Problem loans identified by banks' internal ratings processes have started to climb as work-from-home trends and a jump in interest rates threaten office portfolios.

Criticized loans at the 100 largest public banks totaled $172.75 billion, or a median 16.6% of Tier 1 capital, during the first quarter, up from $162.18 billion, or 15.9%, at the end of 2022, according to data from S&P Global Market Intelligence. Criticized loans had been consistently dropping from a peak in 2020 as sectors like hotels and retail recovered from a drubbing during the pandemic.

Office remains in the crosshairs, however, as a shift toward remote work endures and high interest rates help to endanger the viability of a wave of loans that have to be refinanced over the coming years. Banks including Wells Fargo & Co. and Bank of America Corp. said office loans fueled sequential increases in criticized loans during the first quarter, and banks including PNC Financial Services Group Inc., M&T Bank Corp. and Citizens Financial Group Inc. said 20% or more of their office portfolios were criticized.

Views about the potential fallout for banks from commercial real estate (CRE) vary widely, from predictions that losses are likely to generate a surge of failures to expectations that the industry could mostly muddle through with "can-kicking" accommodations for troubled borrowers. Large banks generally observe that office loans account for small fractions of their total assets and argue that low loan-to-value ratios at origination provide considerable protection against property value declines.

Still, the data on criticized loans — considered a leading indicator since they include loans flagged for weaknesses in addition to those that have already missed payments — underscores that the office sector has emerged as the clearest immediate risk to banks' credit outlooks. "We will see some losses in that portfolio," Wells Fargo CFO Michael Santomassimo said during an investor conference earlier in June.

Individual banks

Detailed disclosures on CRE exposure have become a staple of bank financial reports after the failures in March and May shook confidence in the health of the industry. Some banks in particular have aroused investor questions.

At M&T Bank, about 18.3% of its $45.07 billion of CRE loans, including those related to construction, and about 22.0% of its $5.15 billion of CRE loans backed by investor-owned office buildings were criticized at March 31.

CFO Darren King said at an investor conference June 14 that charge-offs from the office portfolio are expected to come in lumps, including probably during the second quarter. King said some loans might become troubled debt restructurings or result in partial charge-offs, although the bank expects charge-offs to remain low overall during the year.

M&T has emphasized that loans are criticized at the property level but that borrowers can have other resources, such as other buildings, that secure their obligations and that office maturities are "spread out and manageable."

"It won't be Armageddon all in one quarter," King said. "It probably won't be Armageddon at all." M&T has also observed that its hotel portfolio, a focus of acute concern during the pandemic, made it through the COVID-19 era without marring the bank's strong credit performance overall. King previously said 86% of the hotel portfolio was criticized at the peak. At March 31, 41.3% of M&T's $2.88 billion of CRE loans backed by investor-owned hotels were criticized.

Total criticized loans actually fell by 1.4% sequentially at M&T in the first quarter, while a year-over-year increase of 21.3% was driven by the addition of loans from its recent acquisition of People's United Financial Inc.

Citizens Financial said about 24% of its $4.1 billion portfolio of "general" office loans was criticized at March 31 and that its allowance coverage ratio for the portfolio was 6.7%.

At an investor presentation June 12, Vice Chairman and CFO John Woods said the bank now expects its net charge-off rate for the second quarter to be about 40 basis points, up from its previous guidance of mid-30s basis points.

The new guidance reflects "certain valuation aspects of the book, which have come in a little lower than we expected," Woods said. The CFO said the bank is confident in its reserve levels, though the coverage ratio could go higher still for the general office loans.

In office, "our maturities are a little bit more front-loaded than some of our peers," with about 60% of the portfolio coming due by the end of 2024, Woods said. "But we've got an incredibly seasoned group of workout specialists that have been through these cycles," and the bank is keeping a close eye on the loans, Woods said.

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Industry threat

CRE problems generally mean problems for banks, since banks are estimated to hold 50% or more of US loans backed by CRE. The Federal Reserve put banks' share of the $3.57 trillion of nonfarm, nonresidential CRE loans nationally at 60% in its Financial Stability Report in May.

Analysts at BofA Global Research estimated that 17% of US CRE loans will mature in 2023 and that about 23% of that amount represents office loans. With the maturing office loans in 2023 representing only 3.8% of total CRE loans outstanding, however, the analysts described the challenge as manageable.

Still, the risks are uneven. The Fed's data showed that banks with less than $100 billion of assets represented 71% of banks' total CRE loans, or 43% of the market overall. Delinquencies remain low so far, but they are rising, as has the number of banks with heavy exposure to CRE under regulatory guidelines.

"Some smaller or regional banks ... especially those with concentrated or outsized exposure may encounter difficulties," the BofA analysts said. "We think this will likely result in additional banking sector consolidation and the potential that the [Federal Deposit Insurance Corp.] may need to conduct additional loan sales."