Thursday, September 7, 2023

So there we were, reading the Wall Street Journal this week, and came across an article warning of a “doom loop” for small and mid-sized banks: that in an era of rising interest rates, existing commercial loans and securities based upon those loans might decline in value, which will clog banks’ balance sheets like cholesterol in your arteries.

Turns out, Calcbench does have data about those securities in our vast troves of financial disclosures. So let’s take a look at where to find such information and what examples of it already exist.

First let’s review the big picture. Historically, small and mid-sized banks have done a brisk business extending loans to commercial real estate developers. The banks then roll those loans into commercial mortgage-backed securities (CMBS), which they sell to investors. As real estate developers make their loan payments, those payments become the income stream that investors in CMBS enjoy.

Our new era of rising interest rates, however, gums up that whole process. Developers can’t refinance their existing loans at the same low rates they had before. Sometimes they just default on the loans; other times they rework the loan terms. Regardless, as loan failures rise, the CMBS based on those loans decline in value — which leads to unrealized losses piling up on the balance sheets of the banks holding those CMBS.

So how and where does that get reported in practice? Let’s look at an example.

PacWest Bancorp

Our example is PacWest Bancorp ($PACW) only because that’s one bank mentioned by the Wall Street Journal. We looked up its most recent 10-K report, filed on Feb. 27. The 10-K included a footnote disclosure labeled “Investment Securities.” That’s where PacWest listed a wide range of investment securities the bank was holding, including private-label CMBS.

As is typical for banks, PacWest grouped its investment securities in two broad categories: available-for-sale (AFS) and held-to-maturity (HTM). For example, Figure 1, below, shows the various AFS securities that PacWest was carrying as of Dec. 31, 2022. CMBS are high-lighted in blue.

So PacWest had an amortized cost of $28.9 million on those available-for-sale CMBS, and then incurred $2.07 million in unrealized losses, for a fair value at the end of the period of $26.8 million. That is a sharp decrease in PacWest’s available-for-sale CMBS holdings from the prior year, when the fair value amount stood at $450.2 million.

We also have held-to-market CMBS. PacWest reports those values further down, as seen in Figure 2, below, again with private-label CMBS shaded in blue.

So held-to-maturity securities have $26.03 million in unrealized losses, leading to a fair value of $319.8 million for the CMBS portfolio. 

But wait! Figure 2 doesn’t include any comparable disclosures for the year-earlier period. That’s because until this year’s 10-K filing, PacWest didn’t report HTM securities. 

One obvious question would be whether the bank took a large portion of the $450.2 million in available-for-sale CMBS reported at the end of 2021 and reclassified them as HTM securities this year. You’d need to do more digging (or questioning of PacWest executives on an earnings call) to find out.

Even More CMBS Data

Let’s go back to the available-for-sale CMBS that PacWest listed. PacWest also discloses a few characteristics about those securities. For example, it includes two tables listing the maturity dates of the AFS securities. Various types of securities have various maturity dates, but the available-for-sale CMBS all have maturity dates more than 10 years in the future. 

So PacWest paid $28.9 million for those available-for-sale CMBS, and their fair value is currently $26.8 million, and their maturity date won’t hit until at least 2033. The question then arises: Who feels confident enough that those CMBS will be worth more in the coming decade, that they’ll buy them from PacWest?

Calcbench doesn’t know. But we do have the data to bring that question to the fore.

Meanwhile, we have those held-to-maturity CMBS, worth $319.8 million at the end of 2022. PacWest also discloses the credit quality of those securities, as seen in Figure 3, below.

As we can see, PacWest reported AAA credit ratings for all its held-to-market CMBS. And just like the available-for-sale securities, PacWest also reports the maturity dates for all its HTM securities, too. See Figure 4, below.

We can ask the same questions we raised earlier about the AFS securities. What is the likelihood that the value of these instruments will improve in coming years, that those unrealized losses will go away? Or will conditions in the commercial lending and mortgage markets continue to flounder, and the unrealized losses keep piling up? Because if it’s the latter, those losses will eventually need to be realized by somebody. 

We will leave you with one final chart. As fascinating as the above analysis is — and you can conduct similar research on your own, with whatever mid-sized banks you follow — we’re aware that the data is, well, dated. So using our world-famous Show Tag History feature, we pulled the quarterly numbers for unrealized losses on PacWest’s held-to-market CMBS since last summer. 

That’s a swift increase in unrealized losses. The more the CMBS market goes down, the more such losses pile up.

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