The Banking Crisis Is Worse Than You Thought

The clock is ticking on the CRE time bomb at regional banks

Over a month ago, Federal Reserve data made it clear that we weren’t out of the banking crisis. Today, it’s even worse. Not only have the regional banks not cleaned up their balance sheets and eliminated interest rate risk, but they’re holding a ticking time bomb on top of it all. Commercial Real Estate (CRE) is poised to implode small banks, even if those institutions arrest the plague of deposit flight.

The situation is eerily similar to the last real estate crisis, which of course was residential. The mortgage meltdown happened when millions of Americans couldn’t make their mortgage payments on time and the financial derivatives dependent on those timely payments plummeted in value.

There was further fallout. As the bubble burst, home prices plunged. When people couldn’t do cash-out refi’s anymore, they lost what had become a key source of cashflow and consumer spending tanked. Subprime loans that allowed for 100%+ financing under the assumption that home values would go up forever turned into underwater nightmares.

These became known as “jingle loans” because the former homeowners simply abandoned their homes and dropped off at the bank an envelope that rattled from the housekeys inside.

Today, CRE is in an even more precarious position, and so are the banks holding those loans. Although CRE is a much smaller market than residential mortgages, the problem today in CRE is worse than what happened to residential mortgages in the early 2000s.

CRE had a dim outlook even before the pandemic. The market had gotten used to perpetually low interest rates and that fiction was baked into profitability forecasts. While many people get a mortgage and have a fixed interest rate for the next 3 decades, CRE relies more on refinancing and rolling over debt. The normal term is 5 to 20 years (with a distribution skewed to the low end), not 30 years like a residential mortgage.

That makes the industry more susceptible to interest rate volatility. Persistently and artificially low rates for a decade spurred overbuilding, particularly in urban areas. When Powell & Co. began tightening credit shortly before the pandemic, the squeeze was on for CRE. Profitability began to decline, and vacancy rates rose, albeit only slightly. Shopping malls in particular had a double whammy at that time because brick and mortar retailers were also steadily losing sales to online shopping.

Then came the Kung Flu.

When everyone started working from home, businesses began abandoning their CRE dwellings in droves. When contracts came up for renewal in 2020, many let their leases lapse since everyone was already out of the office. More companies followed suit in 2021. The flood waters rose further in 2022. Today, many employment positions that were once strictly in-office jobs are now permanently work-from-home roles. Businesses simply don’t need the office space they used to.

The owners of these office buildings are now stuck with empty suites and mountains of debt. And if you think the interest rates on mortgages are bad right now, remember that CRE loans carry an interest rate premium over their residential counterparts. Rolling over debt today is financial hari-kari. Without rental income and facing tight credit conditions, property owners have already begun to default.

For perspective, there are major American cities with CRE vacancy rates at or above 50% and entire buildings that have been turned over to banks as collected collateral on bad loans. The property owner lost his asset (the building and accompanying revenue stream) but he also lost his liability (the loan). However, the two were not typically very far off in price, at least in book value. In other words, it’s definitely a loss but it’s not an economic catastrophe—yet.

For the banks who made the loan, they’ve lost one asset (revenue stream of mortgage payments) and gained another (devalued real estate that served as collateral). The problem faced by these banks is that the asset they lost was valued much higher than the one they gained in mark-to-market terms. When the whole market is liquidating CRE, it’s the last asset you want to hold because it’s dropping in value.

It’s no exaggeration to say that some properties are now valued at one-third the price they commanded just 4 years ago. So, what banks are disproportionately stuck with these garbage properties? The same ones that got on the wrong side of the interest rate trade back in March: the regionals.

Unlike the failure to hedge against rising interest rates, this is nothing new. Small banks have always had a disproportionate share of the CRE market, in part because they know their local business conditions much better than a large bank’s local branch does. Today, CRE accounts for 30% of the balance sheets of regional banks – a very shaky base for the system. Conversely, the big banks devote less than 7% of their balance sheets to CRE.

If and when CRE goes south, big banks will take relatively small losses while the small banks will get devastated. This precarious position at the regionals is unlikely to change because of their current conundrum: they need to attract more deposits, but that requires paying higher interest rates to depositors. But paying higher interest rates requires steadily replacing low-interest rate loans with high-interest rate ones, and consumers are quickly losing their appetite for borrowing at today’s prohibitively expensive rates. The real estate market, and credit markets more broadly, are already freezing up and the problem is poised to worsen.

Regional banks are also torn between keeping cash on hand and loaning it out. In March, the poorly positioned regionals flocked to the Fed’s new Bank Term Funding Program and borrowed $100 billion using devalued assets “revalued” at par as collateral to pay panicked depositors. Conversely, the deposit flight found a landing strip at the big banks where both deposits and cash on hand climbed rapidly.

This means the troubled banks have only temporarily increased their cash positions while the healthier banks have permanently increased theirs. The ratio of cash to deposits is important because banks need cash to pay depositors. If banks don’t have enough, they need to liquidate assets to raise cash. That’s what got many regional banks into trouble in March and the underlying conditions haven’t changed today.

The problem is compounded by the fact that regional banks will be bumping up against their reserve constraint (approximated by blue line in chart below) once the emergency lending from the Fed expires. In fact, if those loans had to be repaid today, the troubled banks would immediately need to raise billions in capital to increase their cash position or sell off billions in other assets. Of course, the latter is what got them into trouble because their assets have lost value from failing to hedge against interest rate risk.

The regional banks are already beaten up and now they’re holding a ticking time bomb called CRE. But there’s still an outside chance that things work out for almost everyone involved: converting empty office space to housing.

With such high prices today for both houses and apartments, converting vacant CRE into condominiums, apartments, etc. could save the sector. Even with construction price indexes near all-time highs, a cheaply acquired property (like the former owner walking away from a loan) might still be convertible at a profit. That would help solve the housing shortage and possibly save the regional banks.

But what are the odds of drawing that outside straight?