Hello and welcome you are listening to Patrick Boyle on
Finance, a podcast exploring ideas from quantitative finance,
examining events occurring in markets right now and financial
history to see what lessons can be taken away, including
interviews with some of the most interesting people in the world
of finance. To learn more about the podcast,
visit on finance.org. Office mortgage default rates
are rising around the world, which could mean problems for
the banks, insurance companies and pension funds who lend money
to real estate investors. No one loves leverage more than
real estate investors, who aim to amplify returns as much as
possible with borrowed money. Commercial mortgages differ from
residential mortgages in that they're generally interest only
loans, meaning that the investors get to make small
monthly payments but are then faced with a balloon payment of
the initial loan amount on the date the mortgage comes due.
This lump sum needs to either be repaid or refinanced when the
mortgage expires. With an interest only mortgage,
the borrower gets to keep the property consistently leveraged
and the risk to the lender does not get reduced over time
because the principal is never paid down until the mortgage
expires. Commercial real estate
investors, and in particular office real estate investors,
are struggling with changes to how and where people work in the
wake of the pandemic because workers have been reluctant to
return to the office five days a week.
This means that employers don't need to rent as much office
space. It also means that shops and
restaurants in business districts are closing down due
to fewer customers. On top of that, higher interest
rates are making it more and more expensive to buy a building
with borrowed money or to refinance a mortgage.
According to the Mortgage Bankers Association, many
commercial mortgages that were set to mature last year were
extended or otherwise modified, and as a result, the amount of
commercial mortgage debt maturing this year rose from
$659 billion as of the end of 2022 to $929 billion as of the
end of 2023. Many of those loans are on
partially empty office buildings and were taken out in a low
interest rate environment which has now passed.
Commercial mortgage rates have almost doubled since many of
these loans were taken out, and the value of many of the
underlying properties have fallen considerably, raising the
prospect of billions of dollars of losses for real estate
investors and thus losses for those who lend money to them.
A recent paper on commercial real estate and U.S. banks found
that 44% of office loans are likely already in negative
equity and that the majority of office loans are likely to
encounter substantial cash flow problems and refinancing
challenges in the coming years. About 1/3 of the expiring office
loans are funded with commercial mortgage-backed securities,
which are often held by insurance companies, pension
funds, and individual investors. The remaining 2/3 are held by
banks, and these tend to be higher quality, lower risk loans
than the ones backed by commercial mortgage-backed
securities. According to the FDIC,
delinquencies on bank loans backed by offices were at 1 1/2%
at the end of the third quarter of 2023, which is quite low, but
it is rising well. Delinquencies on the equivalent
but riskier CMBS loans reached 6.3% in January, up from 1.9%
from a year earlier, according to the real estate data firm
TRAP. According to Moody's Analytics,
owners of 224 out of the 605 large buildings with mortgages
expiring this year will struggle to refinance, either because the
properties are over leveraged or because their rental performance
is poor. Let's discuss the distressed
sales of office buildings that have been happening over the
last few months, Why New York Community Bancorp is down more
than 65% year to date, what banking regulators are saying
about loan portfolios at large U.S. banks, and how banks are
hedging their loan books. OK, so while workers around the
world have been reluctant to return to the office since the
pandemic, return to office rates have been much lower in the
United States than in Asia and Europe.
And so the problem is more concentrated in big U.S. cities
than anywhere else. According to Commercial Edge,
office space use is only around half of what it was before the
pandemic. For this reason, values for
institutional quality offices are down 27% since this time
last year. There are some big distress
sales occurring on some iconic buildings.
Cigna Holding, an Austrian property company which fell into
insolvency, is selling its 50% share in the Chrysler Building
in New York after being ordered to do so by an Austrian cord.
According to the Insolvency Administrator, just €250 million
of the €5.26 billion debt owed by the property group has been
secured against tangible assets, raising questions about how much
lenders to the group can expect to recoup in the bankruptcy.
In Washington DCA 13 story building with ground floor
retail sold in December for $18.2 million, down 70% from the
price it last traded at in 2017. In London 5 Churchill Place, a
Canary Wharf office building, was recently sold at a 60%
discount to its last sale price, showing how much office real
estate has fallen in London. This was one of the largest
distressed sales in London since interest rates started rising.
