How a series of bad loans drives bank investors to look for hidden risks

The big banks, including JPMorgan Chase And Goldman Sachs had just taken victory laps after a blockbuster quarter when concerns emerged from an obscure corner of Wall Street, sending a collective shudder through global finance.

Regional bank Sions On Wednesday evening, it revealed the near-total write-off of $60 million in loans after discovering “apparent misrepresentations” by borrowers. The next day, look Western Alliance said it sued the same borrower, a commercial real estate company called Cantor Group, for alleged fraud.

The result was a sudden and deep sell-off among regional banks, comparable to the 2023 banking crisis that ravaged Silicon Valley Bank and First Republic. This time around, investors are focusing on a specific type of loans made by banks to non-depository financial institutions, or NDFIs, as the source of possible contagion.

“When you see one cockroach, there are probably others,” JPMorgan CEO Jamie Dimon said this week. “Everyone should be warned about this.”

Concerns about credit quality had been brewing for weeks following the September collapse of two U.S. auto-related companies. JPMorgan, the largest U.S. bank by assets, this week announced a $170 million loss linked to one of them, subprime auto lender Tricolor.

But it was only with a third case of alleged fraud surrounding loans to non-financial financial institutions that investors began to fear the worst, according to Truist banking analyst Brian Foran.

“You’ve now had three situations where there were allegations of fraud” involving NDFIs, Foran said.

Dimon’s comments “really resonated with people who were saying, ‘Oh, man, the tide went out a little bit, and now we see who was missing swimsuits,'” Foran said.

The episode highlighted a rapidly growing category of loans made by both regional banks and global investment banks. Rules put in place after the 2008 financial crisis discouraged regulated banks from making many types of loans, from mortgages to subprime autos, leading to the emergence of thousands of non-bank lenders.

Moving riskier activities outside the regulated banking perimeter, where bankruptcies are guaranteed by the Federal Deposit Insurance Corporation, seemed like a good decision.

But it turns out that banks are a major source of funding for nonbank lenders: Commercial lending to NDFIs reached $1.14 trillion in March, according to the Federal Reserve Bank of St. Louis.

Bank loans to nonbank financial companies are the fastest-growing category, up 26% annually since 2012, according to the St. Louis Fed.

“The increase in NDFI lending is really because all of these different regulations add up to say there are a certain number of loans that banks can’t make anymore, but if they’re lending to someone else who is making them, it’s no big deal,” Foran said.

“We really don’t know much about these NDFI books,” Foran said. “People say, ‘I didn’t know it was so easy for a bank to think it had $50 million in collateral and find out it had none.'”

Part of what’s spooking investors is that while some of the loan losses disclosed by regional banks have been relatively small, they’ve been all but erased, said Catherine Mealor, an analyst at KBW.

“NDFI loans, because of the collateral involved, generally have a higher loss rate, and losses can occur very quickly and out of nowhere,” Mealor said. “It’s really hard to understand these risks.”

Mealor said investors have flooded her with questions about the level of exposure to NDFIs in her coverage universe, the analyst said.

Regional banks are nevertheless benefiting from an improving interest rate environment and increasing merger activity, which are supporting valuations, Mealor said, adding that she believed this week’s selloff in stocks was an “overreaction.”

“You want to avoid companies that appear at the top of the screen for NDFI loans,” she said. “There are many high-quality companies on the KRX that are trading at a massive discount.”