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Many bank boards are stuck as they face investor scrutiny and wait for slippage in credit quality, but experts at the inaugural Raymond James Fixed Income Whole Loan Conference noted that private equity firms are waiting to infuse capital into institutions so they can play offense in the future.

In the latest "Street Talk" podcast, John Toohig, head of whole loan trading at Raymond James and host of the firm's recent conference, discussed the outlook that speakers shared for the economy and the credit quality of mortgages, credit cards and commercial real estate. Toohig also shared how depositories and their boards are reacting to the higher-for-longer rate environment, the current gap between buyers and sellers in the secondary loan market, and investor appetite to support bank M&A and loss trades in institutions' bond and loan portfolios.

At the event, Bill Sammon, head of the financial services sales and trading group at Raymond James, noted that many bank boards might appear that they are not doing much to outside observers, but he said they are working frantically. He said bank boards are evaluating their options as higher interest rates have spurred significant increases in funding costs, pushed bond portfolios deeply underwater and now are testing the mettle of borrowers

Toohig said he has heard Sammon liken the scenario to a duck on a pond. From the top down, the duck appears steady, but underwater it is paddling quickly as it tries to keep things going.

"We're feeling that, too, in our calls in fixed income as we're analyzing portfolios. There's not a lot of people wanting to do anything because they don't like the execution or they don't like the math, but there's a lot of people wanting to figure out how do, how could I go on offense," Toohig said.

However, the Raymond James team encouraged banks to position their balance sheet to go on the offense in the future by taking action today either through balance sheet positioning or M&A activity. Sammon, for instance, said the opportunity cost of not acting is "huge" and noted that capital is being raised to facilitate action. He said there are four to five private equity funds that have raised pockets of $400 million to $500 million aimed at facilitating bond or loan portfolios repositioning or supporting mergers, much like private equity did when backing Banc of California Inc. in its merger with PacWest Bancorp.

Traditional bank M&A activity has slowed considerably in the face of economic uncertainty and punitive interest rate marks required in any transactions — marks that effectively leave many banks with an equity hole in their balance sheet. Credit quality has held up thus far, but there is widespread expectation that credit costs will have to rise from historically low levels.

There are some bright spots on the credit front for banks. Toohig said the mortgage market is probably as "clean as it's ever been from an underwriting standpoint" and benefits from borrowers having sizable amounts of equity in their homes. The downside in the mortgage market for banks is that future origination activity likely will remain depressed given the sharp rise in mortgage rates.

Toohig expressed greater concern over loans tied to autos, cards and commercial real estate (CRE), which have faced considerable scrutiny in the investment community due to sharp increases in interest rates and post-pandemic changes in behavior as more people work remotely.

The true value of many CRE loans, particularly those in the office space, remains uncertain, given the lack of price discovery in the market as transaction activity has declined by close to 70%. A number of banks have assumed that they will experience pain and have built reserves to 7% to 8% of their office portfolios.

Toohig said he has seen some strategic sellers in the bank space who feel that taking the first loss is the best loss. That could prove wise. Toohig said there are a number of loans maturing soon that are unlikely to make payments at the current capitalization rate or debt yield. The question, he said, is how long interest rates stay higher for longer and whether rates remain at current levels when many CRE loans mature. He also noted that regulators recently reiterated guidance about banks' approach to working out distressed credits and providing short-term relief to borrowers, including deferral of payments.

While banks likely will take that approach with a number of credits, investors are waiting on the sidelines as they look to capitalize on dislocation in the market. Victor Calanog at Manulife Investment Management said at the event that he had money ready to spend but also noted that he would be opportunistic with purchases.

Toohig said the gap between the bid and ask on most subcategories in CRE remains "pretty wide."

"We're frozen, I think, is the right feel for it. We're not making any progress to close that gap," Toohig said. "I think it's all being discussed at the board level. Everybody would love to sell if they could get something close to par or maybe in the high 90s kind of dollar price, where the bid is maybe more in the 70s and 80s, depending upon the asset and the location. And that gap has got to close, I think, before you see anything will really shake lose in the commercial real estate market."