It was owned by a Chinese real estate group and sold after
being put into receivership by its lenders.
Urban Land reports that most office buyers in this
environment are private equity groups, family offices and ultra
high net worth individuals who bring cash to the table or can
negotiate seller financing. Three US regulators, the Federal
Reserve, the FDIC and the Office of the Comptroller of the
Currency, announced late last year that they would scrutinize
banks whose commercial real estate loan portfolios are more
than triple their capital. Within that group, they would
focus on loan portfolios that had grown at least 50% in the
past three years, according to Bloomberg.
Under this standard, there are about two dozen banks in the
United States that have portfolios of commercial real
estate loans that would merit greater regulatory scrutiny.
A lot of the stress is showing up in regional banks.
The KBW Regional Banking Index is down about 12% year to date,
and shares of the most leveraged regional banks are down even
more, as investors worry both about the losses associated with
commercial property exposures and the risk that regulators
might force these banks to increase their reserves or cut
their dividends. Shares of New York Community
Bancorp are down 26% today alone on news that the regional lender
has replaced its CEO and disclosed that it has identified
material weaknesses in internal controls that guide how loans
are reviewed. The stock was already down more
than 50% year to date after reporting higher than expected
losses from real estate loans and a dividend cut which was
needed to meet tougher regulatory requirements.
The bank's chief risk officer had quit his job weeks before
the big losses were announced. NYCB had appeared to be one of
the big winners of the 2023 regional banking crisis that
sank Signature Bank, Silicon Valley Bank and First Republic
as they bought the operations of Signature Bank in a deal
arranged by the FDIC. The problems at NYCB have
reawakened investor fears about regional banks, but investors
are also beginning to worry about loan loss provisions at
some of the largest U.S. banks. Loan allowances are the capital
that banks set aside to cover future losses on delinquencies,
and when a bank increases its loan allowances, this reduces
earnings. So banks try to avoid doing this
if at all possible. Regulators said different loan
loss allowances for different types of loans.
Higher allowances are set for risky unsecured loans, while
loans with historically lower default rates, like commercial
real estate loans, require significantly lower allowances.
The problem with using historical loss rates is that
they're a backwards looking metric and the risk of losses on
office real estate loans has increased significantly in
recent years due to falling property values and higher
interest rates. Some are arguing that banks
should base their reserves on current levels of delinquencies.
But the problem with doing that is that bank reserves would
become pro cyclical, where they declined during booms, allowing
banks to lever up even more and then increase in a slowdown,
requiring banks to recapitalize at a time when investors are
backing away from the sector. One way or another, though, the
reserves should relate to the riskiness of the loans on the
books, and these loans are a lot riskier today than they appeared
to be five years ago. According to FDIC filings, the
average reserves at JP Morgan Chase, Bank of America, Wells
Fargo, Citigroup, Goldman Sachs and Morgan Stanley have fallen
from $1.60 to $0.90 for every dollar of commercial real estate
debt on which a borrower is at least 30 days late, meaning that
bad property debt today exceeds reserves at the largest U.S.
banks. This was driven by a spike in
delinquent commercial real estate loans, which more than
doubled last year. Stephen Gandel at the FT pointed
out in a recent article that while Bank of America's FDIC
filing showed that delinquencies on loans tied to office,
apartment and other non residential buildings have
jumped to 50% in the final quarter of last year, the bank
cut its loss reserves for those loans by $50,000,000 to just
under $1.3 billion. You have to be impressed with
whoever worked their way through that regulatory loophole. 50%
higher delinquencies leading to a lower reserve requirement?
Someone really earned their bonus on that one.
When people say that AI will replace white collar workers, I
just don't think that ChatGPT will ever reach that level of
creativity. Well done.
