Pimco Warns of US Regional Bank Failures Amid $441B Property Debt

Key Takeaway

• Pimco warns of more US regional bank failures due to high exposure to troubled commercial real estate loans, exacerbated by high borrowing costs and uncertain Fed rate cuts.
• Regional banks face a $441 billion wall of maturing property debt in 2023, with smaller banks particularly vulnerable due to their lenient lending practices.
• Lending volumes for major public mortgage REITs have plunged 70% from 2021 levels, limiting new investments and increasing stress on the commercial real estate sector.

Regional Bank Failures Loom

Pacific Investment Management Co. (Pimco) has raised alarms about the potential for more regional bank failures in the U.S. due to a "very high" concentration of troubled commercial real estate (CRE) loans on their books. John Murray, Pimco’s head of global private commercial real estate team, stated, "The real wave of distress is just starting" for lenders to various commercial properties, including malls and offices. The uncertainty surrounding the Federal Reserve's interest rate cuts has exacerbated the challenges faced by the CRE sector, where high borrowing costs have significantly impacted valuations and triggered defaults.

Regional banks, which have increased their CRE exposure, are particularly vulnerable. For instance, US Bancorp, the largest regional bank by assets, increased its provisions for credit losses to $553 million in the first quarter. According to a report by MSCI Real Assets, regional banks were the only lenders that did not demand extra down payments from commercial-property borrowers in recent years, highlighting their susceptibility to falling property values. These institutions face an estimated $441 billion wall of maturing property debt this year.

Larger Banks and CRE Exposure

Larger banks have been disposing of higher-quality assets first to avoid deeper losses, according to Murray. However, as stressed loans grow due to maturities, banks are expected to start selling more challenged loans to reduce their troubled loan exposures. Murray noted that his team has been acquiring CRE loans offloaded by large U.S. banks for the past 18 months. Despite the turmoil, larger banks are not expected to face systemic failures due to their more conservative CRE lending practices post-2008 crisis. However, the failure of borrowers to repay loans has led to a reduction in lending compared to 2021 and 2022.

Mortgage real estate investment trusts (REITs) have also been sidelined due to their own issues, limiting their ability to underwrite new investments. For example, Starwood Real Estate Income Trust tightened its shareholders' ability to withdraw money last month to preserve liquidity, while Blackstone Inc.'s $59 billion property trust saw an increase in withdrawal requests. Lending volumes for major public mortgage REITs have plunged 70% from 2021 levels, according to Murray.

Rising Default Rates

Deutsche Bank analysts have indicated that the era of low corporate defaults is over, with rising interest rates expected to increase the number of borrowers failing to repay debts. "For 40 years, virtually all fixed-rate borrowers across the economy could refi at a lower rate than they’d previously achieved," Deutsche Bank analysts Jim Reid and Steve Caprio wrote. "This changed after 2022, but the full impact could still be slow to be felt." The analysts predict that default rates will rise to higher levels, even if a significant surge may be avoided.

One factor that could exacerbate the situation is the number of maturities in the next few years for lower-rated borrowers. More than 20% of sub-BB borrowers are facing a maturity in the next three years. While defaults have not yet risen to the heights many expected, the analysts believe that a structurally higher level of defaults will hold over the next few years.

Street Views

• John Murray, Pimco (Bearish on US regional banks and commercial real estate sector):

  "The real wave of distress is just starting for lenders to everything from malls to offices."
  "As stressed loans grow due to maturities, however, we expect that banks will start selling these more challenged loans to reduce their troubled loan exposures."