What bank credit tells us

Steven Abrahams | August 4, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Weakening credit in public market commercial real estate and leveraged loans have led some investors to argue that it’s just the tip of the iceberg. The bigger problem, they argue, is at banks. Bank loans may be weaker than the ones backing securities, and broader credit may be melting below the surface. But current default rates on public loans and bank loans tell a different story. There is no iceberg. Bank credit, including smaller bank credit, looks as strong or stronger so far than loans in the public market.

The worried investors argue that commercial real estate operators and business owners that borrow from smaller banks run enterprises especially vulnerable to current Fed policy. The loans usually have a floating rate. The borrowers have fewer tenants or customers. Or rely on a narrower set of products or geographic markets. And management may not have as much depth or experience as the team at larger enterprises. All of these risks come to the surface with the rising cost of covering the interest expense on their bank loans. Some investors worry that persistently high fed funds rates will slowly erode the quality of bank loan books, tighten credit, slow the economy and eventually hurt credit quality in the public markets. At least that’s the theory.

Commercial real estate loans

Available delinquency numbers on commercial real estate do not show weaker bank loans. In fact, bank loans look much stronger than CMBS. Over the last year or so, delinquencies on bank commercial real estate loans have run at only 25% or less of the rate on CMBS (Exhibit 1). At the end of March, the most recent date when the Fed published aggregate bank loan delinquencies, commercial real estate showed a 30-day or longer delinquency rate of only 76 bp. CMBS at the end of March, according to Trepp, showed a 30-day or longer delinquency rate of 309 bp.

Exhibit 1: Delinquencies make bank CRE loans look stronger than CMBS loans

Note: Bank data shows loans 30-days or more delinquent and still accruing interest as well as nonaccrual loans.
Source: Federal Reserve, Trepp, Santander US Capital Markets

These numbers deserve a good challenge. There are almost certainly material differences between bank and CMBS portfolios in the mix of office, retail, multifamily, industrial and other property types. These are almost certainly differences in geography. There are likely differences in underwriting and loss mitigation. Aggregate delinquencies do not indicate whether the identical loan held by a bank or a securitization has different risk. But banks and securitizations likely do not hold the same loans. These aggregate differences still add up to much lower delinquency rate for banks.

Another read on the possibility that smaller banks end up with riskier loans—a source of some investors’ concern—is to compare delinquencies across large and small banks, an angle that again suggests no iceberg. Smaller banks more often than not show lower delinquencies on commercial real estate loans than larger banks (Exhibit 2). Banks outside the Top 100 make an estimated 23% of all bank commercial real estate loans. Delinquencies on commercial real estate loans made by smaller banks ran below the rate on loans from larger banks through the 1990s and 2000s and only exceeded larger banks from mid-2013 to mid-2020. As of March, the 100 largest banks showed 30-day or longer delinquencies of 96 bp while smaller banks showed 49 bp.

Exhibit 2: CRE loans by smaller banks usually look stronger than loans by larger

Note: Bank data shows loans 30-days or more delinquent and still accruing interest as well as nonaccrual loans.
Source: Federal Reserve, Santander US Capital Markets

Again, there could be material differences between commercial real estate loans made by small and large banks. But the aggregate risk of the smaller bank loan portfolio looks lower.

Business loans

The picture on business loans is more nuanced. Here, banks still show better loans than public markets on average, but not always. Bank loans to business since early 1999 show a median 30-day or longer delinquency rate of 145 bp while the Morningstar/LCD index of broadly syndicated leveraged loans show a median rolling 12-month delinquency rate of 181 bp (Exhibit 3). Delinquency rates on bank loans show much less volatility than leveraged loans, so sometimes leveraged loan defaults swing well below and well above bank rates. Through March this year, bank delinquencies on business loans stood at 97 bp with leveraged loans at 132 bp

Exhibit 3: Bank business loans often stronger than broadly syndicated loans

Note: Bank data shows loans 30-days or more delinquent and still accruing interest as well as nonaccrual loans. Morningstar/LCD data shows broadly syndicated leveraged loans in the last 12 months declared in default.
Source: Federal Reserve, LCD, Santander US Capital Markets.

