How did a series of bad loans prompt bank investors to look for hidden risks?

Major banks including JPMorgan Chase and Goldman Sachs He had just wrapped up a winning quarter after a busy quarter when concerns emerged from an obscure corner of Wall Street, sending a collective shudder through global finance.

Regional Bank Zion On Wednesday evening, it revealed a nearly complete survey of $60 million worth of loans after finding “clear misrepresentations” from borrowers. The next day, peer Western alliance It said it had filed a lawsuit against 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, drawing comparisons to the 2023 banking crisis that consumed Silicon Valley Bank and First Republic. This time, investors are focusing on a particular type of lending that banks provide to non-depository financial institutions, or NDFIs, as a potential source of contagion.

“When you see one cockroach, there are likely to be more,” JP Morgan CEO Jamie Dimon said this week. “Everyone should be warned about this.”

Concerns about credit quality had been mounting for weeks after the collapse of two US auto-related companies last September. JPMorgan, the largest U.S. bank by assets, this week reported a $170 million loss linked to one such bank, subprime auto lender Tricolor.

But it wasn’t until a third case of alleged fraud surrounding loans to NFIs that investors feared the worst, according to Truist banking analyst Brian Foran.

“I have now come across three cases where there has been alleged fraud” involving NDFIs, Foran said.

Foran said Damon’s comments “really resonated with people who said, ‘Man, the tide has turned a little bit, and now we’re seeing who was missing a swimsuit.'”

The incident highlighted a rapidly growing category of loans offered by regional banks and global investment banks alike. Rules put in place after the 2008 financial crisis discouraged regulated banks from making many types of loans, from mortgages to subprime cars, creating thousands of non-bank lenders.

Moving riskier activities outside the perimeter of regulated banks, where failure is supported by the Federal Deposit Insurance Corporation, appears to have been a good move.

But it turns out that banks are a major source of funding for non-bank lenders: Business loans to non-bank lenders reached $1.14 trillion as of March, according to the Federal Reserve Bank of St. Louis.

Bank loans to nonbank financial companies were the fastest-growing category, rising 26% annually since 2012, according to the Federal Reserve Bank of St. Louis.

“The spike in lending through the National Development Fund was really because all of these different regulations came together to say that there is a pool of loans that banks can’t make anymore, but if they lend to someone else who does, that’s OK,” Foran said.

“We 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 zero.’

Part of what’s spooking investors is that although some of the loan losses disclosed by regional banks were relatively small, they were close to the total losses, KBW Bank analyst Katherine Mellor said.

“National Development Fund lending, because of the collateral involved, usually has a higher loss rate, and losses can come very quickly and out of nowhere,” Mellor said. “It’s really hard to wrap your mind around those risks.”

Mellor said investors have inundated her with questions about the level of NDFI exposures in her hedge universe, the analyst said. Companies including Western Alliance and Axos Financial are among those with the highest percentage of NDFI loans, according to an August research note from Janney Montgomery.

Regional banks are benefiting from an improving interest rate environment and increased merger activity, which is supporting valuations, Mellor said, adding that she believed this week’s stock sell-off was an “overreaction.”

“You want to avoid the companies that appear at the top of the screen for National Development Fund loans,” she said. “There are a lot of high-quality companies on KRX that are trading at a significant discount.”