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Hello and welcome you are 
listening to Patrick Boyle on 

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Finance, a podcast exploring 
ideas from quantitative finance,

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examining events occurring in 
markets right now and financial 

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history to see what lessons can 
be taken away, including 

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interviews with some of the most
interesting people in the world 

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of finance. 
To learn more about the podcast,

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visit on finance.org. 
Office mortgage default rates 

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are rising around the world, 
which could mean problems for 

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the banks, insurance companies 
and pension funds who lend money

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to real estate investors. 
No one loves leverage more than 

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real estate investors, who aim 
to amplify returns as much as 

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possible with borrowed money. 
Commercial mortgages differ from

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residential mortgages in that 
they're generally interest only 

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loans, meaning that the 
investors get to make small 

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monthly payments but are then 
faced with a balloon payment of 

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the initial loan amount on the 
date the mortgage comes due. 

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This lump sum needs to either be
repaid or refinanced when the 

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mortgage expires. 
With an interest only mortgage, 

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the borrower gets to keep the 
property consistently leveraged 

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and the risk to the lender does 
not get reduced over time 

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because the principal is never 
paid down until the mortgage 

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expires. 
Commercial real estate 

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investors, and in particular 
office real estate investors, 

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are struggling with changes to 
how and where people work in the

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wake of the pandemic because 
workers have been reluctant to 

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return to the office five days a
week. 

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This means that employers don't 
need to rent as much office 

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space. 
It also means that shops and 

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restaurants in business 
districts are closing down due 

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to fewer customers. 
On top of that, higher interest 

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rates are making it more and 
more expensive to buy a building

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with borrowed money or to 
refinance a mortgage. 

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According to the Mortgage 
Bankers Association, many 

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commercial mortgages that were 
set to mature last year were 

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extended or otherwise modified, 
and as a result, the amount of 

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commercial mortgage debt 
maturing this year rose from 

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$659 billion as of the end of 
2022 to $929 billion as of the 

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end of 2023. 
Many of those loans are on 

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partially empty office buildings
and were taken out in a low 

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interest rate environment which 
has now passed. 

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Commercial mortgage rates have 
almost doubled since many of 

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these loans were taken out, and 
the value of many of the 

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underlying properties have 
fallen considerably, raising the

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prospect of billions of dollars 
of losses for real estate 

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investors and thus losses for 
those who lend money to them. 

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A recent paper on commercial 
real estate and U.S. banks found

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that 44% of office loans are 
likely already in negative 

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equity and that the majority of 
office loans are likely to 

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encounter substantial cash flow 
problems and refinancing 

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challenges in the coming years. 
About 1/3 of the expiring office

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loans are funded with commercial
mortgage-backed securities, 

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which are often held by 
insurance companies, pension 

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funds, and individual investors.
The remaining 2/3 are held by 

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banks, and these tend to be 
higher quality, lower risk loans

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than the ones backed by 
commercial mortgage-backed 

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securities. 
According to the FDIC, 

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delinquencies on bank loans 
backed by offices were at 1 1/2%

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at the end of the third quarter 
of 2023, which is quite low, but

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it is rising well. 
Delinquencies on the equivalent 

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but riskier CMBS loans reached 
6.3% in January, up from 1.9% 

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from a year earlier, according 
to the real estate data firm 

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TRAP. 
According to Moody's Analytics, 

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owners of 224 out of the 605 
large buildings with mortgages 

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expiring this year will struggle
to refinance, either because the

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properties are over leveraged or
because their rental performance

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is poor. 
Let's discuss the distressed 

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sales of office buildings that 
have been happening over the 

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last few months, Why New York 
Community Bancorp is down more 

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than 65% year to date, what 
banking regulators are saying 

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about loan portfolios at large 
U.S. banks, and how banks are 

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hedging their loan books. 
OK, so while workers around the 

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world have been reluctant to 
return to the office since the 

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pandemic, return to office rates
have been much lower in the 

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United States than in Asia and 
Europe. 

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And so the problem is more 
concentrated in big U.S. cities 

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than anywhere else. 
According to Commercial Edge, 

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office space use is only around 
half of what it was before the 

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pandemic. 
For this reason, values for 

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institutional quality offices 
are down 27% since this time 

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last year. 
There are some big distress 

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sales occurring on some iconic 
buildings. 

