Bank Reserve Coverage Is Thinning: What It Means for Note Buyers

How Thin Is the Reserve Cushion?

According to Reuters, U.S. banks are quietly extending billions of dollars in bad real estate loans because foreclosing on those loans would crush their balance sheets. The call-report data shows the cushion behind those loans thinning: at June 30, 2026, U.S. banks held $1.71 in loss reserves for every $1 of noncurrent loans, down from a record $2.24 in mid-2023. The trend is moving in the wrong direction.

To understand why this matters -- for banks, for borrowers, and for note investors -- you need to understand what bank reserves are and why they exist.

Banks are required to set aside a loss reserve -- the allowance for credit losses -- for the losses they expect on their loan portfolios. That reserve is an accounting cushion, not a pile of cash: the bank builds it by booking provision expense, which comes out of earnings, and the losses it expects are charged against it when loans go bad. The ratio between those reserves and the total dollar amount of past-due loans on the bank's books is called the coverage ratio.

A coverage ratio of $1.71 means that for every dollar of noncurrent debt (90+ days past due or no longer accruing interest), the bank has $1.71 set aside to cover the potential loss. That sounds reasonable until you consider two things:

1. That ratio has been falling. On the standard measure, coverage peaked at a record $2.24 per $1 of noncurrent loans in mid-2023 (224.7% on the FDIC's measure) and has fallen since. A thinner cushion means each new problem loan weighs more on a bank's earnings.

2. The ratio drops dramatically when you include modifications. When you factor in loans that have been modified -- borrowers who fell behind, received adjusted terms, and are now technically current but still carry elevated risk -- coverage across all U.S. banks falls to just $1.22 per dollar, down from $1.83 in mid-2023. That is a razor-thin margin.

Why Are Reserve Ratios Declining?

The decline in coverage ratios is not random. It is the result of several converging forces that have been building for years.

The Extend-and-Pretend Strategy

Banks have been employing what the industry calls "extend and pretend" -- extending the terms of troubled loans rather than recognizing the losses. A bank can modify a delinquent loan, grant a forbearance agreement, or simply allow extra time before initiating foreclosure proceedings. Each of these actions keeps the loan off the official delinquency rolls, which makes the bank's balance sheet look healthier than it actually is.

This strategy works in the short term. It delays the need to allocate additional reserves, preserves capital ratios for regulators, and avoids the visible hit of a foreclosure filing. But it does not fix the underlying problem. The borrower who could not afford the loan six months ago often still cannot afford it today. The gap between the debt owed and the property value continues to grow. The loan is not healing -- it is just being hidden.

Pandemic-Era Accounting Relief

The COVID-19 pandemic gave banks additional cover for extend-and-pretend tactics. The CARES Act and subsequent regulatory guidance provided accounting relief that allowed banks to suspend reporting certain non-performing loans as delinquent. During this period, institutions did not have to classify modified or forborne loans as troubled debt restructurings (TDRs), which would have required higher reserve allocations.

That accounting relief has largely expired. Banks are now required to report the true status of their loan portfolios. And what we are seeing behind the curtain is that balance sheets look rougher than the numbers suggested during the relief period.

The Gap Between Debt and Property Values

In many markets, property values have not kept pace with the amount of debt outstanding. Borrowers who took out loans at or near peak values now owe more than their properties are worth -- a condition known as being upside down. For banks, this means that even if they foreclose, the recovery from selling the property may not cover the outstanding debt. Foreclosure becomes a money-losing proposition, which is another reason banks prefer to extend and pretend rather than liquidate.

What Happens When Problem Loans Squeeze Lending?

This is the part that most people outside the banking industry do not fully appreciate. Loss reserves do not just protect against loan losses -- they directly constrain a bank's ability to do business.

Here is the mechanism: a bank builds its loss reserve through provisions, and every dollar of provision comes out of earnings and therefore out of capital. Capital caps how much a bank can lend. Banks make money by lending -- originating new mortgages, extending commercial credit, funding business loans -- and collecting interest on those loans. So every new problem loan that needs reserving shrinks the bank's capacity to do new business.

