The slow motion shipwreck that everyone sees coming

The slow motion shipwreck that everyone sees coming scaled | ltc-a

As the federal government struggles to contain the financial market turmoil, the next risk hanging over the nation’s banks is in plain sight: the $20 trillion commercial real estate market.

About $1.5 trillion in mortgages are set to fall due in the next two years, a potential time bomb as higher interest rates and spiraling office vacancy push property values ​​down.

And since 70 percent of commercial mortgages held by banks are on the balance sheets of regional and smaller lenders, a write-down in commercial loans could spell major problems for the financial system and hurt the broader economy even as the presidential campaign approaches. of 2024 in progress.

With the country veering towards a possible recession, the financial system is particularly vulnerable to shocks, as demonstrated by the turbulence triggered by the collapse of three regional banks. Adding a commercial real estate market slide to the mix would be particularly dangerous. It’s a major concern for Washington policymakers, even if they recognize that there’s not much they can do to fend off a crisis.

« I’m worried? The short answer is yes,” said Sen. John Kennedy (R-La.), a senior member of the Senate Banking Committee, said in an interview. « The long answer is hell yeah. »

« I hope the Federal Reserve and banking regulators are also concerned, and I hope they are not caught off guard as they have been with the bank failures we’ve had thus far, » Kennedy said.

Fed policymakers last month raised interest rates for the tenth consecutive time, by a quarter of a point, putting more pressure on both the housing sector and banks.

Chairman Jerome Powell has largely downplayed a threat posed by the commercial real estate market, describing the banking system as « strong and resilient. » But FDIC Chairman Martin Gruenberg stressed in a May 31 news conference that this is a significant risk and said the agency is urging lenders to prioritize managing their exposure to the sector.

And the Fed itself has flagged commercial real estate as an area of ​​concern in its own May Financial Stability Reportwarning that « the magnitude of a correction in property values ​​could be substantial and therefore could lead to credit losses » by banks and investors holding commercial real estate debt.

Some lawmakers share this concern.

« Right now, we have a double whammy of much higher interest rates and the commercial real estate market is going through a post-Covid shock, » Sen. Mark Warner (D-Va.) told POLITICO. “So I don’t think we can assume that…we’ll be able to just slip through [without a crash].”

« I’m still trying to weigh some of the policy options, » said Warner, who declined to detail his views. « I have encouraged the White House, however, that we need to take action on these regional banks now. »

In April, White House economic adviser Jared Bernstein told a group of lawmakers that the issue « is very much on our watch list » when asked about the potential for a significant market downturn.

Sen. Elizabeth Warren says regulators have a key role to play in avoiding any crisis.

They must « insist that banks and other lenders adequately hedge against the risks of a significant downturn in commercial real estate, » the Massachusetts Democrat said.

The slow motion shipwreck that everyone sees coming | ltc-a

The « best-case scenario » for the market is that a write-off would be « isolated on a few banks that have a lot of exposure to corporate loans, » according to Columbia Business School real estate and finance professor Stijn Van Nieuwerburgh.

The pandemic-induced increase in remote working has hammered offices. The office vacancy rate reached 18.6% in the first quarter of 2023, well above the pre-pandemic level, according to an estimate by Cushman and Wakefield, which does not expect vacancy rates to stabilize until to 2024.

“It could be a train wreck waiting to happen,” warned Dan Tarullo, a former senior Fed official who overhauled banking regulations in the wake of the 2008 financial crisis. American city.”

But « it would be a mistake to conclude that the problems are isolated to the office market: higher interest rates impact all types of real estate, » said Van Nieuwerburgh.

« The way these loans are structured, you pay mostly interest, not principal, so you have to roll over most of the loan » when it comes due, he said. « The bank will say, no, the interest rate is now 6 percent instead of 3 percent 10 years ago, which means your building is now worth 40 percent less. »

Van Nieuwerburgh said he wouldn’t be surprised if 10% of commercial home loans couldn’t be refinanced, especially as banks become more wary of home loans.

Commercial real estate stocks are down this year: an index of publicly traded commercial real estate mutual funds had dropped by 18.1%. in one year starting from 2 June.

Meanwhile, about 5.4% of commercial mortgage-backed office properties were managed by special services – meaning they were in a delinquent phase – in April, up from 3.4% a year earlier, according to Trepp’s data.

And with so few commercial buildings being sold right now, it’s unclear how bad that could be, as there’s uncertainty about how much office property values ​​have dropped.

« We’re a bit of a stretch in the market right now because the sales transactions aren’t really taking place, which means there’s not a lot of clarity on where the property values ​​are, » said Jamie Woodwell, Head of Property commercial real estate research at the Mortgage Bankers Association. « Without that, it leads to a sort of reluctance of buyers and sellers to agree on a property’s value. »

Commercial mortgage originations in the first quarter of 2023 were down 56% from a year earlier, after declining 42% from the fourth quarter of 2022, according to MBA.

Moving forward, Sen. Jon Tester (D-Mont.) said he did not hope the office sector would recover given the ease of remote working.

« We are where we are, it will always be that way, » he said. « I think the logical solution: We need to develop policies that help convert businesses into housing, apartments, whatever that is. »