BY KEVIN STEIN AND BRIAN GRAHAM
Industry results for the fourth quarter of 2023 were weak on average; the largest banks outperformed and the regional banks materially underperformed. This was in line with expectations, capping a very challenging year for the banking industry. Increased FDIC assessments for the Spring 2023 failures, one-time charges for staffing reductions, and idiosyncratic credit charges contributed to the weak results. But overall the fourth quarter earnings season was notable for the lack of any surprises, with the significant exception of New York Community Bank (more on that topic below).
Among the largest banks, net charge-offs and reserve building continued, particularly amongst those with high consumer and office loan exposure. Embedded losses (unrealized securities and loan mark-to-market losses) for the industry fell from nearly $1 trillion at the end of Q3 to ~$700 billion as of the end of Q4, reflecting the level of rates at that point in time (which moved ~75bps lower in the 5 and 10 year portion of the yield curve). Of course, the 5-year and 10-year UST yields have reversed course in recent weeks, trending over 4%. It is likely that embedded losses will be back to the ~$1 trillion level at the end of Q1 2024. The banking industry is positioning for more than the communicated Federal Reserve rate cuts in 2024 to drive improved margins and profitability. At the same time, the long rumbling impact of commercial real estate exposures has begun to emerge, in maturities and repricings of nearly $800B between 2024 and 2026.
New York Community Bank (NYCB) and CRE
On January 31, NYCB announced fourth quarter earnings that surprised the market with credit deterioration ($552 million increase in reserves vs $45 million expected), a dividend cut (by 70%) and reduced earnings outlook in anticipation of stricter regulatory scrutiny and pressures, (suggesting that the bank had not adequately prepared to cross the $100 billion asset threshold). Following the announcement, Moody’s lowered the Company’s credit rating to junk status. In a subsequent press release and hastily scheduled conference call on February 6, a week after its earnings announcement, the Company announced its non-executive chairman and former legacy Flagstar CEO would become Executive Chairman. On February 29, NYCB announced its CEO was being replaced by the recently announced Executive Chairman, a $2.4B goodwill impairment, and internal controls weakness in loan review. Capping a five week derecha of speculation, short selling, contagion concern and chaos, on March 6, NYCB announced a $1 billion capital raise led by former Treasury secretary Steven Mnuchin, a leadership change to former Comptroller of the Currency Joseph Otting, and a new slate of the independent directors. Mnuchin and Otting last teamed up successfully on Indymac/OneWest. The storm is over (for now) at NYCB.
Many analysts describe NYCB’s challenges as isolated, idiosyncratic and NY CRE-specific. Given continued deterioration in CRE market indices and the performance of CMBS, we believe that there will indeed be further CRE challenges and problems. But, we also believe the risk varies materially by company, geography, and asset type. Some banks will weather the looming CRE storm with few issues while others, like NYCB, will face massive headwinds. NYCB now benefiting from capital infusion, leadership and board changes, as well as the critically important institutional investor endorsement, provides important insights about the banking industry today:
The banking system remains opaque and fragile - NYCB’s multifamily loan portfolio has significant maturities/repricings in 2024 (~$3B), and contains a high percentage (~50%) of rent stabilized properties, which have seen significant collateral value deterioration (negative 20-30% according to Trepp). Given the wide variance in CRE credit risk by geography and asset type, it can be challenging to assess any bank based solely on publicly available information. The Mnuchin-led investor group “wall crossed” to evaluate loan portfolio information unavailable to public side investors.
CRE risk involves more than big city offices - Multifamily loans have joined the category of bank CRE concerns, which already included the well documented and slow moving fears surrounding office loans and loans on retail-focused real estate.
Consolidation by and among stronger mid-tier banks remains viable - We believe that well-capitalized, forward-leaning banks will increasingly take advantage of weaker banks, under pressure from both investors and regulators. Given the regulatory burdens that all banks face, M&A driving scale and efficiency is imperative in our view. This is clearly true for larger banks, as demonstrated by the Capital One/Discover transaction and even more important for our mid-tier banks. Market uncertainty, driven initially by rates and now to some extent by CRE-focused credit uncertainties, has delayed what we view as a likely and necessary return to at- or above-trend M&A.
Scale matters - Based on Klaros and industry analyses, there are earnings and operating leverage break points for bank asset size driven by scale efficiencies and regulatory constraints. Accordingly, investors have been rewarding banks between $10 and $50 billion in assets, as well as those over $250 billion in assets, while penalizing both smaller banks and the mid-sized regionals between those ranges. We would like to see more tangible regulatory support for M&A transactions and we remain positive that regulators understand the need for consolidation to strengthen the banking industry. Moreover, we believe most regulatory scrutiny of bank M&A will be focused on large bank transactions, especially in the wake of Capital One’s proposed acquisition of Discover.