A word about recent regional bank events

Last week, two small regional banks, Zions and Western Alliance, disclosed credit exposures tied to fraudulent relationships, potentially resulting in write-offs on their commercial loan books. This unsettling news followed closely on the heels of bankruptcy filings by Tricolor and First Brands, sparking additional anxiety across the credit markets. While most market participants have been quick to label these three events as isolated and idiosyncratic, echoes of the bank failures from early 2023 have resurfaced. In a pointed remark, JP Morgan chair Jamie Dimon cautioned, “When you see one cockroach, there are probably more.”

Weak metaphors aside, at the heart of the broader concern lies the credit underwriting process itself. In an effort to maintain relationships, diversify risks, or simply to generate returns, banks have increasingly originated loans to entities known as Non-Depository Financial Institutions (NDFI). This “black box” segment of loans involving private credit/private equity, leasing companies and asset securitization instruments has grown steadily over the past decade, with significant acceleration over the past 18-24 months. This growth is creating concerns around underwriting standards and whether there are cracks forming in private credit. 

Importantly, though, most of what is in this category of loans is properly collateralized, and historically, there have been very low losses due to the collateral support. The issue in the headlines now is that in select circumstances the collateral didn't exist (or was pledged to multiple lenders). While it is concerning there have been multiple issues in a short window, we don’t currently have concerns with the fundamental performance of the regional banks. 

We expect credit spread performance could be choppy, similar to recent equity price swings, but have confidence in the underlying strength of regional banks as a whole. Capital is strong, broader asset quality trends still remain very healthy and we’re not seeing noticeable deterioration in consumer or commercial loan books. We also believe the loan segment getting attention now (nonbank financials) is granular and diversified. 

As a reminder, our approach to fixed income begins with a review of the underlying credits conducted by our teams that specialize in the sub-sectors of fixed income. Our positioning by sector and security has been defensive for more than a year, which has been a detractor from a relative performance stance, but is rooted in our deep sensitivity to value and a philosophy that focuses on strong risk-adjusted performance over a business cycle.

Read more on this topic: How to navigate the subprime ABS market
Read more about our current views and positioning at Fixed Income Perspectives