When it comes to business loans, larger banks, which hold an estimated 94% of outstanding bank business loans, typically make stronger loans than smaller banks. Since 1999, large banks show a median delinquency rate of 131 bp while small banks show a rate of 203 bp (Exhibit 4). Delinquencies on business loans at large banks did spike above small banks after the bursting of the Internet Bubble in the early 2000s and during the Global Financial Crisis, so business loans at large banks may be more vulnerable to systemic stress. But as of March, small bank showed a business loan delinquency rate of 141 bp with large banks at 91 bp.

Exhibit 4: Larger banks make stronger business loans than smaller banks

Note: Bank data shows loans 30-days or more delinquent and still accruing interest as well as nonaccrual loans.
Source: Federal Reserve, Santander US Capital Markets.

Delinquencies on business loans suggest banks stand on modestly better ground than public markets, at least measured by leveraged loans. Worried investors’ concern that smaller lenders may end up making riskier loans may apply to the difference between smaller and larger banks. But public markets make riskier business loans than the average bank.

No iceberg here

Investors in public debt for now seem to have their spotlight focused on the right thing: the credit quality in loans backing public securities. Credit stress all along has been most likely to show up in the commercial real estate and business debt with a floating rate, and the public markets backed by those loans have shown signs of pressure. But for now there is no sign of a bigger problem lurking below the surface in the portfolios of banks. There may be pressure on specific borrowers or specific banks, but the bellwether of any trouble, if it comes, is likely to be right out in public.

* * *

The view in rates

OIS forward rates again puts fed funds above 5.40% from September through December and now into January. The same forwards anticipate 128 bp of cuts in 2024, down from 140 in mid-July. But the stickiness of core inflation suggests cuts in 2024 look premature, especially cuts of the magnitude priced. The Fed looks more likely to hold fed funds at a terminal rate well into 2024, something that would actually tighten financial conditions if nominal rates stayed constant and core inflation dropped. Under those circumstances, real rates would rise. That is likely the Fed plan. The risk to the market is that sticky inflation keeps the Fed at higher rates for even longer, which would eventually create credit problems for balance sheets funded at floating rates that already are burning cash.

Other key rate levels:

• Fed RRP balances closed Friday at $1.79 trillion, up $63 billion from a week ago. Heavy Treasury issuance in the second half of the year should keep T-bill yields attractive, a potential draw for cash now parted at the RRP.
• Setting on 3-month term SOFR traded Friday at 537 bp, unchanged over the last week.
• Further out the curve, the 2-year note closed Friday at 4.76%, down 11 bp in the last week. With the Fed likely to hike again and hold fed funds closer to 5.50% into next year, fair value on the 2-year note is above 5.00%. The 10-year note closed at 4.03%, up 8 bp in the last week. Much of the rise in 10-year yields came after hints of a shift in Japan’s yield curve control and the Treasury announcement of heavy supply ahead. With inflation likely to drift down and growth likely to slow, fundamental fair value on the 10-year note is closer to 3.50%.
• The Treasury yield curve closed Friday afternoon with 2s10s at -73, steeper 19 bp over the last week. Expect 2s10s to reflatten beyond -100 bp again as the Fed keeps short rates high and concerns about growth and recession grip long rates. The 5s30s closed Friday at 6 bp, steeper by 23 bp over the last week.
• Breakeven 10-year inflation traded Friday at 237 bp, down by 2 bp over the last. The 10-year real rate finished the week at 166 bp, up by 10 bp in the last week.

The view in spreads

The Bloomberg investment grade cash corporate bond index OAS closed Friday at 144 bp, wider by 4 bp in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 169 bp, wider by 7 bp in the last week. Par 30-year MBS TOAS closed Thursday at 58 bp, wider by 4 bp in the last week. Both nominal and option-adjusted spreads on MBS have been particularly volatile in the last month.

The view in credit

Most investment grade corporate and most consumer balance sheets look relatively well protected against the likely impact of Fed tightening. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. But other parts of the market funded with floating debt look vulnerable. Leveraged and middle market balance sheets are vulnerable, especially with the tightening of bank credit in the wake of SVB. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans in September should add to consumer credit pressure.