Credit quality proved pristine through the pandemic's aftermath and into this year. Soured loans were rare, and losses held below historical averages for most of this decade.
That is changing. Loan charge-offs are beginning to accumulate. More losses are expected, bringing the health of loan portfolios into focus just ahead of third-quarter earnings season in October.
"Across the board, the potential for loan delinquencies is the No. 1 concern," said Tim Scholten, founder and president of the community bank and credit union consultancy Visible Progress. "More challenging credit times are ahead."
The U.S. economy continued to grow this year — gross domestic product expanded at a 2.4% clip in the second quarter — but elevated inflation and higher interest rates now loom large, Scholten said.
The Federal Reserve boosted rates 11 times since early 2022 to combat inflation, reaching a 40-year high last year. The campaign has begun to work but borrowing costs have surged in the meantime. This has hampered commercial real estate borrowers, and office property owners in particular, given remote work trends and its enduring impact on urban centers.
In fact, notable signs of weakness emerged in the second quarter of this year, when net CRE loan charge-offs among U.S. banks increased four-fold from a year earlier to $1.17 billion, according to S&P Global Market Intelligence. The firm said increased default levels motivated dozens of banks to scale back their exposures to CRE, most notably by offloading office loans.
During the third quarter, several banks pre-announced expected charge-offs with their coming earnings reports. This list, which spans community banks to major regional lenders, included the $13 billion-asset OceanFirst Financial in Red Bank, New Jersey, the $36.2 billion-asset Hancock Whitney in Gulfport, Mississippi, and the $61 billion-asset Synovus Financial in Columbus, Georgia.
Synovus expects to post a charge-off of $23 million on a 10.75% participation in a $218.5 million syndicated credit. It previously disclosed the sale of a $1.3 billion medical office CRE loan portfolio that implied an accompanying net loss and a coming charge-off, noted D.A. Davidson analyst Kevin Fitzsimmons.
Taking an industrywide look, Fitzsimmons said that charge-off levels remain low ahead of earnings season. But this "likely isn't sustainable," he said.
The concern now is that CRE woes will worsen and could spread to other loan types, given that everything from retail outlets to apartment buildings have historically depended on the traffic generated by workers flowing in and out of office towers in major cities from San Francisco to Denver to New York. About 40% of bankers surveyed by S&P in the second quarter said they expected CRE credit quality to deteriorate over the ensuing 12 months, up from 26% in a first quarter poll.
The American Bankers Association's latest quarterly Credit Conditions Index, released this week, fell 2.8 points to a reading of 4.5. Anything below 50 indicates expected deterioration among bank economists, whose input is used to calculate readings. The latest figure reflects consensus among bank economists that credit market conditions will further weaken over the next two quarters and perhaps further out, the ABA said in a report.
Economists "are forecasting weak growth in household spending and business investment over the next four quarters before a modest pickup in the second half of next year," said ABA Chief Economist Sayee Srinivasan.
A Piper Sandler survey of investors, released this week, found that their biggest concerns for the bank group are credit quality (44%) and, relatedly, higher interest rates (38%). The firm's head of research, Mark Fitzgibbon, said charge-offs are bound to increase through this year and into early 2024. He said the severity of loan losses depends largely on the direction of the economy and interest rates.
If Fed policymakers can fully tame inflation and stop raising rates, the economy may be able to avoid a recession, or at least a steep downturn. But if full-blown malaise settles in, he said, credit quality could worsen substantially.
"There's going to be some pain in the system," Fitzgibbon said. "There's going to be more credit losses and challenges."
