US Treasury Yields Rise, Exacerbating Commercial Real Estate Distress Risk for Regional Banks

Introduction

Since late 2022, US Treasury yields have been on an upward trajectory, placing renewed strain on the balance sheets of regional banks due to rising commercial real estate (CRE) distress risk.

Impact on Bank Stocks and Borrower Default Risk

The elevated borrowing costs have already impacted bank stocks, with smaller banks experiencing an 8.2% decline since November 2022. The surge in yields also increases the risk of default by borrowers who invested in office buildings before the pandemic, as the plummeting values of these assets are compounded by higher credit costs.

Fragility of the Banking System

"Rising long-term yields leave the banking system more fragile in the short run," said Steven Kelly, Associate Director of Research at the Yale Program on Financial Stability. "However, they may improve profitability in a base case economic scenario."

Unrealized Losses on Securities

The 10-year yield surge in 2024 likely reversed most of the decline in unrealized losses on banks' available-for-sale and held-to-maturity securities in the third quarter, according to Federal Deposit Insurance Corporation Chairman Martin Gruenberg.

Underwater CRE Loans and Regional Bank Vulnerability

Approximately 14% of the $3 trillion of US CRE loans are estimated to be underwater, rising to 44% for office properties. Smaller lenders are particularly vulnerable to CRE defaults due to their lower down payment requirements.

Concerns among Bank CEOs

"The office market has yet to stabilize, which is why we remain concerned," said PNC Financial Services Group CEO Bill Demchak. The bank has increased its reserves for soured office loans to 13.3%.

Impact on Deposit Flows and Duration Risk

The declining cost of deposits, due to lower Federal Funds rates, provides some stability. However, duration risk is also reducing as securities mature.

Investor Confidence

"Investors are less concerned about unrealized losses because it doesn't look like there will be forced sales like with Silicon Valley Bank," said Scott Hildenbrand, Head of Depository Fixed Income at Piper Sandler.

Potential Trump Administration Impact

Deregulation under the Trump administration may boost bank margins, but "we are entering into a very precarious position" with borrowing benchmarks trending up, said Tomasz Piskorski of Columbia Business School.

Week in Review

- Major US banks issued bonds after posting results.
- Electronic trading drives reduced costs for corporate bond trading.
- JPMorgan supports the first leveraged buyout loan of 2025.
- Chinese developer China Vanke recovers from credit market lows.
- Repeat corporate bankruptcies in the US rise to their fastest pace since 2020.
- Blackstone and other lenders provide $5 billion financing to Databricks Inc.
- Major Chinese firms face court cases over debt issues.

On the Move

- Paul Goldschmid establishes long/short credit firm Harvey Capital Partners.
- Goldman Sachs combines teams to form capital solutions group.