Despite a sustained period of economic growth and prosperity, many banks are facing unfamiliar strain. The value of their loan and bond portfolios is dropping due to the continued decline of commercial real estate (“CRE”), particularly the office sector, and the ratcheting up of interest rates by the Federal Reserve.
In August, this strain became evident as Moody’s downgraded the ratings of ten smaller banks and placed six large banks, including Bank of New York Mellon, State Street, and Northern Trust, under review for possible downgrades.
Contemporaneously, federal banking regulators issued nonpublic admonitions on matters ranging from capital and liquidity to technology and compliance to 30 midsize or “Category IV” banks, those with assets from $100 billion to $250 billion. Notably, this group includes Citizens Financial Group Inc., Fifth Third Bancorp, and M&T Bank Corp. These admonitions generally fall into two categories: matters requiring attention (MRAs) and matters requiring immediate attention (MRIAs). MRAs and MRIAs require a board-level response from the receiving bank, along with a timeline for the bank to implement corrective action.
The increased regulatory scrutiny follows a turbulent six months for U.S. banks, marked by the abrupt collapse of three high-profile banks: California’s Silicon Valley Bank (SVB), First Republic Bank, and New York’s Signature Bank, all within weeks of each other. SVB created a niche by catering to tech entrepreneurs and venture capital-backed healthcare and technology companies. In March, 2023, federal regulators shuttered SVB after it suffered a devastating and stunningly fast run on deposits following an announcement that the value of the bank’s bond portfolio had dropped due to rising interest rates. Two days later, federal regulators closed Signature Bank, known as a “crypto-friendly” bank. Signature Bank’s failure was precipitated by the withdrawal by depositors of billions of dollars in the wake of the FTX bankruptcy and subsequent erosion of the crypto market. Less than a week later, amid much fanfare, First Republic received a $30 billion rescue package from a group of 11 large lenders, including Bank of America, Citigroup, J.P. Morgan Chase, and Wells Fargo. On May 1, 2023 – amid much less fanfare – federal regulators seized First Republic which was then sold to J.P. Morgan Chase. The failure of these banks in rapid succession eroded consumer confidence and caused ripple effects throughout the economy. For SVB alone, the FDIC had to provide $20 billion from the government deposit insurance fund to make depositors whole.
These bank failures prompted not only increased regulatory scrutiny but also Congressional action. SVB, First Republic, and Signature had each adopted risky management practices and incentivized such practices through performance and equity-based compensation for bank executives. Senators Sherrod Brown (D-Ohio) and Tim Scott (R-S.C.) introduced the Recovering Executive Compensation from Unaccountable Practices (RECOUP) Act of 2023 earlier this year. Among its provisions, the RECOUP Act empowers the FDIC to claw back all or part of incentive-based compensation and stock profits received by bank executives during the two years before a bank failure. In June, the Senate Committee on Banking, Housing and Urban Affairs overwhelmingly advanced the RECOUP Act to the full Senate with a bipartisan 21-2 vote.
While the concerns caused by the early 2023 bank failures have eased, it remains to be seen whether those failures were a blip or foreshadow economic shoals and rapids ahead. It is increasingly apparent that the Federal Reserve intends to keep interest rates higher for an extended period, which means many businesses will face much higher rates as their existing loan and financing facilities expire and must be renewed. The Wall Street Journal recently reported that borrowing costs are at a roughly 15-year high, with high- grade companies paying an average of 5.7% for corporate bond issues. The extent of the challenges for businesses remains a critical question.
Likewise, banks heavily invested in CRE will proceed with caution in the coming months and may try to shed CRE-secured loans from their portfolios through default, acceleration, or otherwise, as circumstances permit. They may also be reluctant to extend or refinance CRE loans, even at significant interest rate increases, due to concerns that the value of CRE collateral may drop further. Owners of previously well-performing CRE properties may be surprised that their lenders are no longer eager to provide financing against their assets. These owners will face financial challenges as their loans come due and they seek to refinance.
If your enterprise is having difficulty in the new higher interest environment or you own CRE and are facing pressure from your bank – or even if you lease space in a property where the lender is seeking to foreclose – the Hirschler bankruptcy and creditors’ rights team can help you navigate the challenges ahead.
Luis F. Ruiz