Now, to be clear, the expected losses on commercial real estate
at this point are much smaller than the losses that occurred
during the 2007 mortgage crisis. But there still could be
billions of dollars of losses for developers, investors, and
lenders, and we could see more forced sales of office
buildings. A recent NBER paper called The
Secular Decline of Bank Balance Sheet Lending, which analyse
trends in financial intermediation, estimates that
the market share of U.S. banks in all private lending has
almost halved since 1970 and that loans as a percentage of
bank assets have fallen from 70% to 55% over the same time
period. The paper shows that private
credit is increasingly intermediated through arms
length transactions, where a lender originates and then sells
the resulting loan through debt securities.
The paper highlights that the share of household wealth held
in deposit accounts at banks has also fallen from 22% in 1970 to
13% in 2023, as savers are increasingly putting their
savings in money market funds, Treasury securities and
retirement accounts, cutting out banks as middle men.
The professors argue that most of the decline in bank lending
and household savings being held at banks happened in the 1990s
and was not significantly impacted by the global financial
crisis, despite all of the additional regulation that came
in its wake. They go on to analyse how the
changes in the nature of credit intermediation have impacted the
financial sector's sensitivity to regulation and capital
requirements. Their analysis shows that the
impact of raising bank capital requirements would have had
twice the economic impact in 1963 than it would have today.
Now in their stress test, they find that raising bank capital
requirements to 25% would cause bank balance sheets to contract
dramatically. But the effect on overall
lending in the economy would be much more muted today because of
an offsetting increase in lending through shadow banks
that substitute for bank balance sheet lending.
Essentially, they show that as lending has moved away from
banks and into private and public markets, the availability
of loans is less sensitive to changes in bank regulation.
This possibly explains why the overall share of bank lending
didn't change much after the introduction of all of the new
regulations that came in the wake of the global financial
crisis. Banks are still making the same
amount of loans today, but they're less risky loans, and
risky lending is being done by less regulated lenders.
It might be reasonable, based on this research, to expect that
any increase in banking reserve requirements brought about by
delinquencies in commercial real estate loans would have less of
an impact on the overall economy today than it would have had in
the past. Significant risk transfer, also
known as SRT, which should not be confused with the cars that
tailgate you on the highway, is a balance sheet strategy that's
been approved under the European and UK banking framework and has
been used for some time on a small scale to hedge credit risk
at European banks. The Federal Reserve clarified
its rules on the use of this strategy last September, which
involves the sale of credit link notes that carry the risk of
losses on bank loan portfolios to investors.
Canadian banks have started using this strategy too.
In Europe and the UK, each SRT transaction is examined by
regulators to ensure that a real transfer of risks is occurring
and getting this regulatory approval transaction by
transaction can be slow. SRTS allow banks to reduce their
risk rated assets and free up capital held against these
assets, which are mostly loans on their balance sheet.
U.S. Banks like JP Morgan have
already started using these deals to cut their exposure to
risky loans. Shedding risk this way does cost
banks money, but it does reduce their risks and thus their
capital requirements. These products are usually
bought by specialist investors with expertise in credit risk,
who feel that they're being adequately compensated for the
risk that they're taking. U.S. banks can and likely will
use these structures to reduce their exposures to risky loans,
but doing so will lower their earnings.
Profits in the US banking sector fell almost 45% year on year in
the final quarter of 2023. This was the biggest year on
year drop in quarterly profits since the second quarter of
2020. Some of this was driven by the
government imposed special assessment, which replenished a
Deposit Insurance fund depleted by the regional bank failures
earlier in the year. Increased bad loan provisions,
losses on securities and higher costs due to redundancy payments
to laid off staff also cut into profitability.
While profits fell at the biggest banks, they did better
than their smaller peers. In the final quarter of 2023, JP
Morgan earned 22% of the entire industry's profits.
It'll be sometime until the problems in commercial real
estate are worked out. While there is an excess of
office real estate, there's also a shortage of residential
housing in the United States. This imbalance has LED
commentators to question whether empty office buildings can be
rezoned and repurposed as housing.
The economists at Goldman Sachs build a model showing that the
current prices for struggling office buildings are still too
high for conversion to residential use to make sense.
They estimate that office prices would need to fall an additional
50% for conversion to housing to be financially feasible, meaning
that offices will likely remain underutilized in the near term.
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