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In just two days New York Community Bancorp (NYSE:NYCB) stock swooned 45% after it shocked Wall Street with a massive provision for credit losses in Q4 2023 ($552M vs. $45M Bloomberg consensus) in response to weakness in the office sector, potential repricing risk in its multifamily portfolio, and its growth through acquisitions that triggered stricter capital requirements.
What happened?
NYCB’s allowance for credit losses to total loans rose to 1.17% at Dec. 31, 2023 compared with 0.74% at Sept. 30, 2023.
Another measure of credit quality, net charge-offs, increased to 0.22% of loans on an annualized basis from 0.03% in the previous quarter. That increase primarily stemmed from two loans. One was a co-op loan with a unique feature that pre-funded capital expenditures. The borrower wasn’t in default, but the loan was transferred to held for sale during Q4. The second loan was an office loan that moved to non-accrual during Q3 based on an updated valuation. “Given the impact of recent credit deterioration within the office portfolio, we determined it prudent to increase the ACL coverage ratio,” NYCB said in its earnings release on Wednesday.
Besides NYCB, midcap bank stocks that declined the most since Wednesday are Valley National Bank (NASDAQ:VLY), which fell 14% on Wednesday and Thursday, and Bank OZK (NASDAQ:OZK), which dropped 13% during that same period. Both have high exposures to commercial real estate (“CRE”) in their loan books.
Read-throughs
What does New York Community Bancorp’s (NYCB) Q4 results mean for midcap banks? Morgan Stanley analyst Manan Gosalia laid out the issues in a recent note to clients.
Firstly, he expects that the consensus estimates for provision expense are too low for nearly every bank Morgan Stanley covers as CRE is expected to deteriorate from here and remain lumpy for several quarters. CRE net charge-offs won’t return to more normal levels until 2026, he figures.
Gosalia anticipates that reserve levels will move up at other banks, but not by much. “We have been noting the risk that banks with a higher exposure to CRE tend to have a lower CRE reserve ratio, and may have to move their reserve levels up over time,” the analyst wrote.
Reserve Risk
“We still see this as a risk, particularly after NYCB’s reserve build this quarter. However we don’t see a reserve build nearly as large or nearly as quick as what NYCB did, because the other banks that have lower reserve levels are smaller banks, nowhere near the $100B asset threshold for Category IV.”
Banks that are near or above $100B in assets will have to spend more to meet new risk management/infrastructure investments. Specifically, Morgan Stanley’s estimates for 2024 expenses are above consensus for M&T Bank (NYSE:MTB) Fifth Third Bancorp (NASDAQ:FITB), and Citizens Financial Group (NYSE:CFG).
Buybacks are expected to stay on hold or stay at lower levels as they conserve capital as credit deteriorates and the macro outlook remains uncertain. He doesn’t expect other banks in his coverage at risk of cutting dividends (like NYCB did), though.
He also points out that banks intending to make acquisitions are likely to bolster their capital due to updated principles that the Office of the Comptroller of the Currency will use when reviewing bank merger applications. Those emphasize the importance of the acquirer’s capital position, risk management, overall performance and degree of supervisory concern.
Defensive positioning
All things considered, Gosalia keeps an In-Line recommendation on the midcap bank sector and advises to position defensively across the group. He prefers banks with strong deposit franchises, capital, and excess liquidity, notably M&T Bank (MTB), East West Bancorp (NASDAQ:EWBC), Webster Financial (NYSE:WBS), and Huntington Bancorp (NASDAQ:HBAN). And even though MTB, EWBC, and WBS have higher CRE exposure, the banks also keep higher capital ratios to cushion against potential credit losses. They also have attractive valuations at 8-9x Morgan Stanley’s 2024 EPS, compared with 10x for their peers.
For investors preferring less CRE risk in banks, he advises a look at large cap banks. Last week, Morgan Stanley analyst Betsy Graseck upgraded the sector to Attractive on the expectation that final Basel III endgame rules won’t be as harsh as proposed. She upgraded Citigroup (C), Bank of America (BAC), and Goldman Sachs (GS) to Overweight.