Might we see a decline in bank book values?
An interesting trend develops in bank investment portfolios and my local observations in CRE
Greetings and welcome to another issue of Conversion Confidential! I have noticed two topics bubble to the surface of the banking world in the past week or so. I believe each one is potentially quite relevant to thrifts and small banks so I wanted to explore these topics a bit further. The first is related to the investment portfolios at various banks. Many investors have highlighted some major mark downs to 1Q22 book values as noted in these two Twitter threads:
We all know bank balance sheets are vulnerable to deteriorating credit quality and loan losses, but to date, that largely hasn’t been the driving factor (yet?). So what’s happening here?
Accounting for Marketable Securities
Accounting standards require companies classify debt and equity security investments, otherwise known as marketable securities as either “held-to-maturity”, “available-for-sale”, or “trading securities”. Today, we’re largely concerned with those deemed as available-for sale. While commonly seen on bank financial statements, held-to-maturity securities are generally low risk, debt instruments with a set maturity and held on the balance sheet at amortized cost. Any fluctuations in the value of the underlying security are not recognized on the balance sheet, therefore the bank’s equity level isn’t really affected.
Meanwhile, material amounts of “trading securities” tend not to make it onto the balance sheets of small banks in the first place. These securities are bought with the intention of selling for a short-term profit, require adjustments to fair value each reporting period, and have a corresponding line item in the income statement which shows these movements. Depositors don’t want mini hedge funds operating within their small community bank, and rightfully so.
So that brings us to the part of investment portfolios known as available-for-sale (AFS) securities, which are defined by Investopedia as:
a debt or equity security purchased with the intent of selling before it reaches maturity or holding it for a long period should it not have a maturity date.
It is basically the catch-all category for any marketable securities not deemed as held-to-maturity or trading securities. While AFS securities can be sold, the company has the intent of keeping them at least for some significant period of time at the time of purchase. In practice, AFS securities tend to be financial assets such as corporate debt securities, agency backed securities, and/or mortgage backed securities (MBS).
AFS securities are held on the balance sheet at fair value. This means that realized and unrealized gains/losses are recognized in each reporting period, which is where they differ from held-to-maturity securities. But instead of fluctuations being reported on the income statement, changes get rolled into the other comprehensive income (OCI) category. OCI changes are captured in the equity section of the balance sheet known as accumulated other comprehensive income (AOCI).
The trouble that a lot of competitively disadvantaged banks may have is finding a place to put their excess deposits. Rather than being able to lend against these deposits and earn the typically higher spread, the bank may elect to buy safer, but lower yielding investment securities. Most readers are well aware that debt securities become less valuable as interest rates rise, particularly those securities with fixed rates and extended durations. This is why we’re currently seeing declines in bank book values as 1Q22 reports start to come out against a rising rate environment. AFS securities held as investments will reflect an unrealized loss at the time of reporting if rates have increased. Depending on the magnitude of a bank’s investment portfolio and how its securities were categorized according to accounting standards at the time of purchase is one way we get book values are moving lower as interest rates move higher. In several cases, these equity declines have been in excess of 10%.
Now, aside from the optical hit to a bank’s equity level via AOCI declines, it shouldn’t be the end of the world as long as the bank continues to hold the security until maturity. Any recent, mark-to-market losses should accrete back to equity given a long enough period. But what happens if a bank, for whatever reason, needs to sell those securities at the notable discount (thereby locking in a realized loss) or assets start to go bad? One troubling scenario would be if credit quality deteriorates and these lowered equity levels begin to look even more strained from a capital perspective if loans are being charged off against equity. This brings me to a second, somewhat related observation…
What’s happening in my neighborhood?
I like to take a daily walk around my neighborhood in San Diego. It’s a nice area to live with plenty of foot and street traffic given it’s immediate proximity to Balboa Park, downtown, and good restaurants/bars. Recently however, I can’t help but notice the number of “for lease” signs in the vicinity. It’s interesting to me because despite the pandemic being very hard on restaurants and small business, I wouldn’t consider San Diego a “Covid loser” like some major metros who have seen a large population exodus in recent years. The weather is warm and folks are very outdoor oriented.
By my count though, there are 10 vacancies within a half mile radius to my house, all on the main commercial avenue. I would consider these a mix of mostly street retail and a little bit of small office as far as commercial property asset classes are concerned. I don’t track a neighborhood index (perhaps I should start), but I feel pretty confident stating this is an elevated level for the area. It’s also in a strange contrast to a number of places that have “help wanted” signs posted. Yes I know, this is all very anecdotal and hyper-local. I am not in the know regarding commercial real estate (CRE) in my neighborhood. Perhaps asking rents are simply too high or there is another factor impacting demand that I’m unaware of. So why am I mentioning all this?
Well, I can’t help but be curious about tying my observations from the real world to the implications of the investing world, or in this case, bank balance sheets. After all, behind every stock is a real business. Behind every property is an owner, and behind most properties, is a mortgage. If landlords aren’t getting paid rent by tenants for their space, presumably they’re eating some, if not all of the debt servicing costs. If that goes to too far of an extreme, will they have any trouble paying back their lenders? There is of course quite a bit a distance between me seeing vacancies in my neighborhood and credit quality issues at banks, but yet I’m curious if any readers have noticed similar trends in their respective areas.
Sam Haskell, of Colarion Partners, had a really interesting writeup in the April edition (topic #5) of his 5 Points Substack where he noted the potential impacts in CRE to anyone who needed to refinance or borrow at the now, significantly higher interest rates. I’d recommend you take look at his post and understand that dynamic as it pertains to CRE.
CRE is often the second largest, if not the largest lending category of thrifts and small banks. Banks like commercial properties because they understand there is an underlying asset that generates cash income to service the debt. Real assets also serve as meaningful collateral in the event of a foreclosure.
When looking at small thrifts, what you’ll see listed as CRE is often multi-family properties with five or more units (the definitional line between residential and commercial), but it can also be other smaller commercial/retail properties. Have, or will interest rate increases impact CRE valuations or the ability of borrowers to service debts? Is it possible that any of these recent observations from my daily stroll are part of a larger trend and will ultimately trickle their way down to lenders as problems? For now, I don’t have any answers…I’m just asking the questions and thinking out loud about how what I’m seeing in my daily routine might tie into the world of investing. Thanks for reading!
https://www.sandiegouniontribune.com/business/story/2022-04-29/san-diego-migration-is-a-lack-of-housing-and-high-costs-pushing-people-to-move-elsewhere