The bad loan term that's back for banks trying to spot a recession

Important Points

Banks talk more about loans that have been criticized, particularly to owners of office buildings, but not every bank discloses the same information.

It's time to get familiar with the new "criticized loan" that's been introduced to the banking industry.

This is a loan which has not defaulted or missed a payment. It's becoming more popular at a time when Wall Street vibrates to any signs of recession, particularly from banks. The loans that are being criticized show signs of high risk. For example, a developer making payments, but otherwise in financial difficulty, or a building that has recently lost an important tenant and must replace it.

They're also rising, which is what has sent bank shares down by around 20% since March, despite the fact that earnings are better than expected. Wall Street pays close attention to the statistics on commercial real-estate loans, almost as much as it does to signs that depositors will be fleeing money market funds for higher rates of interest. Recent earnings calls asked the No.

David George, a Robert W. Baird & Co. banking analyst, says that banks are asked about criticized loans more because other credit metrics look good. This is despite Silicon Valley Bank's and Signature Bank's failures last month. These loans can provide some insight into the real estate slump that many analysts believe will get worse before getting better. This is due to a combination between recession fears and a slow return of employees to their offices after Covid.

He said that although it was subjective, there were regulators in every bank. "Criticized Loans could be performing or paying but a loan may be singled out due to its collateral."

Some banks do not disclose the growth of criticized loans in their earnings reports. The definition of a "criticized asset" is also more flexible than the classification of a loan that has been classified as non-performing, meaning it has failed to make payments or has violated another term of the contract. According to David Fanger of Moody's Investor Service, a bank's quarterly list of criticized loans is created by the bank under the supervision and guidance of examiners.

Federal Deposit Insurance Corp. guidelines on such loans state that they should be emphasized if "well defined weaknesses" are present, which could jeopardize an orderly liquidation. These include a lack of marketability for a project, insufficient cash flow, or the failure of the project to meet economic expectations. The Federal Deposit Insurance Corp.'s guidelines for such loans state that 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."

Bank earnings are showing modest growth for 'criticized loans

Reports for the first three months show a slight increase in the number of criticized loans. This is despite the fact that they are now being highlighted by national and regional commercial banks such as Bank of America and Wells Fargo.

Bank of America's criticized office loan projects amounted to $3.7 billion, out of $19 Billion in office loans. Office buildings make up only a quarter the bank's loans for commercial real estate, and CRE as a whole is only 7% of all the bank's loans and leases. Even that seemingly alarming figure -- 20% of all office loans are at least potentially risky -- is less than 1% the total amount of loans and leases of the bank. Bank of America has set aside $900,000,000 for all possible loan losses, which is a better indicator of the bank's short-term vulnerability.

George stated, "They are over-reserved." It's very unlikely that we will see losses in the office loan exceeding 4 or 5 per cent. They have already set aside reserves to cover that.

According to American Banker's earnings report, Wells Fargo did not reveal the number of loans that were criticized. In an email, a spokeswoman stated that the amount will be included in the bank's quarterly Securities and Exchange Commission report. Wells Fargo had previously stated that its commercial real estate loan levels fell in 2022. However, they ticked up in the fourth quarter and reached $12.4 billion of 155.8 billion loans.

Huntington Bancshares is a regional bank based in Columbus, Ohio, with assets of $169 billion. The amount of criticized loans - which includes all commercial lending, not just real estate - rose by 5%, to $3.89billion. This included upgrading of loans by $323 million to a higher rating and paying down loans of $483 millions, offset with $893 million of loans that were newly placed into the "criticized" category. The total amount of loans classified as "criticized" is only 3.5%, and the number of loans in this category is 13 times greater than all commercial loans past due by 30 days.

Huntington has commercial real estate loan balances of over $16 billion. None are past due 90 days and only 0.25 percent are past due 30 days or more. The 30-days late category has increased from a near-zero in late 2022. What is the magnitude of this problem? Huntington's earnings for the quarter of 602 million dollars would have fallen by approximately 7% or $41 millions if all loans that were 30 days late had been unpaid. Total criticized loans equals $2.13 billion in 2022.

Stephen Steinour, Huntington's CEO, told analysts during a recent earnings call that "our credit quality is top-tier." "Huntington was built to thrive in times like these."

Regional banks are generally experiencing the same problem. PNC, second largest regional bank in the country, reported that criticized real-estate loans now account for 20% of all office loans. This is because the multi-tenant building it lent money to has about 25% of its tenants vacant, and 60% are due for repayment or refinancing by the end 2024. Only 0.2% of the office loans are delinquent. Robert Reilly, CFO of PNC, told analysts that "in the near-term this (multitenant offices) is our main concern area". PNC's loan loss reserves are 9.4% of the total multi-tenant loans.

Fifth Third Bancorp in Cincinnati has 8.2% of its office loans rated as 'unsatisfactory,' but this represents only 0.1% of their total loan portfolio. Cleveland-based Keycorp reported that its criticized loan total was about 2.8%, up from the 2.5% it had late last year. However, only 0.2% were not paid on time.

Keycorp CEO Christopher Gorman stated after the company's earnings that "credit quality remains strong". He added that Keycorp has been reducing risk for over a decade by eliminating construction loans given to developers of office buildings. He told analysts during the quarterly earnings call that "we have limited exposure in high-risk areas such as office, retail and lodging."

According to CNBC Pro, a recent study using data from Deutsche Bank, the CRE risk concentration is lowest at the largest banks where office loans are less than 5 percent of total loans and less than 2 percent on average.

Fanger says that investors should look at all metrics in conjunction to manage their risk. He said that many, if not most, of the criticized loans, will never be bad because they can be restructured, refinanced or office building collateral sold to pay off some loans. He said that the recently prominent metric has been around for many years and is a good place to start looking for a possible outcome.

Fanger stated that any rating has a qualitative component. We find it useful in predicting the direction of likely risk.