Regional Banks Weakening: Investors Should Brace for More Pain

The stock of Dallas regional bank First Foundation (FFWM) plummeted following a $228 million investor infusion, the latest reminder that commercial real estate challenges for some regional lenders are far from over.

First Foundation said the investment from private equity giant Fortress and other firms announced Tuesday would help it reduce its concentration of multifamily apartment loans. Roughly 52% of its portfolio is tied to such properties in places like Texas, Florida, and California.

Its stock closed down 24% on Wednesday.

“We’ve been honest about the fact that some of these multifamily loans are on the lower-yielding side, which has led to a decline in our earnings,” First Foundation CEO Scott Kavanaugh told analysts Tuesday.

The CEO assured analysts that “there has been no degradation in our credit whatsoever.”

The market’s reaction to the developments at a $13 billion bank is the latest example of underlying concerns that investors have about the ability of some regional banks to weather this challenging period.

More than a year after several sizable regional banks were seized by regulators, many mid-sized financial institutions are still wrestling with elevated interest rates, high costs of funding, and their exposure to weaknesses in the commercial real estate industry.

Investors have pushed down the stocks of other regional banks this year as problems or concerns surface.

It happened in May when an analyst’s report highlighted the debt held by Bank OZK (OZK) on a life sciences construction project in San Diego and a multi-use project in Atlanta. It also happened in June when a short seller targeted Axos Financial (AX) over its property loan portfolio.

And earlier this year the stock of New York Community Bancorp (NYCB) plummeted after the bank set aside more money for real estate loan losses related in part to rent-regulated apartment complexes in the New York City area.

NYCB was able to calm the market with an emergency equity infusion from a group that included former Treasury Secretary Steven Mnuchin.

Bank stock investors will be on the watch for more vulnerabilities in the coming weeks as many regional banks report their first quarter earnings and discuss challenges related to everything from profit margins to lending.

Steven Mnuchin, founder and managing partner of Liberty Strategic Capital and former Treasury secretary, led a rescue of NYCB this year. REUTERS/David Swanson (REUTERS / Reuters)

“We expect loan loss provisions will be higher than the street expects this year, particularly as banks build reserves for CRE,” Morgan Stanley regional bank analyst Manan Gosalia said in a Tuesday note.

There is “increased pressure on some banks’ balance sheets, especially smaller banks,” Apollo chief economist Torsten Sløk said last month. (Disclosure: Apollo Global Management is the parent company of Yahoo Finance.)

Mid-sized to smaller regional banks carry nearly four times as much exposure to commercial real estate as larger domestic commercial banks, according to Sløk.

Regulators have warned banks they must reduce their commercial real estate exposure. At the same time, overseers also are allowing lenders the flexibility to work out problematic loans with borrowers and, in some cases, extend maturities ahead of refinancing.

However, extending maturing fixed loans that were made before the Federal Reserve began sharply raising interest rates two years ago also means less profits for banks.

In the first quarter, First Foundation set aside $577,000 for credit losses while its net income was $38 million.

“We believe our reserves are adequate, bottom line,” the bank’s CEO, Kavanaugh, said Tuesday. “But in this cycle that the banking sector seems to be in right now, I think most people would say that our reserves appear low.”

First Foundation CEO Scott Kavanaugh at a 2012 awards gala in Beverly Hills, Calif. (Photo by Jesse Grant/Getty Images for Arthritis Foundation) (Jesse Grant via Getty Images)

The outside investors include $115 million from Fortress Investment Group, $46 million from Canyon Partners, and $22 million each from Strategic Value Bank Partners and North Reef Capital.

First Foundation will also add four new seats to its board of directors and give Fortress the right to add a fifth seat in the future.

After the transaction closes, which is expected early next week, First Foundation plans to use the capital infusion to potentially sell some of its multifamily loans.

“We are surprised by the highly dilutive capital raise,” Piper Sandler managing director Matthew Clark said in a note Tuesday evening.

The bank analyst said the transaction would dilute the value of First Foundation’s stock by 50%.

“Not the outcome shareholders were looking for,” Clark added.

This article originally appeared on Yahoo Finance.