DX Insights:  Bank Deposits, Interest Rates and the Secondary Market

Fall 2022

“The banking industry reported generally positive results in the second quarter as loan balances strengthened, net interest income grew, and credit quality remained favorable, although net income declined as a result of increased provision expenses.”  FDIC Acting Chairman Martin J. Gruenberg

FDIC’s September 8, 2022 summary of the banking industry seemed upbeat and optimistic about banking and credit quality.  But we expect a rise in troubled and non-performing debt to come on to the secondary market over the coming quarters despite this upbeat assessment. 

We think two factors in particular, shrinking deposits and rising interest rates, will stress the banking system, cause rising credit problems and increasing secondary loan market activity. These factors are in addition to other macro-economic conditions noted by FDIC that will stress both banks and their borrowers.

Total Deposits Declined Moderately for the First Time Since Second Quarter 2018

Bank deposits ballooned in 2020 and 2021, swelling banks (and borrowers) with virtually limitless liquidity.  In the second quarter this year, over $300 Billion of these deposits left the banking system.  Believing in reversion to the mean, many more deposits are sure to follow out bank doors.

Neither the run up in deposit balances over the past two years, nor the second quarter run on deposits (can we call it a run?) were “moderate”.  This unwinding of bank liquidity does not seem to be getting the attention it deserves.

FDIC: Rising Interest Rates One of Several Factors that Could Challenge Bank Credit Quality.

Fed funds rates have increased from 0.15% in early 2022 to a recent rate of 3.08%.  Similarly, the Prime Rate has increased from a low of 3.25% to a current 6.25%

While a 3% rise in rate may seem modest, the Prime Rate has nearly doubled this year.  That is a significant increase in borrowing costs for a wide range of commercial borrowers.

How Shrinking Bank Deposits and Rising Interest Rates Affect Credit Quality and the Secondary Market.

Marginal borrowers will no longer have easy access to refinancing.  Non-performing asset levels have remained historically low due to an abundance of liquidity even for less credit worthy borrowers. As bank deposit levels shrink, banks will no longer feel pressure to grow earning assets and may feel pressure to shrink assets.  That may narrow the banks’ credit box and begin to exclude a range of CRE and C&I borrowers.  We’re already hearing anecdotes of tightening underwriting standards from banks and non-bank lenders alike; higher rates, reduced leverage, excluded asset classes, less interest in buying participations, and general risk-off appetite overall.  Look for this to trickle down to marginal credits as the first group left without refinance opportunities.

We think secondary market non- and sub-performing loan prices may fall as investors adjust to a workout environment where easy discounted payoffs become less likely and workout hold periods begin to expand.

Rising interest rates will similarly put pressure on marginal borrowers, and CRE and C&I borrowers generally, as the cost of borrowing suddenly rises above near-zero.  Debt service coverage ratios will quickly come down, and cap rates should rise.  Loans that were underwritten in last year’s low-rate environment may struggle with the rising rate environment.

While fixed-rate borrowers may be somewhat shielded from the effects of rising interest rates, the holders of the loans may not.  Like any other fixed income instrument, loan values decline as interest rates rise.  We’ve already seen many banks, credit unions and other lenders attempt to sell loans originated before the rise in rates.  Those willing to accept a market price will transact at a discount while those that hold out will face NIM compression as funding costs rise. 

We expect shrinking deposits and rising interest rates will impact the banking system and cause a rise in secondary market volume of troubled and non-performing debt over the coming quarters.  These stresses are in addition to other macro-economic factors that will stress both banks and borrowers.

Canary in the coal mine?  Black swan in the coal mine?  Only time will tell, but should credit markets rapidly deteriorate, we will likely look back on these two factors, shrinking bank deposit bases and rising interest rates, as the obvious causes.

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