A hawkish Federal Reserve is narrowing the window on trades that some U.S. regional banks have been hoping to use to reduce their commercial real estate exposure, investors, analysts and lawyers said.

Banks, particularly small regional and community banks, have looked to trim their outsized exposure to CRE on rising default risks after a post-pandemic social behavior change led to an increase in office vacancies and sharp drop in property valuations.

The rise in U.S. rates over the last few years has left their fixed rate ‘back-book’ loans mispriced compared to current market rates, said Sam Graziano, managing director at Chatham Financial. So inability to shed the exposure could expose them to losses and weaken their balance sheets.

Since the bank collapses last March, some regional lenders have sold billions of dollars of loans to private investors to reduce risk and shore up liquidity. Some have also bought insurance against risk of loss on loan pools from investors to free up precious capital.

Nine investors, analysts and lawyers involved in such trades said while banks are still looking to reduce their exposure to CRE through such deals, investors are less keen to buy such assets off them.

The waning interest follows a recent reversal in investor expectations that the Fed would aggressively cut rates this year.

Fed funds futures traders were mostly betting for a first rate cut to occur in June, later than previous March expectations. They were pricing for about 80 basis points of cuts this year, down from nearly double that earlier this year.

As a result, the risk of defaults in corners of the CRE market such as offices and multifamily homes has increased.

Property valuations, particularly those of office buildings, have dropped nearly 25-30% from their 2019 peaks, when many of the loans that are maturing this year were originated, according to Matt Reidy, director of CRE Economic Analysis at Moody’s Analytics.

Investors said they are either going to stay away from some CRE assets or demand to be paid a lot of money to take them on.

"We don’t intend to take on higher risk entailed in CRE portfolios whose loss probability cannot be modeled easily as consumer or corporate loans," said Jason Walker, chief investment officer of asset backed securities at alternative credit firm CQS.

CQS has invested $1.7 billion in risk transfer transactions, a trade that involves essentially selling insurance to the bank against losses from a portfolio of loans.

Another investor, who has been involved in selling insurance on banks' loan portfolios but requested anonymity to talk about deals, said regional banks may have to pay investors high double-digits in yield for insurance on CRE loans, compared with high single-digits on consumer and corporate loans.



The lack of investor interest can make it harder for banks to sort through the CRE sector's woes. The banking sector as a whole faces $441 billion of CRE loans maturing this year, according to Moody's Analytics, which expects the share of troubled loans to increase.

A preview of the dangers lurking in banks' books came earlier this year, when worries about New York Community Bancorp's exposure to the New York multi-family property market hit stocks across the sector, prompting checks by regulators and ratings agencies.

Losses could pile up on bank books as borrowers struggle to refinance old loans at new, higher interest rates, making some properties unprofitable.

Losses are also likely to add up in loans packaged into securities. Moody's Reidy said roughly 75%-80% of the maturing office loans included in securitized pools this year could have issues with timely payoff, leading to more charge-offs and delinquencies.

"We expect more workouts and extensions by banks to delay losses this year," Reidy said.



Banks are trying to get some trades done, nevertheless.

Matt Bisanz, partner of Mayer Brown’s financial services regulatory practice, said his firm was "working on multiple deals right now for regional banks" to sell the risk of losses on several asset classes, including performing CRE loan portfolios.

“We could see risk transfer trades on CRE loans in the second quarter," he said.

Whether they succeed remains to be seen. Any headway could help calm market nerves, but if it comes at heavy pricing discounts, it could also spook investors.

David Meneret, founder and CIO of credit hedge fund Mill Hill Capital who is short-selling some regional banks' bonds because of their CRE exposure said the problem was more structural.

"Losses need to be taken (by banks), they will be taken and it will take years," he said.

(Reporting by Shankar Ramakrishnan; additional reporting by Carolina Mandl, editing by Paritosh Bansal and Anna Driver)