Waving a Red Flag – Nov. 25, 2024
At a topline level, the Federal Reserve’s November Supervision and Regulation Report conveys a pretty sanguine outlook, at least in the first few sentences of the executive summary.
“The banking system remains sound and resilient overall,” the executive summary reads. “Most banks continue to report strong capital levels above applicable regulatory requirements. Liquidity and funding conditions remain stable compared to 2023. Asset quality generally remains sound.”
Then a red flag is raised: “However, credit performance in commercial real estate (CRE) lending and some consumer lending sectors continues to show signs of weakness.”
The highlighting of CRE as an area of concern continues in the Banking Systems Conditions section of the report. Loan delinquencies in general remained below 1% in the first half of this year, according to the Fed.
But then comes another caveat: “However, delinquency rates for CRE loans and consumer loans are elevated.”
The report notes that the delinquency rate for CRE loans has increased to its highest level since 2014. “Looking closer at the CRE sector, loans secured by offices, especially those in major cities, remained the top concern. At the large banks, the delinquency rate for office loans increased to 11.0 percent in the second quarter of 2024.”
Indeed, a chart accompanying the text shows the office delinquency rate continuing on a steep upward trajectory since the second half of 2022. Conversely, the delinquency rate for hotels, which peaked during the pandemic at about 6%, has fallen pretty steadily since then. Retail has followed a similar trajectory, and industrial has tended to rank last for delinquencies, albeit with a slight upturn more recently.
The Fed report notes that deterioration in CRE loan performance has so far been mostly concentrated at large banks. “However, the delinquency rate for CRE loans held by smaller banks also increased during the first half of 2024,” the report states. “Smaller banks generally hold a higher share of their assets in CRE loans compared to large banks.”
Although its climb into delinquency hasn’t been nearly as steep as that of office, the multifamily sector “has come under some stress,” according to the Fed report. “Revenue growth has slowed, operating costs have risen, and valuations have declined for certain multifamily properties. As a result, the delinquency rate for multifamily loans held by large banks has increased steadily, from a low level.”
Less immediately impactful to CRE yet still a cause for concern, the delinquency rate for consumer loans remained elevated in the first half of 2024 despite a decline in the second quarter. Q2’s improvement was mostly due to a decline in credit card delinquencies.
“Still, the credit card loan delinquency rate was notably higher than a year earlier,” the report states. “The delinquency rate for auto loans also increased from a year earlier and was just below its five-year high as of the second quarter of 2024.”
Accordingly, the Fed reports, “Banks have continued to provision against potential credit losses amid elevated delinquencies in CRE and consumer lending.”
Spotlighting weakness in CRE loan performance isn’t a new thing with the Fed. The central bank has been doing so since at least Q1 of this year. Given the impact of both reductions in the federal funds rate and the uptick in economic growth touted by the next administration, it’ll be interesting to see whether the Fed is still waving that red flag six to 12 months from now.