Patience is a Virtue
By Adam S. Finkel
The U.S. bank crisis that unfolded quickly in the first few months of this year revealed several troubling themes and situations for both depositors and bankers. The concerns caused by these events impacted the national economy, capital markets and commercial real estate sectors in complex and confusing ways that will take time to understand.
Before a clear path forward emerges, commercial mortgage brokers and their clients must be patient as the pieces begin to reassemble in the capital markets and in the larger marketplace. They must also weigh the past and future actions of the Federal Reserve. All of these factors add up to a time of uncertainty for the economy as well as the structured finance sector.
“Initially, there was a move by many bank depositors to shift their money from smaller banks to larger ones, specifically those that are considered ‘too big to fail.’”
Currently, market participants are seeing expectations being reset and bond yields declining due to a changing outlook in the Fed’s rate-hike trajectory, as well as a flight to safety. Should banks pull back further on their lending activities and the economy suffers, the Fed may pause or reverse hikes in the near future.
A commonly held view early in 2023 was that the Fed would continue hiking rates until something broke. Clearly, something did break in the banking sector.
Crisis takes shape
The beginning of the crisis occurred this past March when Silvergate Bank became the first institution forced to liquidate, largely due to the collapse of its cryptocurrency banking operations. A few days later, Silicon Valley Bank (SVB) became the largest bank to fail since the 2008 financial crisis. Two days after that, Signature Bank collapsed.
More recently, JPMorgan Chase acquired most of the assets and assumed the deposits of First Republic Bank, which had been taken over by the Federal Deposit Insurance Corp. (FDIC). These failures sent shockwaves through the ranks of the country’s local and regional banks, which hold about two-thirds of all U.S. commercial mortgages. At many banks, real estate loans remain the largest component of the balance sheet.
According to Fitch Ratings, commercial mortgages account for 33% of the loans held on the books of banks with total assets of $1 billion to $10 billion. The exposure is even greater when looking beyond the 25 largest domestically chartered banks, as the Federal Reserve estimates that commercial real estate loans comprise 43% of the assets at these institutions.
With the recent news of declining values across commercial real estate, it is yet unclear how these smaller banks will be impacted. But compared to the financial crisis of 2007 to 2009, banks today are lending a smaller percentage of their capital, so there’s less concentration in real estate. Thus, there’s less exposure and potential opportunity for growth.
Fueling the fire
While various factors played into the failures of these banks, one factor that they all had in common was increased pressure from the Fed’s interest rate hikes that began in 2022. The higher rates weighed heavily on digital assets. When deposit bases are drained, banks get squeezed.
The lack of depositor diversification can push banks past the limits of solvency. Pressure is placed on banks since depositors have other options, such as money market accounts or government bonds, to hold their cash.
SVB is a telling example. With a focus on venture capital-funded firms and startups, the bank got in trouble when these companies spent down their cash balances, draining the bank of deposits. Because SVB was poorly diversified, it had to sell government bonds to raise cash, and it did so at a loss of $1.8 billion. Ultimately, trust in the bank was lost and its shares declined. Companies panicked and pulled cash out in what amounted to the fastest bank run since the Great Depression. This forced regulators and the FDIC to take control of the bank.
The Fed likely realized the implications of rate hikes on banks due to the securities they held but believed there was liquidity elsewhere in the system due to high levels of cash and the ability to borrow from the Federal Home Loan Banks. While this is true, the fundamental problem was the volume of securities, the size of the unrealized mark-to-market assets and the implications of holding them until maturity.
When large depositors acted at the same time, the runs created big problems for banks. The result was a modern-day electronic bank run that had not been seen before but has been revealed as something to keep a closer eye on in the future.
Now the spate of interest rate hikes may be nearing a pause. The Fed has expanded its balance sheet to provide additional support to banks. But the crisis makes a soft economic landing even more unlikely and many experts believe a recession is unavoidable.
