Just how bad off are America’s banks, really?

Bond rating agencies trash-talked banks all through August, helping drive a near-6% drop in the S&P 500 during the month. But Wall Street equity analysts who cover banks argue that their counterparts on the bond side of the research profession, at Moody’s Investors Service, Standard & Poor’s and Fitch Ratings, got it wrong. They point to a period of rising bank stock prices before the bond ratings calls and better-than-expected earnings reports as evidence that things are better than the agencies think.

While the regional banking sector as tracked by the SPDR S&P Regional Banking Index is down nearly 25% year to date, according to Morningstar — and on pace for the worst year on record back to its inception in 2006, with the long tail of the SVB collapse hard to claw back gains from — bank stocks had been in rally mode from May to July. Regional bank stocks, in particular, gained as much as 35% before the bond warnings and downgrades began. Meanwhile, second-quarter bank earnings beat forecasts by 5%, according to Morgan Stanley.  

The higher interest rates bond analysts cited hurt profits some, but most banks’ net interest income and margins were higher than a year before. Delinquencies on commercial real estate loans rose, but stayed well below 1% of loans at most institutions, with some of the banks singled out by bond rating agencies reporting no delinquencies at all. The ratings actions pushed the regional bank stock index 10% lower for the month-long period ending Sept. 8, according to Morningstar (the Moody’s bank warning was issued August 7).  

At stake is not only what bank stocks may do next, but whether banks will be able to fill their role in providing credit to the rest of the economy, said Jill Cetina, associate managing director for U.S. banks at Moody’s. Their medium-term fate will have a lot to do with outside forces, from whether the Federal Reserve cuts interest rates next year to how fast the return-to-work push from employers in recent months gains momentum. Looming over all of this is the question of whether there will be a recession by early 2024 that worsens credit problems and cuts banks’ asset values, as Moody’s Investors Service expects.

“It’s reasonable to ask, is there a credit contraction in the banking sector?” Cetina said. She pointed to Federal Reserve surveys of bank lending officers that look like pre-recession measures in 2007 and 2000, with many banks raising credit prices and tightening lending standards. “Banks play a key role in shaping macroeconomic outcomes,” she said.

By any reckoning, the argument about banks is about two things: Interest rates and real estate, specifically office buildings. (Banks also call warehouses and apartment complexes commercial real estate, but their vacancy rates are not historically high). The arguments depend on two assumptions that markets believe less than they did earlier this year.

The bear case relies heavily on the prospect of a recession, which stock investors and economists think is much less likely than many believed six months ago. Goldman Sachs chief economist Jan Hatzius cut the firm’s estimated U.S. recession odds to 15% on Sept. 4, meaning the bank sees only a baseline risk of a downturn. At Moody’s, while the bond-rating arm expects a U.S. recession next year, the company’s economic consulting unit Moody’s Analytics doesn’t.

It also turns on an assumption of sustained high interest rates. While debate continues and the Fed’s own commentary continues to express a willingness to raise rates more, many investors now think the Fed will begin to trim the Fed funds rate by spring as inflation fades, according to CME Fedwatch. And while experts such as RXR Realty CEO Scott Rechler and billionaire real estate investor Jeff Greene believe office vacancies will stay high enough to force defaults by more developers, even as employers gain the upper hand against workers who want to continue to work from home, that didn’t show up in second–quarter bank earnings.

“I don’t necessarily think what they said is not true– it’s just less true than in May,” said CFRA Research bank stock analyst Alexander Yokum. “Expectations have improved over the last few months.” 

March’s bank failures were about interest rates. The rise in rates since the Fed’s first post-Covid boost to the Fed funds rate in March 2022 had left banks with trillions of dollars of bonds written at lower rates before last year, whose value fell as rates rose. That opened precarious holes in the balance sheets of some banks, and fatal ones for banks that failed. Coupled with commercial real estate, higher funding costs create “layers” of risk going forward, Cetina said. “They’re both a problem, and they are happening at the same time,” she said.

The Fed stepped in with a short-term solution for banks’ funding issues, extending more than $100 billion in financing under a program called the Bank Term Funding Program, designed to help banks close the gap between the book value of their securities, mostly U.S. Treasuries, and their market value in a new, higher interest-rate market. That lets banks act as if their capital is not impaired, when it is, said veteran analyst and Fed critic Dick Bove of Odeon Capital.

“If the capital is not there, the bank can’t put more money out there” in loans, Bove said. “People say they understand that, but they don’t.” 

Interest rate effects on bank profits

The jump in rates threatens the net interest income that is the source of bank profits and their long-term lending capacity, the bond rating agencies said. Indeed, interest income fell at most banks in the second quarter – compared to the first quarter – and Yokum says it will fall more in the third quarter. So did net interest margin –  the difference between the rates banks pay for funds, usually deposits, and what they collect on loans and other assets. 

But the drops were small enough that banks made up the lost income elsewhere. The average regional bank stock rose 8% after earnings, Morgan Stanley said, with banks beating profit forecasts by an average of 5%. Most banks reported before the bond agencies acted.

Bulls point out that while interest rates began to bite at bank profits in the second quarter, the impact so far has been minor for most, and several banks said that higher interest rates have boosted profits over the past year. At most banks, both net interest income and net interest margins did better in the second quarter than in the second quarter of 2022, making rising rates helpful to bank profits overall. Morgan Stanley analysts Manan Gosalia and Betsy Graseck said most banks, even regional banks thought to be most vulnerable to depositors fleeing as rates rise, also added deposits in the quarter. That stems fears they would boost rates sharply to keep customers. 

