Home Forex Banks begin to choke on their exposure to commercial real estate

Banks begin to choke on their exposure to commercial real estate

by SuperiorInvest

Last year – around April – about the increasing fragility in the commercial real estate sector. And specifically how exposed the smaller and mid-sized banks were.

High vacancy rates, falling rental prices, oversupply and higher interest rates are weighing on the sector and those who financed them.

But to give you some context, I wrote:

“It is important to remember that banks are black boxes – also known as something with internal parts that are usually hidden or mysterious to viewers. Even the best analysts don't really know how much bank loan portfolios are really worth. But one thing seems clear: the commercial real estate sector is becoming increasingly fragile. And with it, so are the smaller banks that granted them credit. “The black swans are on the prowl.”

Now, I don't particularly like quoting myself. But it's important to what I'm about to share with you.

And the regional banking sector has been shaken after the “surprisingly” Horrible Q4 2023 Earnings New York Community Bancorp (NYSE:NYSE:) – causing the bank's shares to fall by approximately 50% (at the time of writing) since January 30, 2024.

NY Bank Stock Price Change

Some of you may remember this bench. It had acquired assets worth $40 billion from the bankrupt New York Signature Bank (OTC:) last year (one of the victims after the Silicon Valley Bank implosion).

So what led to this brutal liquidation of NYCB?

A few things, but let's break down the key points:

  • They cut the dividend by 71% to shore up their balance sheet.
  • Moody's downgraded its credit rating to junk territory.
  • It suffered a “surprise” loss of $260 million in the fourth quarter of 2023, reflecting deterioration in loans tied to commercial real estate (specifically offices).
  • The provision for credit losses rose to $552 million, more than ten times the consensus estimate.
  • The bank is now considering selling distressed assets sooner than it would have preferred.

So, in summary, the pain is largely due to a weakening commercial real estate market that prompted NYCB to face mounting losses.

Of course, as NYCB absorbed the assets of the former NY Signature Bank, it grew in size. Which requires the bank to have higher capital requirements (meaning it must set aside more cash).

They also announced the new appointment of Mr. Alessandro (Sandro) DiNello as Executive Chairman effective immediately on Wednesday.

But such a sudden change in leadership does not usually improve trust. If anything, uncertainty increases.

And if there is something that the market hates, it is uncertainty.

Meanwhile, NYCB's newly appointed CEO said in a conference call with analysts Wednesday that his company will do what it takes to raise capital (i.e., sell assets like loans) and reduce its commercial real estate concentration as quickly as possible. that can

“If we must shrink, then we will shrink.” Mr. DiNello said. “If we must sell non-strategic assets, then we will do so.”

Changing risk like hot potatoes: buyer beware

It is particularly important to note that, in general, I believe that banks have so far refrained from selling mortgage packages to private lenders or hedge funds.

Because? Because many of these long-term loans are underwater since rates went up.

Remember, as rates go up, bond prices go down. So, thanks to the Federal Reserve's rate hikes over the past two years, banks still have a sickening amount of unrealized investment losses: a staggering $700 billion worth in the third quarter of 2023.

Unrealized gains and losses

Unrealized gains and losses

Banks have therefore sought to sell short-term debt, such as car loans, off their books (which have not been hit as hard as longer-term investments due to rate increases).

But still, “synthetic securitizations” have begun to make their way into the US market as banks look for ways to manage their capital constraints.

Simply put, in a synthetic securitization, a bank purchases credit protection on a portfolio of loans from an investor (such as a hedge fund, pension fund or insurance company). Therefore, if a loan in the portfolio defaults, the investor reimburses the bank for the losses incurred on the loans in that portfolio.

Think about things like credit default swaps, credit guarantees, or other derivative contracts to try to “cover” losses (i.e., shift risk).

Seems like a good deal, right?

Banks can sell risks to reduce their exposure to specific sectors and free up cash. Meanwhile, buyers – mainly insurance companies and hedge funds – are getting attractive spreads.

Well, the problem is that it simply transfers the risk to another party. It doesn't remove it.

And while this is a problem, there is another point I would like to highlight.

A trust game: uninsured deposits are a problem

My big concern here is that banks can try to shift risks as much as they want, but if the underlying loans – particularly commercial real estate – start to default or deteriorate, this could drive investors away (who would want to catch them). a falling knife?).

Therefore, if the problems in the commercial real estate sector continue (and I believe they will), they may begin to affect banking confidence.

And as a bank, there is no worse problem than the collapse of trust.

For example, if customers start seeing headlines saying their primary bank is selling assets to raise cash, facing a rise in loan defaults, etc., they may start withdrawing money.

Something like, “Hey, that's worrying. The bank where I keep all my savings just saw its stock price drop. Maybe I should take out my deposits.”

In essence, this is how a bank usually fails: because it can't sell assets fast enough to raise cash for depositors who want it. Therefore, they are forced to sell on the market at huge discounts.

But this is where things get interesting.

The deposits these banks rely on are “fickle” because many of them exceed the government's insurance limit of $250,000 per account, meaning they are deposits that exceed the FDIC's insurance of $250,000.

For example, if you had $1,000,000 in Bank A and it imploded, you would only recover $250,000 from the FDIC alone. You will possibly suffer a loss of $750,000.

To emphasize the magnitude of this point, uninsured deposits – as of May 2023 – represent around 40% of all deposits (up from just 20% three decades ago). And these unsecured deposits are a hidden problem for banking stability, especially in an era of online banking (i.e. how quickly money can be transferred).

Unsecured deposits

Unsecured deposits

As we saw last spring, uninsured deposits are the first to go, which can quickly leave banks insolvent.

To make matters worse, banks converted those fleeting (unsecured) deposits into illiquid loans, like commercial real estate.

Flight risk

Therefore, any decline in confidence leading individuals to withdraw their money from banks would force them to sell those illiquid loans on the market, likely resulting in large losses.

Wrapping it up

As we saw in NYCB's latest results, the problem now is commercial real estate debt, which is going sour like milk on a porch during an Arizona summer.

And unfortunately, I don't think it helps banks shift risk.

Because? As landlords face higher interest rates than they can afford, tenants are cutting their leases and landlords are struggling to raise rents as excess capacity weighs on margins.

This increase in supply has left many landlords struggling to fill vacancies, prompting them to stop asking for rent in some cases (i.e. more supply than demand).

For example, the average asking rent in the US decreased -2.1% year-over-year in November to $1,967 (the largest annual drop since February 2020) and fell -0.6% from October.

Decreasing rents

Decreasing rents

This is great for potential tenants. But for commercial real estate investors, landlords and banks, it's not a big deal.

It's always a double-edged sword, right?

The point is: be careful about the contagion effects of other problems in commercial real estate.

Maybe NYCB was a one-off.

But maybe it wasn't like that.

As always, just something to ponder.

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