FORECASTS & TRENDS E-LETTER
By Henry Rohlfs
July 23, 2024

FDIC Report: Banking Risks Rise

IN THIS ISSUE:

1.  FDIC as Banking Watchdog

2.  What’s All the Fuss?

3.  The Problem Bank List

4.  The Bottom Line

This week we review the FDIC Quarterly Banking Profile for First Quarter 2024. The report gives readers a peek at the health of U.S. banks and financial institutions. Besides an analysis of industry earnings, deposits and asset yields, the report displays troublesome trends in FDIC-insured banks, especially in the areas of credit card debt and commercial property loans.

These trends could put serious pressure on regional and community bank balance sheets, causing increased attention by the FDIC. But will banking regulators see a potential problem in time before that institution fails? Those who study the banking industry have their doubts.

FDIC as Banking Watchdog

Most anyone who holds a checking or savings account at a bank or credit union has heard of the Federal Deposit Insurance Corporation, or FDIC. This independent agency insures deposits and monitors the soundness of the financial institutions it insures. It also manages receiverships in case an FDIC-insured entity becomes insolvent. Congress created the agency in 1933 after a slew of bank failures during the Great Depression wiped out many Americans’ savings. Generally speaking, the FDIC now insures deposits up to $250,000 per account.

Each quarter the agency releases its FDIC Quarterly Banking Profile which details the banking industry’s financial health. Net income, interest rate margins, balance sheet totals and loan qualities are discussed. Particular attention has been paid of late to regional and community banks, probably because of last year’s failure and near-failure of several regional banks.

In its most recent report, the FDIC states, “the banking industry still faces significant downside risks from the continued effects of inflation, volatility in market interest rates, and geopolitical uncertainty. These issues could cause credit quality, earnings, and liquidity challenges for the industry.”

The report further notes “deterioration in certain loan portfolios, particularly office properties and credit card loans, continues to warrant monitoring [emphasis mine].”

What’s All the Fuss?

Let’s take a look at credit card balances first. It has been widely reported that total credit card debt has ballooned to nearly $1.2 trillion in the United States. This is a significant increase from the pre-pandemic level of $927 billion, according to the Federal Reserve. This growing amount of personal debt is troubling by itself.

Banks anticipate a certain small percentage of “charge-offs” will occur due to delinquent credit accounts they do not expect to recover. Alarmingly, the credit card charge-off rate has nearly doubled from 2.63% at the end of 2020 to 4.7% this year. Although the charge-off rate for all loans is just slightly higher than levels seen over the last 10 years, the FDIC is concerned that credit cards drove the annual increase in net charge-off balances across all loans.

The other area of concern is non-owner occupied commercial real estate loans, dubbed CRE loans.

The agency reports a substantial increase in CRE “noncurrent loan balances” – loans delinquent by more than 90 days. Weak demand for office space causes a decrease in property values, and higher interest rates affect the ability to refinance those CRE loans. This translates to the noncurrent rate for CRE loans is at its highest level since Q4 2020, especially for the largest banks who hold them.

But here’s the kicker – FDIC reports unrealized losses in loans and mortgage-backed securities held by banks increased to a whopping $517 billion this year.

Read that again. $517 billion in losses they know exist but not officially on the balance sheet. The report states that unrealized losses have been unusually high since the Federal Reserve began to raise interest rates in Q1 of 2022. Although the largest banks have the largest percentage of problem CRE loans, the losses will impact regional and local banks the most.

The Problem Bank List

The FDIC also supervises banks they determine to have potential problems. The federal Office of the Comptroller of the Currency (OCC), a division of the Treasury Department, examines bank data each quarter and scores them from “1” to “5” on a scale they call CAMELS.

CAMELS is an international rating system developed in the U.S. and used by regulatory banking authorities to rate financial institutions. The CAMELS system rates six factors: capital adequacy, asset quality, management, earnings, liquidity, and sensitivity. A rating of “1” is considered the best, and a rating of “5” is considered the worst.

The number of banks on the Problem Bank List, those with a CAMELS composite rating of “4” or “5,” increased from 52 in fourth quarter 2023 to 63 in first quarter 2024. The number of problem banks represented 1.4% of total banks. Total assets held by problem banks increased $15.8 billion to $82.1 billion during the quarter.

If a bank lands on the Problem Bank List, it is subject to ever increasing scrutiny from the OCC and Federal Reserve. A bank that remains at a “5” rating is taken into conservancy and given some form of emergency assistance or merged with another institution.

I looked at length to see if I could find a list of banks on the Problem Bank List, but I never found one. Apparently, bank ratings are not released to the public but only to top management to prevent a possible bank run when an institution receives a rating downgrade.

But I did wonder if Silicon Valley Bank, the bank that failed in March 2023, ever released its CAMELS score. It didn’t take long to find the Bank Policy Institute’s examination of why the bank failed. In the report, it states the bank’s CAMELS rating was “1” (Strong) until November 2022 when it was downgraded to only a “2” (Satisfactory).

And what about Washington Mutual Bank’s $309 billion flameout? It also had a CAMELS rating of “2” before it became the largest U.S. bank to fail in 2008.

The Institute’s report reveals that CAMELS rating factors are self-reported, without direct examination by banking regulators. The only time regulators step in is when the rating drops to a “5”, and then the bank is formally examined yearly.

So even though the FDIC tells us that a 1.4% Problem Bank List is in a normal range, the question has to be asked if regulators are seeing the real picture, or perhaps turning a blind eye. I have to think we won’t know until more institutions actually fail.

The Bottom Line

Fed chair Jerome Powell stated in his July 9 testimony before Congress, “Given our forecast for the unemployment rate to climb to 4.5% in 4Q, we expect that by year-end the Fed will be prioritizing the employment leg of its mandate.” Of course, many who heard this rejoiced at the surety of an interest rate cut this year. Over 80% of economists in a recent Reuters poll believe the Fed will cut interest rates in September.

But think about what else a rising unemployment number infers. The Sahm recession indicator sits at 0.43 as of June 2024 (see my article on the Sahm indicator). A continued rise in unemployment will push it over the 0.50 mark, signaling the start of a recession.

Rising unemployment and a continued move to remote and hybrid working environments for white collar employees will put pressure on commercial property owners to either sell or refinance those properties.

If interest rates remain higher and if property prices hold or worse yet drop further, we will see more regional and local banks struggle with balance sheets overweighted in commercial paper. If that happens, the Federal Reserve will force problem banks to unload loans – at a substantial discount – to other larger banks and trusts. Institutions and investment funds with large amounts of cash will be ready to take advantage of a real estate fire sale.

Between the presidential election, an economy at transition and an inflated stock market, the rest of 2024 should be very interesting. We’re living in an amazing time.

All the best,

 

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