Signs explaining Federal Deposit Insurance Corporation (FDIC) and other banking policies on the counter of a bank in Westminster, Colorado November 3, 2009.
Rick Wilking | Reuters
If there wasn’t enough banking jargon to blind you, it’s time to learn a new piece of it: Welcome to the industry’s era of the “criticized loan.”
It’s a loan that’s not gone bust, or even missed a payment. But in a time when Wall Street is vibrating to any sign of recession risk, especially from banks, it’s gaining new currency. Criticized loans are those that show preliminary signs of higher risk, such as a developer who’s making payments but is otherwise having financial trouble, or an office building that recently lost a big tenant and needs to replace it.
And they’re rising, which sets off the kind of bells that have sent bank stocks down roughly 20% since early March, even as earnings from the sector are coming in healthier than expected. Wall Street is watching stats on commercial real estate loans almost as closely as for signs that depositors are fleeing for higher interest rates paid by money-market funds (the No. 1 question on recent earnings calls).
Banks are being asked more about criticized loans partly because other credit quality metrics look so good, despite the failures of Silicon Valley Bank and Signature Bank last month, according to David George, a banking analyst with Robert W. Baird & Co. Watching these loans is a way to gain at least limited insight into a real estate downturn many analysts expect to get worse before it gets better, as a combination of recession fears and the slow return of workers to post-Covid offices drives expectations of rising office vacancy rates.
“It’s more subjective, but there are regulators at every bank,” he said. “Criticized loans could be paying or performing but a loan could be singled out because of its collateral.”
Not all banks disclose criticized loan growth in earnings reports, and the definition of a criticized asset is more fluid than classifications of whether a loan has missed payments or is otherwise “non-performing,” meaning it has missed payments or violated some other term of the loan deal. A bank’s quarter-end list of criticized assets is developed by a bank itself, under the supervision of bank examiners, according to David Fanger, senior vice president at the bond-rating agency Moody’s Investor Service.
The Federal Deposit Insurance Corp.’s guidelines for such loans say they should be singled out if “well-defined weaknesses are present which jeopardize the orderly liquidation of the debt, [including] a project’s lack of marketability, inadequate cash flow or … the project’s failure to fulfill economic expectations. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.”
Bank earnings show modest growth in ‘criticized loans’
So far, reports for the first quarter show only slight growth in criticized loans, even as they move into the spotlight at regional banks and national-level commercial banks like Bank of America and Wells Fargo.
At Bank of America, criticized loans to office building projects rose to $3.7 billion out of $19 billion in office loans. But office buildings represent only a quarter of the bank’s commercial real estate loans, and all CRE is just 7% of the bank’s total loans and leases. So even that ominous-sounding number — 20% of office loans look at least potentially shaky — works out to less than 1% of the bank’s total loans and leases. Bank of America set aside $900 million for potential loan losses in all categories, a truer indication of short-term vulnerability.
“They’re over-reserved,” George said. “It’s almost impossible for us to see office [losses] more than 4 or 5 percent of office loans. They already have reserves for that.”
Wells Fargo, the nation’s biggest commercial real estate lender, according to American Banker, did not disclose its level of criticized loans in its earnings report. A spokeswoman said in an e-mail that the number will be in the bank’s quarterly Securities and Exchange Commission filing. Wells Fargo previously said its criticized loan levels in commercial real estate fell during 2022, but ticked upward in the fourth quarter to $12.4 billion out of $155.8 billion in loans.
Among the most detailed disclosures are those from Huntington Bancshares, a Columbus, Ohio-based regional with $169 billion in assets. Its criticized loans, which include all commercial lending and not just real estate, rose 5% to $3.89 billion. That included upgrades of $323 million in loans to a higher risk rating, and paydowns of $483 million, offset by $893 million in loans newly placed in the “criticized” category. Criticized loans are only 3.5% of Huntington’s total loans and 13 times more than the total of commercial loans that are 30 days past due.
Of Huntington’s $16 billion-plus in commercial real estate loans, none are 90 days past due and only 0.25% of balances are 30 days past due or more. But the 30-days-late category is up from close to zero in late 2022. How big a problem is this? If all of the 30-days-late loans went unpaid and had to be written off, Huntington’s quarterly earnings of $602 million would have dropped by about 7%, or $41 million. The total of all criticized loans compares to 2022 net income of $2.13 billion.
“Our credit quality remains top-tier,” Huntington CEO Stephen Steinour told analysts on its recent earnings call. “Huntington is built to thrive during times like this.”
The story is similar among regional banks generally. PNC, the second-largest regional bank, said criticized real estate loans are now 20% of office loans, because multi-tenant buildings it has lent to are about 25% empty, and 60% of the loans are up for refinancing or repayment by the end of 2024. But only 0.2% of office loans are actually delinquent. “In the near term, this (multi-tenant office) is our primary concern area,” CFO Robert Reilly told analysts. PNC has loan loss reserves of 9.4% of total multi-tenant office loans.
At Cincinnati-based Fifth Third Bancorp, 8.2% of office loans are now criticized, but that represents about 0.1% of the bank’s total loans. Cleveland-based Keycorp said its criticized loans were about 2.8% of its total, up from 2.5% late last year, but that only 0.2% of loans aren’t being paid on time.
“Credit quality remains strong,” Keycorp CEO Christopher Gorman said after its earnings, adding that the company has reduced risk for a decade, including by eliminating most construction loans to office building developers. “We have limited exposure to high-risk areas, such as office, lodging and retail,” he told analysts on the quarterly earnings call.
There is an estimated $1.5 trillion in the commercial real estate refinancing pipeline over the next three years, but Moody’s research shows the portfolios to be well diversified across bank types, and according to a recent analysis from CNBC Pro using Deutsche Bank data, the concentration of CRE risk is smallest at the largest banks, where office loans make up less than 5% of total loans, and are less than 2% on average.
For investors, the key is to look at all the metrics together to manage their own risk, Fanger said. Many, even most, criticized loans will never go bad, he said, since they can be restructured or refinanced, or the office building collateral can be sold to repay some loans. But the newly prominent metric, which he said has been around for years, is the place to look for one version of what could happen down the road.
“There’s a qualitative aspect to any rating,” Fanger said. “We find it a useful measure for the likely direction of risk.”
