💼 Financial Crisis?
briefcase | invest smarter | Issue #132
Is there a financial crash on this horizon? And if so, what will be the cause? Here’s what you had to say…
As such, today we will explore the banking system’s exposure to a financial crisis.
🏦 Financial Crisis?
After watching the Silicon Valley Tank fiasco, and First Republic, and Signature Bank, real estate watchers can’t help but wonder if we are out of the woods or if there is more pain to come.
The Federal Reserve last week released its 2023 Supervisory Stress Test report looking at all tier 1 banks and their power to “withstand an economic downturn.”
And the verdict is?
The results of the 2023 Supervisory Stress Test conducted by the Federal Reserve indicate that the 23 large banks subjected to the test have ample capital to withstand challenging economic conditions. These banks can absorb over $540 billion in losses while still being able to provide loans to individuals and businesses…All banks tested remained above their minimum capital requirements, despite total projected losses of $612 billion.
Nothing to worry about here folks!
Unless you’re a smaller bank, which all have way more exposure to commercial loans. This is where it’ll get a little dicey.
Queue reaction…
Thanks, J-Pow.
Indeed, the Financial Stability Oversight Council said in a statement two weeks ago that although delinquency rates are low, vacancies are rising.
Exposure to CRE loans at depository institutions has been increasing, with higher levels of concentration at smaller institutions. While delinquency rates remain low, vacancy rates have been increasing, particularly in the office sector.
According to Axios, small banks have an over-exposure to commercial loans that will be coming due in the next year or two at significantly higher interest rates.
But what do “exposure” and “risk” mean in this equation? We all like fancy words, but let’s dumb it down so even Clay the Intern can understand.
Here’s a specific example of why smaller financial institutions are most at risk of a downturn.
🔫 Bond, Bank Loan Bond
Although the Fed held rates steady at its last meeting, it did indicate that we can expect 📈 two more increases in 2023. This comes amidst central banks battling to keep inflation at the 2% target, which currently remains stubbornly high at 4%+.
Why does this matter to the smaller banks holding larger commercial and residential mortgage portfolios?
Let’s grab our crayons and a napkin to provide an example…
Four years ago, a commercial loan was taken out at a 2% interest (those were the days!) on a 30-year term.
The current market rate for the same loan is 5%+, leaving a gap of 3%.
Ok…Now banks don’t just sit on loans; they package them up and sell them on a secondary market to bondholders.
Because the prevailing rate of bonds is currently 6% per year, the 2% loan needs to be discounted to obtain a similar return to the current bond market return of 6%.
Still with us? Our above example loan has 26 years left in its term, meaning that we need to discount 3% (difference between 2% and 5%) per year to match current market returns.
26 years left, multiplied by the rate differential (3%), means this loan requires a discount of 78% to match current yields. Why would a bondholder buy this loan if they can currently get 6% yields? So, the loan needs a discount to be competitive.
Now, the above isn’t perfect math. To be fair, we used Skittles as counters and ended up eating most of them and tossing a few at Clay the Intern.
But the above illustration does give you a sense of the problem facing the smaller banks, which have a larger exposure to commercial loans, most of which are coming up for renewal in the next 2 years.
So, the end of 2023 into 2024 should be particularly telling on how we weather a potential financial storm.
According to CRED iQ, there are a lot of B’s coming due in the CRE loan market that’ll have to face a doubling or tripling of interest rates.
Further, this problem transcends one single loan. Considering our example, each 30-year loan issued in the U.S. within the last ten years has experienced a similar depreciation scenario ranging from 40-80% since its issuance.
And the pain is already starting, with Bloomberg reporting that sales of commercial mortgage bonds have “fallen off a cliff,” dropping 85% YoY.
Cager, can you please illustrate…
Speaking of gone in 60 seconds, a recent academic study notes that the market value of U.S. banking assets is $2.2T lower than their loan portfolio book value. Bank asset values have declined an average of 10% across all banks, with the bottom 5th percentile experiencing a drop of 20%.
Further, a second draft study found that 2,315 U.S. banks (mostly small) have assets that “are worth less than their liabilities” when valued at market prices. This all adds up to the reality over the coming years that banks will be lending less money.
So What? This significant predicament remains largely unacknowledged, acting as a potential tinder box for any forthcoming recession.
Keep an eye out on the commercial loan sector; it may act as a bellwether for real estate investors wanting advanced warning of a potential recession or financial crash.
At the very least, it is clear banks will be lending less in the medium term.