Credit "cockroaches" appear! Is the US regional banking crisis resurfacing?

Amid the ongoing “blackout” of economic data and escalating trade war tensions, investors already have plenty to worry about this week.

Then, a regional bank added another concern: a massive credit loss possibly stemming from fraudulent activity. In a regulatory filing released Wednesday evening local time, Salt Lake City-based Zions Bancorp disclosed that it will record a $60 million loan loss provision in its third-quarter financial report, which the bank will release later this month.

The bank added that about $50 million of this may never be recovered. The bank stated it has filed lawsuits against two borrowers, though it did not name them in the filing. Zions also emphasized that this is an “isolated incident.”​

It’s perhaps understandable that investors are not convinced. On Thursday morning, the market received another warning, this time from Western Alliance Bancorp.

This Phoenix-based bank disclosed that it has filed a fraud lawsuit against a borrower for failing to provide sufficient collateral for a revolving credit line. Although the bank added that it believes existing collateral is sufficient to cover the debt and expects the dispute will not impact its operating results.

In terms of amount, these disclosures may not seem significant. But Stephen Innes, managing partner at SPI Asset Management, said that at this point, investors are more concerned that these so-called “isolated” credit events are starting to look like a pattern.

These two disclosures hit regional bank stocks hard, with the SPDR S&P Regional Banking ETF, which invests in many such companies, falling 6.2%, marking its worst single-day performance since April 10. Even large financial companies were not spared. The S&P 500 Financials sector fell 2.8% on Thursday, also its biggest drop since April. All major financial stocks closed lower on Thursday.

This led to a broader 0.6% decline in the S&P 500 index. According to Dow Jones Market Data, this wave of selling pushed the Cboe Volatility Index (VIX) above 25 at the close, its highest closing level since April 24.

Recently, after two high-profile bankruptcies resulted in losses for banks, bank loan losses have come under increasing scrutiny from investors. Auto parts supplier First Brands and subprime auto lender Tricolor both went bankrupt in September, and many questions remain about why banks failed to spot potential losses earlier.

On a Tuesday analyst call, JPMorgan CEO Jamie Dimon referenced the “cockroach theory” to describe the situation.

“When you see one cockroach, there are probably more,” Dimon said after JPMorgan released its third-quarter earnings. The company once again performed strongly in Q3, but as the largest U.S. bank by assets, it also disclosed a $170 million loss related to loans made to Tricolor. Ohio-based Fifth Third Bancorp also disclosed losses related to Tricolor.​

Michael Green, portfolio manager and chief strategist at Simplify Asset Management, said: “All of this points to growing concern and awareness that things may not be as robust as people thought, and now we’re seeing one credit event after another.”

For many investors, memories of the 2023 Silicon Valley Bank collapse are still relatively fresh. Steve Sosnick, chief strategist at Interactive Brokers, said this may have contributed to investors’ fearful reaction during Thursday’s market turbulence.

But Green explained that there are several key differences between the latest round of regional bank credit troubles and the Silicon Valley Bank incident.

Silicon Valley Bank’s collapse was due to a bank run, when uninsured depositors withdrew funds after the bank warned it had invested too much capital in long-term U.S. Treasuries. As the Federal Reserve aggressively raised rates in 2022, the value of those bonds plummeted. What’s happening now, however, stems from questions about banks’ lending standards and whether they are strict enough.

Mark Gibbens, chief investment officer at Gibbens Capital Management, said that while there is indeed reason for concern, investors have no reason to panic completely. Banks’ capital positions today are generally much better than before the 2008 financial crisis.

Gibbens said: “I think there may be more problems for banks or other participants in the private credit space, but I don’t think this is a systemic issue that could threaten the entire financial system.”

In addition, Jefferies held its annual investor day on Thursday. Innes said that although the event was not open to the media, the bank’s exposure to the First Brands bankruptcy came under renewed scrutiny.

In the broader credit sector, other signs of stress have also begun to emerge, with the spread between publicly traded bonds and their corresponding Treasuries recently hitting the narrowest levels in decades. According to Federal Reserve data, spreads on BB-rated bonds have recently begun to rise. Green noted that rising delinquency and default rates could also cause problems in the securitization market, where consumer debt is packaged into products sold to investors.

Shares of companies active in the private credit sector, including industry pioneer Blue Owl Capital, have struggled for months.