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Cigna Holding, an Austrian 
property company which fell into

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insolvency, is selling its 50% 
share in the Chrysler Building 

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in New York after being ordered 
to do so by an Austrian cord. 

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According to the Insolvency 
Administrator, just €250 million

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of the €5.26 billion debt owed 
by the property group has been 

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secured against tangible assets,
raising questions about how much

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lenders to the group can expect 
to recoup in the bankruptcy. 

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In Washington DCA 13 story 
building with ground floor 

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retail sold in December for 
$18.2 million, down 70% from the

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price it last traded at in 2017.
In London 5 Churchill Place, a 

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Canary Wharf office building, 
was recently sold at a 60% 

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discount to its last sale price,
showing how much office real 

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estate has fallen in London. 
This was one of the largest 

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distressed sales in London since
interest rates started rising. 

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It was owned by a Chinese real 
estate group and sold after 

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being put into receivership by 
its lenders. 

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Urban Land reports that most 
office buyers in this 

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environment are private equity 
groups, family offices and ultra

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high net worth individuals who 
bring cash to the table or can 

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negotiate seller financing. 
Three US regulators, the Federal

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Reserve, the FDIC and the Office
of the Comptroller of the 

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Currency, announced late last 
year that they would scrutinize 

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banks whose commercial real 
estate loan portfolios are more 

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than triple their capital. 
Within that group, they would 

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focus on loan portfolios that 
had grown at least 50% in the 

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past three years, according to 
Bloomberg. 

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Under this standard, there are 
about two dozen banks in the 

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United States that have 
portfolios of commercial real 

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estate loans that would merit 
greater regulatory scrutiny. 

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A lot of the stress is showing 
up in regional banks. 

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The KBW Regional Banking Index 
is down about 12% year to date, 

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and shares of the most leveraged
regional banks are down even 

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more, as investors worry both 
about the losses associated with

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commercial property exposures 
and the risk that regulators 

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might force these banks to 
increase their reserves or cut 

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their dividends. 
Shares of New York Community 

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Bancorp are down 26% today alone
on news that the regional lender

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has replaced its CEO and 
disclosed that it has identified

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material weaknesses in internal 
controls that guide how loans 

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are reviewed. 
The stock was already down more 

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than 50% year to date after 
reporting higher than expected 

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losses from real estate loans 
and a dividend cut which was 

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needed to meet tougher 
regulatory requirements. 

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The bank's chief risk officer 
had quit his job weeks before 

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the big losses were announced. 
NYCB had appeared to be one of 

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the big winners of the 2023 
regional banking crisis that 

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sank Signature Bank, Silicon 
Valley Bank and First Republic 

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as they bought the operations of
Signature Bank in a deal 

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arranged by the FDIC. 
The problems at NYCB have 

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reawakened investor fears about 
regional banks, but investors 

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are also beginning to worry 
about loan loss provisions at 

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some of the largest U.S. banks. 
Loan allowances are the capital 

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that banks set aside to cover 
future losses on delinquencies, 

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and when a bank increases its 
loan allowances, this reduces 

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earnings. 
So banks try to avoid doing this

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if at all possible. 
Regulators said different loan 

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loss allowances for different 
types of loans. 

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Higher allowances are set for 
risky unsecured loans, while 

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loans with historically lower 
default rates, like commercial 

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real estate loans, require 
significantly lower allowances. 

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The problem with using 
historical loss rates is that 

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they're a backwards looking 
metric and the risk of losses on

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office real estate loans has 
increased significantly in 

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recent years due to falling 
property values and higher 

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interest rates. 
Some are arguing that banks 

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should base their reserves on 
current levels of delinquencies.

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But the problem with doing that 
is that bank reserves would 

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become pro cyclical, where they 
declined during booms, allowing 

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banks to lever up even more and 
then increase in a slowdown, 

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requiring banks to recapitalize 
at a time when investors are 

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backing away from the sector. 
One way or another, though, the 

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reserves should relate to the 
riskiness of the loans on the 

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books, and these loans are a lot
riskier today than they appeared

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to be five years ago. 
According to FDIC filings, the 

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average reserves at JP Morgan 
Chase, Bank of America, Wells 

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Fargo, Citigroup, Goldman Sachs 
and Morgan Stanley have fallen 

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from $1.60 to $0.90 for every 
dollar of commercial real estate

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debt on which a borrower is at 
least 30 days late, meaning that

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bad property debt today exceeds 
reserves at the largest U.S. 

