few factors draw an FDIC regular's attention to a bank for CRE concentration risk. According to the agency's 2006 guidance , the threshold for CRE concentration risk is met when a bank's loans in construction, land development, and other land and loans secured by multifamily and nonfarm nonresidential property are above 300% of the bank's total capital. This ratio does not include loans secured by owner-occupied properties.

Another flag is if a bank increased its exposure by 50% within the last three years. The agency emphasizes that higher scrutiny is placed on institutions that have seen significant growth in CRE as opposed to those with higher concentrations that have managed their risk successfully.

Rebel Cole, a professor of finance at the Florida Atlantic University and former economist and analyst at the Fed, has been sifting through call-report data to determine which banks face those risks. He compiled the list below using data from the Federal Financial Institutions Examination Council's (FFIEC) repository.

These 28 financial institutions have the highest concentration risk based on the FDIC's threshold. The agency's definition to determine concentration risk varies based on a bank's capital and how much it relies on borrowed money. Generally, smaller or community bank ratios are based on tier 1 capital, which factors in common stock and retained earnings, plus the money it has set aside for potential losses, which is classified as ALLL (column RCRE).

To provide a standard measure across banks, including those that don't report ratios based on the above guidelines, the CRE to total capital is included (column TCRE). Regulators concentrate more closely on banks that exceed a 300% ratio and have also increased their exposure by more than 50% in 36 months.

Fifth-ranked Flagstar is a subsidiary of New York Community Bank, which recently saw its shares plunge after news they were seeking to raise $1 billion in capital to cover potential losses from commercial real estate loans. NYCB had absorbed assets from Signature bank, which failed in 2023.

NYCB's issues weren't due to CRE exposure alone, says Matt Reidy, director of economic research at Moody's Analytics CRE. It takes multiple contributing factors to cause a bank to fail, and it could be why we haven't seen other banks under stress yet, he added.

"We think very few banks will run into issues just from their commercial real estate exposure," Reidy said. "From the way that this system is designed, obviously in what you've seen with New York Community Bank, where the pain has been largely felt to this point is in their share price. So stockholders are taking it on the chin from that standpoint."

Deposits that are under the FDIC-insured limit are protected and unlikely to take a hit, Reidy added.

Cole noted that one of the issues with the ratio regulators use is that it doesn't factor in loan commitments, which can be binding depending on the terms of the agreement. Adding commitments places some of these banks at almost double the threshold.

Rossi noted that it's unsurprising to see concentrated CRE portfolios at small banks because it's their sweet spot. The issue is that many of those banks aren't geographically diversified.

"We have a major issue in this country, in our banking system, where the people that are there to look after the long-term interests of these banks are not necessarily doing that in a good way because we have too many of these recurring problems, either with large banks or with smaller banks," said Rossi. "And until we've solved this one and get the governance straight on this, we're going to be in these recurring episodes of where banks are going to get into trouble."

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