Now consider the scale. At the 2023 peak, banks held about $2.24 in reserve for every $1 of noncurrent debt. Today the cushion is thinner, and the constraint is just as real -- because the dollar amount of past-due debt has grown.

For the roughly 890 U.S. banks that now hold less than $1 in reserve for every dollar of noncurrent debt (among banks with at least $1 million of it), the math is even more dire. These institutions have less in reserve than they have in delinquent loans. Every additional default further erodes their capacity to lend.

This is not a sustainable position. Something has to give.

How Do Banks Fix Their Balance Sheets?

Banks facing deteriorating coverage ratios have a limited number of options:

1. Raise additional capital. Issue new equity or retain more earnings to build reserves. This is expensive, dilutive to existing shareholders, and signals weakness to the market.

2. Foreclose on delinquent loans. Convert the debt into REO (real estate owned) and sell the properties. This recognizes the loss immediately but removes the drag on the balance sheet. The problem, as noted above, is that foreclosure often results in losses that exceed current reserve allocations -- especially in markets where property values have declined.

3. Sell the non-performing loans. Package the delinquent debt and sell it into the secondary market at a discount. This is the fastest path to cleaning up the balance sheet. The bank takes a known loss -- the discount between the unpaid principal balance and the sale price -- but in exchange, it removes the non-performing asset entirely. The reserves that were allocated against that loan are freed up. The bank can lend again.

Option three is the one that creates opportunity for note investors. And it is the option that banks increasingly have no choice but to pursue.

Why Banks Are Not in the Loss Mitigation Business

A question that comes up constantly from people new to this space: Why don't banks just work out these loans themselves?

The answer is straightforward. Banks are in the business of lending money and collecting payments. They originate loans, earn interest, and manage performing portfolios. They are not staffed, structured, or incentivized to handle large-scale loss mitigation on defaulted loans.

When default rates are low, a bank's collections department can handle the occasional delinquency. But when defaults surge -- as they did after the 2008 financial crisis and as they are doing again now -- the volume overwhelms the bank's operational capacity. Every non-performing loan requires individual attention: borrower outreach, financial analysis, legal coordination, property evaluation, and workout negotiation. Banks cannot do this at scale for thousands of defaulted loans while also running their core lending operations.

This operational mismatch is the structural reason the secondary mortgage note market exists. Banks sell non-performing loans to investors and entrepreneurs who can dedicate the time, expertise, and attention required to resolve them. It is a division of labor that benefits everyone:

• The bank cleans up its balance sheet and frees capital to lend
• The investor acquires assets at steep discounts with multiple resolution paths
• The borrower gets a new counterparty who is incentivized to find a workable solution rather than simply foreclose

What Is Changing in 2025 and Beyond?

Several developments are accelerating the pressure on banks to sell non-performing debt.

Expiration of Forbearance Relief

HUD's COVID-era forbearance relief -- which allowed banks and servicers to grant extended forbearance periods without the typical regulatory consequences -- is set to expire. When it does, loans that have been in extended forbearance will need to be resolved. Banks can no longer kick the can. They will need to either modify these loans into sustainable payment plans, initiate foreclosure, or sell the debt.

For note investors, this means a wave of new inventory entering the secondary market. Loans that have been sitting in regulatory limbo for years will finally need to find a resolution, and many of those resolutions will come through secondary market sales.

Regulatory Reporting Requirements

With accounting relief expiring, banks must report the true status of their loan portfolios. The gap between reported performance and actual performance is narrowing, which means coverage ratios may decline further as hidden delinquencies surface. Every delinquent loan that moves from "forborne" to "non-performing" on the bank's books increases the denominator in the coverage ratio calculation, driving the number lower.

The Lenders Below $1

The count of lenders holding less than $1 in reserve for every dollar of problem loans -- about 890 banks and 539 credit unions at mid-2026, among those with at least $1 million of them, with the bank count doubled from 437 in mid-2023 -- is arguably the most important number in this entire analysis. (Banks count noncurrent loans; credit unions count loans 60+ days delinquent.) An allowance smaller than the problem-loan balance doesn't prove a lender is under-reserved, since collateral and guarantees cut actual losses. But it leaves less room for error, and those lenders' options narrow faster.

