The Regional Bank Crisis Is Not Over (2024)

Anyone who thinks that the regional banking crisis is over has not being paying attention to the dismal recent earnings reports of New York Community Bank, a US $100 billion regional bank, Aozora, a Japanese bank with significant US commercial real estate loan exposure, and Julius Baer, a Swiss bank. All of these banks’ earnings have been hit hard by troubled UScommercial property loans that are on their books.

Nor have those who are sanguine about the regional banks’ outlook been paying attention to the warnings from the International Monetary Fund and the Fitch rating agency. Those institutions are warning of the risk that a rising tide of delinquencies in commercial property loans could derail the economic recovery. It could do so by triggering a wave of regional bank failures reminiscent of the 1980s Savings and Loan crisis. The Federal Reserve seems to be compounding that risk by maintaining high interest rates for too long.

In March last year, markets were roiled by the failure of Silicon Valley Bank and First Republic Bank. Those failures were the second and third largest US bank failures on record. They required large scale Federal Reserve intervention to prevent the regional banks’ problems from morphing into a systemic bank crisis. The principal factor triggering those failures were the large mark to market losses those banks recorded on their bond portfolios as a result of the Fed induced spike in long term interest rates. It is estimated that for the banking system as a whole, bond-related mark to market losses are in the range of $600 billion.

Fast forward to today. In addition to still suffering from the damage high interest rates are exacting on their bond portfolios, the banks are being hit hard by souring commercial property loans. These loans are souring due to record high office vacancy rates as employers have allowed a large part of the workforce to work at least part of the week form home. It is estimated that the national office vacancy rate is at a record of close to 20 percent while in New York alone, office space equivalent to 30 Empire State buildings now sits vacant. As leases continue to expire, those vacancy rates are bound to go even higher.

Record vacancy rates are now being reflected in plunging commercial property prices. Commercial property prices have already fallen by around 20 percent. Meanwhile, Morgan Stanley expects that commercial property prices will decline by around 40 percent from their pre-Covid peak. That in turn is bound to induce a wave of commercial property loan defaults to occur as property developers will find it difficult to roll over at higher interest rates the $500 billion that are due to mature this year. It has to be of concern that real estate experts think that losses totaling around $1.2 trillion in the $3 trillion commercial property market will need to be distributed among lenders. It also has to be of concern that major property developers like Brookfield and Blackstone are already walking away from their mortgages and handing back the keys to the lenders.

If rising commercial property loan default rates are a problem for the banking system as a whole, they are a major problem for the regional banks. For those banks, commercial property lending accounts for close to 20 percent of their overall loan portfolio. Those banks are in no position to have to make large loan loss provisions for their commercial property lending at a time when they are still losing deposits and when they are nursing large mark to market losses on their bond portfolios.

A recent study by the National Bureau of Economic Research underlines the dimension of the prospective regional bank crisis. It estimates that should interest rates stay at their current levels, a wave of commercial property loan defaults could result in the failure of up to 385 regional banks. In early 2008, Ben Bernanke’s Federal Reserve downplayed the problems surfacing in the subprime loan and housing markets. It did so only to find out that those problems triggered the worst economic recession in the postwar period. We have to hope that Jerome Powell’s Fed has learned from that experience. Maybe then it will not make the mistake of keeping interest rates too high for too long and thereby avoid an unnecessary hard economic landing.