Bank failures are coming. Here’s how it could play out
More regional lenders will go under, experts say, and real estate is bracing for impact
Jul 1, 2024, 7:00 AM
The echoes began in May.
Barry Sternlicht of Starwood Capital Group predicted a regional bank failure “every day or every week.”
Days later, Newmark Chair Howard Lutnick warned, “Every single weekend a regional bank is going to go bye-bye,” and predicted 500 to 1,000 failures in 2025 and 2026 — as did alternative lenders speaking at the same event. In June, PIMCO’s head of global private commercial real estate joined the chorus.
Their take: The distress shaking commercial real estate — office, most violently — will collapse the small- and midsize banks that have been bread-and-butter lenders to the industry.
Most economists agree that because of rising rates, declining asset values and banks’ hesitancy to mark their loans to market, such failures are a certainty. The question is whether bigger banks and the Federal Deposit Insurance Corporation can stop collapses from spinning into crisis.
Few, if any, believe a full-blown system failure is coming. But a contraction this significant, they say, will permanently alter the lending landscape for landlords and investors.
“The danger here is there are a lot of small banks that could fail,” said Paul Kupiec, a senior fellow at the American Enterprise Institute.
“If those banks go away, the big banks don’t tend to make that many commercial real estate loans,” he added.
Not all office
When industry people predict bank failures, the culprit is inevitably office properties.
The story is so well-known, it has become banal: With the rise of remote work, commercial tenants left less-desirable buildings, whose values sank — often below the balance of their mortgages.
Of U.S. office buildings that sold in the first quarter, half traded at “distressed pricing,” meaning lower than 80 percent of their inflation-adjusted closing price in sales since 2010, according to a report by brokerage JLL.
Some trades or reappraisals have revealed drastic declines — Los Angeles properties sold at 50 to 60 percent discounts; a Chicago Loop building picked up at $14 per square foot; an amenity-rich Manhattan asset’s value cut in half. Pick a major U.S. city and there are anecdotes supporting that narrative.
Could commercial real estate’s threat to banks be overstated? Some have insisted that the problem is confined to the office sector. Multifamily and industrial assets are generally healthy, and retail is on the upswing.
CoStar’s Commercial Repeat Sales Index, which tracks price changes across all CRE sectors, has fallen less dramatically — by 20 percent between July 2022 and March 2024.
“They’re going to be forced to merge by regulators. Those that can’t will fail.”
“The value declines are in office, and office is not all of CRE,” said Rick McGahey, an economist and senior fellow at the New School’s Schwartz Center for Economic Policy Analysis. “I think that distinction gets lost.”
Though other sectors appear resilient, none has been immune to higher interest rates. The Federal Reserve’s aggressive hikes in 2022 and 2023 have made borrowing more expensive, sidelined buyers and eroded values.
Falling valuations, coupled with the $870 billion in commercial real estate loans maturing this year, according to MSCI, are forcing refinancings at untenable rates.
It’s this recipe that poses the biggest risk to smaller banks that built their businesses as go-to lenders for commercial real estate but failed to diversify.
A recent paper by Kupiec analyzed commercial real estate loan concentrations — outstanding CRE debts compared with capital and funds set aside to cover loan losses — for the banking system at large.
He found that 2,114 banks had what regulators would consider “excessive” commercial real estate loan exposure that warranted a closer look by bank examiners. That’s about half of all of the FDIC-insured banks in the country, according to Statista.
The paper found that the majority of those are smaller banks, most with less than $1 billion in assets.
It gets worse
As bad as that sounds, it is likely worse, given that the snapshot of CRE loan exposure is out of date.
If banks were to mark those loans to market — recognize their true value — CRE concentration ratios would balloon. Financial statements would show more banks without adequate capital to cover losses on CRE loans.
“If you adjust the measure, there’s a lot more concentration than you would think,” Kupiec said in an interview.
When accounting for mark-to-market loan losses and unrecognized losses on banks’ securities or investments, Kupiec found 2,916 banks with excessive exposure. Again, many were on the smaller side and included community banks, which have less than $10 billion in assets.
Notably, 21 had assets of $50 billion to $250 billion, which are characterized as medium-size banks and regional banks. (Regional banks have up to $100 billion in assets.) Two banks with outsize CRE exposure had more than $250 billion in assets each— the so-called too-big-to-fail ones.
Kupiec declined to name names.
Not so fast
High CRE concentration doesn’t mean failure is imminent. “If CRE loans don’t default, there’s no problem,” Kupiec said.
Big-ticket defaults have yet to ravage private lenders’ balance sheets, but that doesn’t mean symptoms aren’t showing. Defaults and foreclosures continue to mar commercial mortgage-backed securities, for which securities law demands frequent disclosures about loan performance.
Private CRE loans might be performing just as poorly. The lenders just haven’t had to show their hand.
Banks have been extending loans to stave off a mass event. Autonomous Research estimated that 40 percent of bank CRE loans maturing this year were initially set to come due last year. But about $214 billion in expiring, bank-originated commercial real estate loans were likely extended, according to MSCI’s recent report.
Those lenders are hoping the Fed lowers rates enough that distressed borrowers can refinance. Economists have factored in one or two rate cuts this year.
“The FDIC doesn’t have that much money. It could be a problem.”
The problem is, they may not be deep enough.
