Loan Fraud and 'Cockroach' Concerns Slam Regional Bank Stocks as Credit Cracks Emerge

The shares of two prominent US regional banks plummeted recently following disclosures that both institutions were victims of fraud involving loans made to investment funds focusing on distressed commercial mortgages. This news has intensified investor anxiety regarding potential cracks emerging within the credit markets.

Zions Bancorp's Exposure and Lawsuit

Zions Bancorp's (ZION) stock sank 13% after the company disclosed it would take a $50 million charge-off in the third quarter related to a loan. This specific loan was underwritten by its wholly-owned subsidiary, California Bank & Trust, located in San Diego. Zions subsequently filed a lawsuit, stating that California Bank & Trust is owed money by two investment funds associated with Andrew Stupin and Gerald Marcil, among other parties.

The subsidiary had previously provided two revolving credit facilities to the borrowers in 2016 and 2017, totaling more than $60 million. These facilities were intended to finance the purchase of distressed commercial mortgage loans. The loan terms guaranteed the bank a "first-priority, perfected security interest" in all collateral, including every mortgage loan the investment funds purchased. However, an investigation revealed that numerous notes and their underlying properties were transferred to different entities. According to the lawsuit, these properties had either been foreclosed on or were approaching foreclosure. Analysts suggested the bank faces the challenge of proving this is a "one-off event and not indicative of broader supervision or credit control weakness".

Western Alliance's $98.6 Million Allegation

Western Alliance Bancorp (WAL) also tumbled significantly, dropping nearly 11%. The bank disclosed it had lent money to the same investor group for the purpose of originating or acquiring mortgage loans. Western Alliance initiated a lawsuit against the same group (Cantor Group V, LLC) in August, which prompted Zions' investigation. The outstanding balance of Western Alliance’s loan stands at $98.6 million.

Western Alliance found that although the collateral was supposed to be backed by a first-priority lien, this was not the case. The lender alleged that the borrower had created fake title policies by intentionally omitting senior liens. Furthermore, the borrower allegedly drained funds from accounts designated as additional collateral. As of August 18, the borrower's account at Western Alliance held just over $1,000, significantly below the required monthly average of $2 million. Despite the issue, Western Alliance sought to reassure investors, noting that its total criticized assets were lower than they were on June 30. The bank stated it does not expect the issue to alter its 2025 outlook.

Wider Credit Market Stress

These fraud disclosures occurred amid existing investor anxiety surrounding hidden credit stress in the market. Zions and Western Alliance were the largest decliners in the KBW Bank Index, which registered its steepest drop in half a year. The disclosures follow other recent high-profile loan blowups, including the bankruptcies of subprime auto lender Tricolor Holdings and auto-parts supplier First Brands Group. These events have raised scrutiny over lenders’ risk controls and the often-opaque nature of the private credit market.

Shares of Jefferies (JEF), which has exposure to First Brands, fell by more than 10% on Thursday. The investment bank's stock has lost around 23% in October, which would make it the worst month since the start of the pandemic in March 2020. Jefferies stated that the hedge funds it manages are owed $715 million by companies associated with First Brands. UBS reported that it has approximately $500 million in exposure.

While large banks like JPMorgan Chase & Co. (JPM) and Fifth Third Bancorp (FITB) have disclosed hundreds of millions of dollars in combined losses tied to Tricolor, analysts note that such hits are far more concerning for regional lenders. Mike Mayo, an analyst at Wells Fargo & Co., stated that if JPMorgan faces a loan problem with Tricolor, "it’s puny," but if smaller banks encounter similar issues, "it takes more of a hit". JPMorgan CEO Jamie Dimon commented on the anxiety in the credit market after the bankruptcies, warning: “When you see one cockroach, there are probably more, and so everyone should be forewarned”. The risk, according to some analysts, is that if further losses are revealed, the regional banking index could be "re-rated aggressively downward".