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banks. 
This was driven by a spike in 

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delinquent commercial real 
estate loans, which more than 

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doubled last year. 
Stephen Gandel at the FT pointed

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out in a recent article that 
while Bank of America's FDIC 

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filing showed that delinquencies
on loans tied to office, 

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apartment and other non 
residential buildings have 

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jumped to 50% in the final 
quarter of last year, the bank 

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cut its loss reserves for those 
loans by $50,000,000 to just 

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under $1.3 billion. 
You have to be impressed with 

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whoever worked their way through
that regulatory loophole. 50% 

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higher delinquencies leading to 
a lower reserve requirement? 

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Someone really earned their 
bonus on that one. 

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When people say that AI will 
replace white collar workers, I 

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just don't think that ChatGPT 
will ever reach that level of 

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creativity. 
Well done. 

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Now, to be clear, the expected 
losses on commercial real estate

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at this point are much smaller 
than the losses that occurred 

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during the 2007 mortgage crisis.
But there still could be 

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billions of dollars of losses 
for developers, investors, and 

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lenders, and we could see more 
forced sales of office 

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buildings. 
A recent NBER paper called The 

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Secular Decline of Bank Balance 
Sheet Lending, which analyse 

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trends in financial 
intermediation, estimates that 

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the market share of U.S. banks 
in all private lending has 

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almost halved since 1970 and 
that loans as a percentage of 

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bank assets have fallen from 70%
to 55% over the same time 

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period. 
The paper shows that private 

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credit is increasingly 
intermediated through arms 

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length transactions, where a 
lender originates and then sells

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the resulting loan through debt 
securities. 

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The paper highlights that the 
share of household wealth held 

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in deposit accounts at banks has
also fallen from 22% in 1970 to 

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13% in 2023, as savers are 
increasingly putting their 

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savings in money market funds, 
Treasury securities and 

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retirement accounts, cutting out
banks as middle men. 

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The professors argue that most 
of the decline in bank lending 

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and household savings being held
at banks happened in the 1990s 

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and was not significantly 
impacted by the global financial

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crisis, despite all of the 
additional regulation that came 

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in its wake. 
They go on to analyse how the 

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changes in the nature of credit 
intermediation have impacted the

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financial sector's sensitivity 
to regulation and capital 

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requirements. 
Their analysis shows that the 

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impact of raising bank capital 
requirements would have had 

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twice the economic impact in 
1963 than it would have today. 

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Now in their stress test, they 
find that raising bank capital 

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requirements to 25% would cause 
bank balance sheets to contract 

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dramatically. 
But the effect on overall 

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lending in the economy would be 
much more muted today because of

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an offsetting increase in 
lending through shadow banks 

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that substitute for bank balance
sheet lending. 

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Essentially, they show that as 
lending has moved away from 

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banks and into private and 
public markets, the availability

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of loans is less sensitive to 
changes in bank regulation. 

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This possibly explains why the 
overall share of bank lending 

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didn't change much after the 
introduction of all of the new 

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regulations that came in the 
wake of the global financial 

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00:15:15,240 --> 00:15:17,920
crisis. 
Banks are still making the same 

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amount of loans today, but 
they're less risky loans, and 

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risky lending is being done by 
less regulated lenders. 

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It might be reasonable, based on
this research, to expect that 

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any increase in banking reserve 
requirements brought about by 

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delinquencies in commercial real
estate loans would have less of 

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an impact on the overall economy
today than it would have had in 

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the past. 
Significant risk transfer, also 

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known as SRT, which should not 
be confused with the cars that 

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tailgate you on the highway, is 
a balance sheet strategy that's 

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been approved under the European
and UK banking framework and has

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been used for some time on a 
small scale to hedge credit risk

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at European banks. 
The Federal Reserve clarified 

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its rules on the use of this 
strategy last September, which 

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involves the sale of credit link
notes that carry the risk of 

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losses on bank loan portfolios 
to investors. 

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Canadian banks have started 
using this strategy too. 