Not all banks felt much pressure on deposit rates: Wells Fargo said its average was 1.13% in the second quarter; at Bank of America it was just 1.24%. 

Credit quality is on the decline

Credit quality is getting a little worse, but still better than pre-pandemic levels at most institutions, Yokum said. Even the office sector still is showing few signs of serious problems. Moody’s calls banks’ current credit quality “solid but unsustainable.”

Take Valley National Bancorp, a New Jersey institution whose rating S&P cut in mid-August. Or Commerce Bancshares, cut by Moody’s. Or Zions Bancorporation, a target of low ratings from both stock and bond analysts.

Valley has $50 billion in loans on its balance sheet, and $27.8 billion of them are in commercial real estate, according to the bank, a much higher proportion than the 7% at Bank of America. But only 10% of Valley’s commercial real estate loans, less than 6% of its total loans, are to office buildings. 

Valley has had stumbles in office lending, to be sure. It disclosed that its total non-performing assets were $256 million at the end of June. But that remains only about half of 1% of its total loan book. Chargeoffs of loans the bank thinks won’t be fully repaid fell in the quarter, and the company’s $460 million in loan loss reserves is nearly double the amount of all its troubled loans. 

Similarly, Zions’ $2 billion office portfolio, part of a commercial real estate exposure that is more than a quarter of the bank’s assets, doesn’t have a single delinquent loan, according to the bank’s second-quarter report. Neither did Commerce.

“Zions’ chargeoffs were .09 of 1% of total assets,” said Yokum, who doesn’t follow Commerce or Valley. “Not alarming.” 

Many banks argue that bears overstate real-estate lending problems by overlooking how few of their real estate loans are to office buildings. With hotel and warehouse occupancy high, they’re selling the idea that only their office portfolio is at serious risk, and that the office loans are too small to threaten banks’ health. At KeyCorp, whose shares have dropped 36% this year and which S&P downgraded, office loans are 0.8% of the bank’s total.

Bank delinquencies rose in the last quarter, but remain lower than a year ago.

“We have limited office exposure with … almost no delinquencies,” Fifth Third Bancorp chief financial officer James Leonard said on the bank’s earnings call. “We continue to watch office closely and believe the overall impact on Fifth Third will be limited.”

Two big questions about banks finding a bottom

There are two big unanswered questions about banks and real estate. Eight months into a year where nearly a quarter of office building mortgages are expected to mature and need refinancing at today’s higher rates, chargeoffs — while getting more common — are still less than 1% of loans at nearly every major bank. Is a surge coming, or are banks delaying a reckoning with short-term financing, hoping for rates to fall or occupancy to rise? 

And, when will more workers go back to the office, relieving pressure on companies to stop paying for space they don’t really use?

The share of U.S. workers working from home at least part of the week has stabilized at around 20-25%, below its peak of 47% in 2021 but well above the pre-pandemic 2.6%, Goldman’s Hatzius wrote in an Aug. 28 report. With CEOs as prominent as Amazon’s Andy Jassy becoming more forceful about return to office, Goldman says online job postings are down to only 15% of new positions allowing work from home. Even Zoom Communications, maker of video-conferencing software, is making staffers return to the office two days a week. Hatzius estimates remaining part-time WFH will add 3 percentage points to office building vacancy rates by 2030. But that impact will be lessened by a near-halting in new construction, he wrote.

Findings like these have some market players speculating that a bottom may be near. 

Manhattan real estate attorney Trevor Adler says he’s seeing an uptick, with public sector tenants like Empire State Development signing long-term leases. ESD took 117,000 square feet in Midtown in July, he said. 

“To have that kind of deal in July is not typical,” said Adler, a partner at Stroock & Stroock & Lavan. “That work is keeping me busy, educational, hospital and charity.”

Others argue that the slow rate of foreclosures is normal early in what they believe is a long-term crisis. 

“Crises happen slowly, then all at once,” said Ben Miller, CEO of Washington-based Fundrise, an online platform for real estate investment, pointing out that several years elapsed between early warnings and the depth of the late-2000s home mortgage crisis.  

Banks have been encouraged by the Fed and other bank regulators to give previously-solvent borrowers extensions or other workouts, Miller said. Regulators argue that this guidance, released in June, simply restated previous policy.

The primary way the Fed can defuse upcoming foreclosures is to lower rates, so developers can refinance office buildings and stay profitable, Miller said. 

“If we end up higher for longer, the banks have a huge problem,” Miller said. “If high rates are transitory, it gets the bank to a normalized rate environment and there’s no problem.”

Officials at the Fed declined comment. 

The takeaway may be that banks’ problems are big enough to contain earnings for a few quarters, while not threatening their solvency, Yokum said. At Standard & Poor’s, analysts emphasized that 90% of U.S. banks have stable outlooks, even as it downgraded five banks. “Stability in the U.S. banking sector has improved significantly in recent months,” analysts led by Brendan Browne wrote.

“I do expect net interest margins to fall in the third quarter, and for credit quality to get worse, but I expect them both to be manageable,” Yokum said. “And both are well built into the stock prices.”