Standard & Poors (S&P) has recently downgraded five regional banks, further highlighting the ongoing challenges in the sector. In its latest outlook report, S&P announced downgrades for First Commonwealth Financial Corp., M&T Bank Corp., Synovus Financial Corp., Trustmark Corp., and Valley National Bancorp. All five banks have been downgraded from a “stable” to a “negative” rating.

S&P specifically points to the banks’ exposure to the troubled commercial real estate (CRE) market as a potential sign of weakness ahead. The stress in CRE markets, including reduced property prices and higher vacancies in investor-owned office properties, poses a significant challenge for banks with substantial loan exposures to CRE.

Although most rated banks have not reported a significant increase in delinquent and nonaccrual CRE loans, S&P warns that the rise in criticized and modified loans, as well as increasing loan maturities, may indicate a future deterioration in asset quality and performance.

Among the downgraded banks, M&T stands out as having one of the worst exposures to CRE. S&P suggests that the bank may experience further deterioration as it struggles to service over $33 billion in loans to the sector. M&T’s loan portfolio is heavily weighted towards office loans, which have been particularly vulnerable since the rise of remote work due to the Covid pandemic. S&P highlights that these loans are susceptible to unfavorable long-term secular trends.

M&T’s CRE loans are higher compared to most rated U.S. banks and even more so when compared to similarly rated regional bank peers. As of December 31, 2023, CRE loans accounted for 25% of total loans and approximately 174% of Tier 1 capital for M&T. Office loans, specifically, made up nearly 4% of total loans and about 25% of Tier 1 capital. S&P believes that these office exposures could further deteriorate but notes that potential losses on CRE loans, including office loans, should be partially mitigated by conservative loan-to-value ratios at origination.

Last month, Desmond Lachman, an insider from the International Monetary Fund (IMF), expressed concerns about CRE being a significant vulnerability for the industry. Lachman warned that around 385 small and medium-sized banks could fail due to a wave of defaults on commercial property loans. Over $900 billion in commercial property loans are set to mature this year, and with higher interest rates compared to when the loans were initially contracted, it is uncertain how these loans will be rolled over without major rescheduling. This poses a particular problem for regional banks, which are a crucial source of finance for small and medium-sized companies, as commercial property loans make up approximately 18% of their overall loan portfolios.

In conclusion, the downgrades by S&P highlight the challenges faced by regional banks due to their exposure to the troubled CRE market. The potential deterioration in asset quality and performance, particularly in the case of M&T, raises concerns about the sector’s stability. The warnings from experts like Lachman further emphasize the potential risks and consequences of a wave of defaults on commercial property loans.