- Value Decline – Due in large part to higher interest rates, properties and loans are worth less today than a year ago, creating significant refinancing risk and a need for creative solutions to recapitalize the assets and resolve troubled loans.
- Smaller Bank Exposure – Smaller banks hold a disproportionally large share of commercial real estate loans, and the potential for a Minsky Moment is rising. If they have not already, banks should start to identify asset risk. As Banks conduct these reviews, bank lending will be curtailed – creating opportunities for other non-bank lenders.
- Embrace Technology – Transparency – No longer are depositors piling into banks demanding their money upon rumors of trouble – and no longer can banks lock the doors to keep depositors out. Social media rapidly spreads rumors, and banking apps allow depositors to quickly drain accounts. Bank management should be transparent and immediately address misinformation, no matter where it appears.
The recent Silicon Valley Bank (SVB) and Signature Bank collapses – and the cracks at First Republic Bank – have managed to re-focus depositors and regulators alike on bank risk. Inflation may erode the value of money, but if one’s life savings evaporate – that is catastrophic. A good portion of the revived scrutiny is focused on the soundness of bank commercial real estate loan portfolios amid the rapid rise in the cost of capital. It’s a wake-up call that many banks had no doubt hoped to ignore (higher capital costs), or hoped would resolve itself with a miraculous return to lower loan rates from a year ago.
This is not the Great Financial Crisis (GFC), when the game of musical chairs that financial institutions were playing with worthless mortgage securities came to a halt. This round of banking uncertainty is the product of the Federal Reserve’s efforts to bring down the highest inflation rate in 40 years by raising the benchmark federal funds rate 450 basis points over the last 12 months. But similar to 15 years ago, today’s crisis will restrict liquidity in the commercial real estate market as regulators demand more caution among banks and other lenders, further tightening underwriting standards.
The catalyst of the latest banking turmoil – SVB’s long dated bonds with low yields sold at a loss – did not pose a credit risk. But when the Federal Reserve began raising interest rates, they did pose market risk.
SVB was not alone in misjudging market risk. Smaller banks hold nearly 70 percent, or $1.8 trillion, of the total $2.6 trillion in outstanding commercial real estate debt. Much of that debt features interest rate yields that are roughly half of where yields are today. And the rising cost of capital has fueled a decline in property values. How much is hard to say, as a drop in property investment sales, owing to a standoff between buyers and sellers, has prevented price discovery. But Oxford Economics projects that U.S. property values will drop 15 percent over the next two years.
Other researchers suggest that the market value of held-to-maturity loan portfolios across the entire U.S. banking system is already $2 trillion below their estimated book value. That equates to a 10 percent haircut for all banks and a 20 percent decline for bottom-tier financial institutions. These same researchers report that potential bank runs currently threaten 186 additional banks.
Dig into Assets
While banks are supposed to hedge risk, some are more effective at the practice than others. Nevertheless, regulators are likely to keep a more watchful eye on small banks in particular and demand higher capital requirements to reduce the chance of further bank failures and potential contagion. As a result, bank boards may dramatically slow loan growth. The higher interest rates and lower property valuations have already created a difficult refinancing environment, and a further reduction in liquidity could lead to even less maneuverability for Borrowers, leading to workouts and restructuring.
From a free-market perspective, this could provide opportunities for strategic equity investors to recapitalize assets or more nimble private lenders to craft creative and structured financing solutions. Alternatively, it could lead to more kicking the can down the road: The Real Estate Roundtable, a national trade association, is lobbying federal agencies to give financial institutions more flexibility to refinance loans with debt restructuring programs similar to those rolled out during the GFC. The organization might be successful, as Treasury Secretary Janet Yellen abruptly convened a meeting of the Financial Stability Oversight Council a week after the roundtable issued its request.
Regardless of how market participants and/or regulators ultimately react, banks need to implement a plan to assess their vulnerability. That includes evaluating loans and securities for impairment, matching the duration of assets to liabilities, anticipating liquidity needs, and setting aside capital for risk-rated loans. It also includes recognizing that the first loss is often the best loss, a hard lesson learned by many during the GFC. Therefore, some situations may warrant banks accepting a discounted loan pay off while others may require a foreclosure or loan sale sooner rather than later.
The SVB collapse is being heralded as the “first Twitter-fueled bank run.’ Customers withdrew $42 billion in a single day, leaving the bank with a $1 billion negative cash balance. Over a 24-hour period, that withdrawal rate represents $29.2 million every minute, or almost $500,000 a second. Even with the advent of internet banking several years ago, the sheer speed of that type of run would not have been previously possible. Not all depositors would have had ready access to a computer, and some may not have banked on the internet at all.
Consequently, in addition to conducting a loan assessment, banks should prepare a plan to quickly address potential misinformation or news that is designed to foment panic among depositors. Remaining transparent and maintaining trust is a critical part of any plan. As Warren Buffett said in 2015, “When you have a panic, you have to have someone, somewhere, who can say and be believed, and be correctly believed, that he or she will do whatever it takes.”