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In Europe and the UK, each SRT 
transaction is examined by 

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regulators to ensure that a real
transfer of risks is occurring 

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and getting this regulatory 
approval transaction by 

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transaction can be slow. 
SRTS allow banks to reduce their

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risk rated assets and free up 
capital held against these 

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assets, which are mostly loans 
on their balance sheet. 

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U.S. 
Banks like JP Morgan have 

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already started using these 
deals to cut their exposure to 

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risky loans. 
Shedding risk this way does cost

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banks money, but it does reduce 
their risks and thus their 

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capital requirements. 
These products are usually 

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00:17:11,640 --> 00:17:16,160
bought by specialist investors 
with expertise in credit risk, 

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00:17:16,319 --> 00:17:19,560
who feel that they're being 
adequately compensated for the 

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00:17:19,560 --> 00:17:24,079
risk that they're taking. 
U.S. banks can and likely will 

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use these structures to reduce 
their exposures to risky loans, 

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00:17:28,720 --> 00:17:31,560
but doing so will lower their 
earnings. 

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00:17:32,280 --> 00:17:37,480
Profits in the US banking sector
fell almost 45% year on year in 

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00:17:37,480 --> 00:17:41,480
the final quarter of 2023. 
This was the biggest year on 

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00:17:41,480 --> 00:17:45,320
year drop in quarterly profits 
since the second quarter of 

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00:17:45,320 --> 00:17:48,840
2020. 
Some of this was driven by the 

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00:17:48,840 --> 00:17:53,040
government imposed special 
assessment, which replenished a 

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00:17:53,080 --> 00:17:57,600
Deposit Insurance fund depleted 
by the regional bank failures 

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00:17:57,600 --> 00:18:01,720
earlier in the year. 
Increased bad loan provisions, 

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00:18:01,920 --> 00:18:06,600
losses on securities and higher 
costs due to redundancy payments

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00:18:06,600 --> 00:18:10,160
to laid off staff also cut into 
profitability. 

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00:18:10,520 --> 00:18:14,400
While profits fell at the 
biggest banks, they did better 

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00:18:14,400 --> 00:18:19,840
than their smaller peers. 
In the final quarter of 2023, JP

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00:18:19,840 --> 00:18:24,840
Morgan earned 22% of the entire 
industry's profits. 

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00:18:25,400 --> 00:18:28,800
It'll be sometime until the 
problems in commercial real 

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00:18:28,800 --> 00:18:32,360
estate are worked out. 
While there is an excess of 

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00:18:32,360 --> 00:18:36,520
office real estate, there's also
a shortage of residential 

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00:18:36,520 --> 00:18:40,120
housing in the United States. 
This imbalance has LED 

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00:18:40,120 --> 00:18:44,280
commentators to question whether
empty office buildings can be 

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00:18:44,280 --> 00:18:47,000
rezoned and repurposed as 
housing. 

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00:18:47,560 --> 00:18:51,880
The economists at Goldman Sachs 
build a model showing that the 

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00:18:51,880 --> 00:18:55,800
current prices for struggling 
office buildings are still too 

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00:18:55,800 --> 00:18:59,560
high for conversion to 
residential use to make sense. 

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00:18:59,920 --> 00:19:04,440
They estimate that office prices
would need to fall an additional

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00:19:04,440 --> 00:19:10,000
50% for conversion to housing to
be financially feasible, meaning

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00:19:10,000 --> 00:19:14,680
that offices will likely remain 
underutilized in the near term. 

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00:19:15,120 --> 00:19:17,520
Thanks for tuning into this 
week's podcast. 

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00:19:17,640 --> 00:19:21,280
We've seen amazing growth in our
number of listeners over the 

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00:19:21,280 --> 00:19:24,880
last few months, so thank you. 
If you've told your friends 

278
00:19:24,880 --> 00:19:28,840
about the podcast, it seems that
word of mouth is how these 

279
00:19:28,840 --> 00:19:31,600
things grow. 
Have a great week and talk to 

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00:19:31,600 --> 00:19:34,360
you again soon. 
Bye if you. 

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00:19:34,360 --> 00:19:37,480
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00:19:39,880 --> 00:19:42,600
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284
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If you enjoyed this content, you

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can find more like it on 
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00:19:53,240 --> 00:19:54,560
Thanks for listening. 
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