Impact on lending
Initially, there was a move by many bank depositors to shift their money from smaller banks to larger ones, specifically those that are considered “too big to fail.” But there’s also a shift by the government to protect smaller banks. Depositors must believe the money they deposit in banks is safe. With the current banking crisis, the FDIC acted to shore up medium- and small-sized banks by quickly making an exception at SVB and Signature Bank to insure deposits above the usual $250,000 limit.
A common view is that economic conditions will deteriorate for the next few quarters and commercial real estate will most likely suffer too. The consumer housing market is in the midst of a major correction and average mortgage rates have increased from 3.22% at the start of 2022 to 6.57% as of May 25, 2023, Freddie Mac reported. The Fed is trying to backstop liquidity risk, but there is underlying credit stress that also can be found in the commercial real estate capital markets.
Banks are currently looking to boost liquidity by asking for greater depositor relationships. Because the largest banks saw a major inflow of deposits following the regional bank failures, many lenders are willing to give better rates to borrowers who provide meaningful deposits. There are also numerous lenders that are shifting their resources from originations to asset management. In some cases, banks are sharply reducing their lending levels.
The largest area of concern in the second half of this year is in extension of credit. The expectation is that commercial real estate borrowers will be hard-pressed to secure loans, unless they are willing to accept low leverage, higher rates and more stringent underwriting standards. Banks are unlikely to fully retreat from real estate, although they are expected to be even more careful about the loans they do make going forward.
Opportunity will knock
As the crisis progresses, developers and value-add investors are being forced to ask for extensions from lenders. Some sponsors are having to make capital calls to cover cost overruns because construction lenders won’t provide more capital or interest reserves have been expended. Lenders will not be able to provide extensions indefinitely because they need to be repaid to make new loans.
Large national and regional banks have a much lower concentration of real estate today. There is opportunity for them to expand, even if it is only a 5% increase from what they have been doing. Industry experts believe the transactions that can be executed today will be among the safest loans possible given the low levels of leverage. The balance of this year could be a prime opportunity for banks that remain active during turbulent times to build relationships with brokers and borrowers.
As the year progresses, expect to see more distressed deals. These are transactions in which the borrower cannot meet the project’s financial obligations. These deals typically involve partially built developments but they occasionally happen with projects that have entered the lease-up phase. If materials and labor costs turn out to be higher than anticipated, the developer may need to find other capital sources to meet their needs.
The process ahead to recover from the recent banking issues will likely require a relaxing of federal regulations, in particular those relating to troubled debt restructuring. This refers to the renegotiation of terms between a debtor and creditor in an effort to reduce or delay repayments while avoiding bankruptcy. Changes to troubled debt restructuring will require guidance from the Fed and the FDIC.
In the interim, borrowers could discover a bit of flexibility coming from banks, which may be more amenable to making deals. Other elements that could serve as solutions are additional collateral and more cash in properties to backstop loans. Banks will likely need to add people with experience in handling troubled loans (such as brokers, consultants, attorneys, or experts in commercial real estate and receivership) to work through the turmoil that may be on the horizon.
Many real estate and finance experts view the banking issues that emerged in the spring of 2023 as more akin to a crisis in confidence. Eventually, the situation should stabilize and reveal a market that is fundamentally in a better place. Commercial real estate may suffer in general, but some markets will fare better than others. Many high-growth markets are still undersupplied in housing. Supply and demand will continue to drive success.
How thin the capital markets are will be clear when funds are truly needed for some projects. Distress obviously impacts supply, and when the floodgates open, it could be a feeding frenzy as those with dry powder jump in. The stress being felt in the mortgage markets will be a negative drag in the short term. But in the medium to long term, there are expected to be opportunities that smart investors can capture.
The sound advice for mortgage brokers and their clients is to stick to the fundamentals, use moderate leverage and include conservative underwriting assumptions. If they adopt this approach, they’re less likely to be caught without a chair when the music stops.