“Anybody who’s sitting here hoping for the Fed to cut to zero or 1 percent is probably deluding themselves,” said Ryan Severino, chief economist at real estate investment firm BGO.
“In the 3 to 3.5 percent range, give or take, feels reasonable,” he added, referring to the federal funds rate. CRE rates typically exceed that rate by a few percentage points.
Run for your money
Absent defaults, Kupiec said banks can be “technically insolvent and still operating.” A bank fails when the FDIC says it does. If balance sheets look clean, regulators can turn a blind eye.
Unless nervous customers make a run on the bank.
Uninsured depositors, meaning those with more than $250,000 in a bank, are typically the first to withdraw. A rush to pull deposits above that threshold triggered the collapses of Silicon Valley Bank, Signature Bank and First Republic Bank last year.
Community banks or those with the highest concentration of CRE loans tend to have fewer of those accounts. Regional banks, particularly the larger ones, have more.
“Uninsured deposits are typically businesses that have multimillion-dollar accounts,” said Rebel Cole, a professor of finance at Florida Atlantic University. “Bigger customers tend to go to the regional or super-regional or national banks.”
The federal Office of Financial Research, in a March report, found 54 banks with a CRE concentration of 25 percent or more that also had an uninsured deposit ratio of at least 50 percent, characteristics of “vulnerable banks.”
Commercial real estate defaults at any of those mid-tier banks could set off chain reactions akin to the contagion that spread from Silicon Valley Bank to Signature and First Republic.
Take this year’s near-collapse of New York Community Bank. After its shares went into free fall, a $1 billion capital injection stopped the bleeding. But it never recovered that lost market value: Its stock is trading at around $3 per share, compared with $10 in January.
Peer banks have suffered for it. Shares of Long Island-based Flushing Financial and Dime Community Bank are trading at 31 percent below their January highs, while New Jersey’s Valley Financial is down 38 percent.
All have high commercial real estate exposure, according to Fitch Ratings.
Shotgun weddings
Most economists are loath to predict how many banks will collapse, preferring to point to risk factors. Cole, though, said he expected 600 fewer banks when the calendar turns to 2025.
“They’re going to disappear,” Cole said. “They’re either going to be forced to merge by the regulators, or those that can’t will fail.”
Mergers, often called shotgun weddings, are the FDIC’s first course of action if a bank’s solvency is on the line.
“When a bank is in trouble, they try to find a buyer,” Kupiec said, noting that an acquisition saves the bank’s equity holders from being wiped out.
The FDIC, the Federal Reserve or the Office of the Comptroller of the Currency will often give a bank 90 days to find a merger partner. For today’s at-risk banks, acquisitions could be a way out.
“A $10 billion bank can be bought by a $20 billion bank, a $20 billion bank can be bought by a $40 billion bank, ” Cole said. “There’s always a larger fish.”
But inevitably, some banks won’t find the right partner or one willing to take the bulk of their assets. JPMorgan deemed First Republic attractive enough to buy, but no one wanted Signature Bank because of its “toxic” commercial real estate loans.
Federally bankrupt
When a failing bank fails to find a buyer, the FDIC is left holding the bag. But the deposit insurance fund that the FDIC taps to cover losses is only so big — about half a percent of the $23.69 trillion banking system’s total assets in December, according to Kupiec’s report.
The economist outlined a scenario in which hundreds of banks holding 10 percent of the banking system’s assets fail, forcing the FDIC to seize them and kick in 20 percent of the value of their assets to lure buyers.
“The FDIC doesn’t have that much money,” Kupiec said. “It could be a problem.”
It’s possible the FDIC would fail banks gradually, as it did during the 1980s savings and loan crisis. The agency could also tap bigger banks for early payments of their insurance premiums to boost the fund, repeating its 2008 financial crisis strategy.
Scarring
If a black swan event plays out, it would disfigure CRE lending markets.
Smaller banks are the backbone of CRE financing. Without them, borrowers’ next-best options would be the big institutions, which, as Kupiec noted, do relatively little commercial property lending.
Reduced competition will likely lead to pricier loan products and push more borrowers into the private markets — to lenders like Benefit Street or Starwood, whose executives say they expect sweeping bank failures.
That alarms some observers. “Any system, whether it’s banks or cars or groceries, you don’t want too much of a monopoly,” McGahey said.
But failures would likely hit smaller borrowers the hardest, as in the case of Signature Bank, a once-reliable lender to rent-stabilized buildings.
After Signature failed, landlords with at-risk mortgages tried to tap big banks like JPMorgan to refinance their loans. But the larger institutions didn’t play in those pools, and Signature’s peers — New York Community Bank among them — were unwilling to expose themselves to the risks that fueled Signature’s collapse.
Some owners were hung out to dry.
If collapses aren’t limited to a few banks, but sweep through a market, the effect will be severe for borrowers already struggling with higher rates, declining revenue and lower valuations. Some will have nowhere to turn.
As the threat of failure grows more acute, economists say that despite the warning signs, borrowers and depositors still figure to be blindsided. The investor-led run on Signature and the near collapse of NYCB show a storm can erupt in a single weekend, even in one afternoon.
“As the saying goes,” said Viral Acharya, an economics professor at NYU, “the best predictor of a crisis is that you’re in the middle of one.”
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