For many of these lenders, selling non-performing loans becomes the fastest way to clean up the balance sheet. And when sellers are under pressure, buyers get better pricing.

What Does This Mean for Note Investors?

The declining coverage ratio across U.S. banks is one of the clearest macroeconomic signals that the secondary mortgage note market is positioned for growth. Here is why:

More Inventory

As banks are forced to clean up their balance sheets, more non-performing loans will flow into the secondary market. This is basic supply and demand. When inventory increases, buyers have more options, more negotiating leverage, and better selection.

Better Pricing

Motivated sellers -- and banks with sub-$1 coverage ratios are very motivated -- sell at steeper discounts. When a bank needs to move a pool of loans to free up capital, the priority is speed and certainty of execution, not maximizing the sale price on each individual loan. Investors who have capital ready, relationships established, and systems in place to close quickly will capture the best pricing.

Longer Runway

The extend-and-pretend strategy has created a backlog of unresolved loans that will take years to work through. This is not a one-time liquidation event. It is a sustained pipeline of distressed debt that will enter the market in waves as forbearance expires, regulatory pressure increases, and banks reach the limits of their balance sheet capacity.

More Workout Opportunities

Every non-performing loan that enters the secondary market represents a borrower who needs help. Banks failed to resolve the situation -- not because they did not care, but because their operational model is not built for it. Note investors who specialize in loan modifications, repayment plans, discounted payoffs, and other workout strategies can step in where the institution was stuck.

How Should Investors Position Themselves?

Understanding the macro picture is important, but it only matters if you translate it into action. Here is what the reserve ratio data suggests for note investors at every level:

If You Are New

• Learn the fundamentals now. The window of opportunity created by declining bank reserves will not last forever. Investors who understand how to evaluate a tape, conduct due diligence, and execute workout strategies will be positioned to act when inventory surges.
• Build relationships with brokers and sellers before you need them. The best deals go to buyers who are already in the seller's network when a pool hits the market.
• Capitalize your entity. Have your LLC set up, your servicer relationship in place, and your capital ready to deploy. Speed matters when motivated sellers are liquidating.

If You Are Active

• Increase your acquisition activity. If your resolution pipeline is healthy and you have capital cycling back, this is the time to deploy it aggressively into new acquisitions. The inventory coming to market over the next 12-24 months will be some of the best-priced deal flow we have seen in years.
• Strengthen your loss mitigation systems. More volume means you need better processes. Automate borrower outreach, streamline your workout documentation, and ensure your servicer relationship can handle increased boarding volume.
• Watch the forbearance expiration dates. The regulatory timeline will dictate when specific tranches of loans hit the market. Investors who anticipate these waves can prepare bids in advance.

If You Are Institutional

• Build direct bank relationships. Lenders with sub-$1 coverage ratios are identifiable through FDIC call report data. Many of these are community banks and credit unions that have never sold loans on the secondary market before. They need education on the process, and the investor who provides that education earns the first look at the portfolio.
• Prepare for larger pool sizes. As banks face increasing pressure, the size of individual loan sales will grow. Institutions that can bid on and close larger pools will have a significant competitive advantage.

The Structural Case for Note Investing

The shrinking coverage ratio is not just a data point. It is a structural indicator of why the secondary mortgage note market exists and why it will continue to grow.

Banks are built to lend. When problem loans eat into their capital and tie up their staff, they cannot perform their core function. Selling non-performing loans is the most efficient mechanism for freeing that capital. On the other side of every sale is an investor -- an entrepreneur -- who is built to do what the bank cannot: work with borrowers individually, find sustainable resolutions, and turn distressed debt into performing assets.

The declining coverage ratio tells us that the pressure on banks is increasing. The backlog of unresolved loans is growing. The extend-and-pretend strategy is running out of runway. And the secondary mortgage note market is where these problems ultimately get solved.

For investors who are prepared -- with capital, systems, and expertise -- this is not just a market opportunity. It is a chance to build a business that solves real problems at scale, where institutions are stuck and borrowers need someone willing to do the work.