The Long and Short

NYCB selloff in regional bank paper creates value

| February 2, 2024

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.

New York Community Bancorp (NYCB: Baa3*-/BBB) sparked major concerns about regional banks lately after reporting a large, unexpected provision for losses in commercial real estate and drastically cutting its dividend. Dislocation in the market for investment grade regional bank credit appears to be creating a temporary value opportunity, although it may take time for investors to get comfortable. The event seems unique to just a single issuer, given a similar instance of US CRE losses taken at a Japanese bank later in the session. Nevertheless, regional banks appear even more undervalued to broader investment grade credit than before NYCB’s earnings and present a near-term opportunity to add relative value against the rest of the investment grade index.

NYCB’s sole index-eligible notes, a floater maturing in 2028, saw its indicated price drop from above par to below the $90 threshold. More importantly, domestic banks and the broader financial sector saw spreads move out rapidly in wake of the troubling earnings report. New issues from the big 6 US money center banks are about 8 to 10 bp wider over the last two sessions. The bigger and more stable, super-regional banks, e.g. PNC, USB, TFC, are wider by about 6 to 9 bp. The next tier of regionals, which include newer issues from CFG and CMA, are wider by about 15 to 20 bp. Also, demonstrating the extent that this event has shaken investor confidence in lending, recent new issues from IG business development companies—of which there was a nearly unprecedented ten issuers in the market in January—are seeing spreads as much as 10 to 25 bp wider as well. While not part of the banking segment, as middle market operators, these credits often serve as a proxy for perceived risk among lenders and higher risk loan categories.

Worth noting from a relative value standpoint is just how much domestic bank spreads had been compressing despite absorbing a tremendous amount of supply via the primary market. The banking sector outperformed the overall IG index in January despite roughly $70+ billion in issuance across the broad sector throughout the month. The fact that spreads are now backing up in wake of the NYCB earnings development is not altogether surprising given how much new paper investors have taken on over the past month.

NYCB reported earnings on Wednesday. There were multiple factors at work in the earnings, but the main source of concern was that the company took a $552mm provision for credit losses versus an estimate of only $45mm, which resulted in a net loss of $252mm in the fourth quarter. $185mm of the provision will go to meet net charge-offs for the quarter, which management stated were elevated due to one co-op loan as well as an office loan that went non-accrual in the previous quarter. The co-op loan was moved to held-for-sale and they expect that it will be sold in the current quarter. The remainder of the provision will go to build reserves against future potential losses in its loan portfolio. Non-performing loans (NPLs/total loans) jumped to 0.51% from 0.20% in the previous quarter. In the office portfolio, criticized loans were at 38% but with no early-stage delinquencies.

To offset the impacts of the credit provision and more importantly to help bolster regulatory capital (ie CET1), management slashed the dividend drastically to $0.05 from $0.17, leading to the rapid sell-off in the company stock, which quickly spread to the rest of the sector. The attempt to bolster capital is largely a function of NYCB having crossed over the $100 billion asset threshold to qualify as a Category IV bank and their need to get those ratios up for regulatory purposes.

The closest candidates of shifting up into the Category IV designation were among the harder hit in the sell-off following NYCB’s results, which include ZION (roughly $87 billion), CMA ($86 billion), and FHN ($82 billion). Those banks could gradually transition to Category IV but are unlikely to do so in the near-term absent a material acquisition of bank assets. RF is just above NYCB on the list of US regional banks by size at $152 billion, and already subject to enhanced regulatory capital requirements.

Spooking markets further in the same day, Japan-based lender, Aozora Bank Ltd., saw its own share price drop by more than 20% after warning of US commercial property losses. Aozora stated that they would book a $190.5 million (28 billion yen) loss for fiscal year ending in March (its first since 2009), in part due to reserving for possible losses for US office loans (32.4 billion yen), of which it holds $1.89 billion as of calendar year-end.

Obviously, this was a really ugly quarter for NYCB and a repricing of risk at the credit seems highly warranted. Management did a poor job of communicating these risks in earlier quarters since assimilating the assets from Signature bank last year that pushed it over the $100 billion threshold, and markets are punishing the credit for its poor handling of the situation. It appears possible that they themselves were perhaps not fully aware of the necessary measures that the bank would eventually need to take under new regulatory guidelines.

As far as contagion risks, those still seem somewhat limited given the uniqueness of the situation with NYCB still transitioning after having taken on new assets from Signature last year. Given that the source of credit quality issues seems to be targeted toward the bank’s multifamily and CRE holdings, this clearly causing some stir at similar lenders, but the fact that most of the IG banks have already recorded fourth quarter results, mostly without incident so far, should provide some significant relief about this being a broader issue for the sector in the immediate term.

The sector remains rightfully sensitive following last spring’s events, so it could take some time for investors to get comfortable with the idiosyncrasy of NYCB’s predicament. Office maturities ramp up significantly over the next two years, at which time it seems probable that future delinquencies could arise as those loans continue to mature, but damage in the current year seems more likely to be on a limited scale. Most regional banks have been providing enhanced disclosures in their results that have helped quantify at-risk categories within CRE, and specifically in office portfolios.

Moody’s reacted by placing the Baa3 rating for NYCB, as well as the A3 deposit rating for the operating company Flagstar Bank NA, on review for downgrade, threatening to strip the company of investment grade ratings. The rating agency highlighted the bank’s weak earnings, lower capitalization, and growing reliance on wholesale funding as factors that could influence the outcome of the review.

Dan Bruzzo, CFA
1 (646) 776-7749

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