Banking Crisis May Strike Commercial Real Estate After Tech, SVB
Mar 30, 2023
The banking crisis is not going away. It may hit commercial real estate next after tearing through the tech sector and claiming the life of Silicon Valley Bank (SVB).
The markets have seemingly settled into anxious drift after US officials scrambled to stop a banking crisis from engulfing the global financial system. The blow-up began with the hurriedly managed collapse of Silicon Valley Bank (SVB) and shuttering of Signature Bank.
Already-wounded Swiss banking giant Credit Suisse seemed like it would be unable to withstand the rough seas in the wake of the shock and was promptly cajoled into a tie-up with its main rival UBS. Further contagion seems to have been mostly contained, at least for now.
Nevertheless, investors remain cautious.
The OFR Financial Stress Index – a catch-all benchmark for market health coming out of the US Treasury department – has stopped rising after a steep jump but remains pinned near recent highs. Fed rate hike odds plunged as the crisis hit. They have been unable to rebuild despite de-escalation. The MOVE index of 1-month implied Treasury options volatilities – the sort of ‘fear’ gauge for the bond market that the VIX is for stocks – jumped to levels unseen since the bedlam of 2009 and looks stuck there.
Data Source: Bloomberg
This lingering unease makes sense considering the problems that brought down SVB seem to threaten a broader swathe of the US banking sector. The story begins with dropping deposits: money market funds have been faster to pass on the Fed’s rapid rate hikes to investors, and so capital has increasingly flowed into them and out of the banks. These funds then park the influx with the Fed via its reverse-repo facility, which too offers better yields than the banks.
FDIC data shows that this led to a sharp 2.5 percent year-on-year drop in deposits at US commercial banks as of the fourth quarter 2022. On the surface, it looks like lenders should be able to stomach such a thing. Deposits are liabilities for banks because they must be paid back on request to clients, and so have to be offset with assets to ensure the business is solvent. Total asset holdings fell 0.5 percent year-on-year in Q4, a seemingly plush cushion against the larger deposits drop.
The reality is grimmer, as we the world learned with SVB. Banks keep securities in two buckets on their balance sheet. Those labelled as “Available for Sale” (AFS) are marked to market – meaning their values rise and fall with prevailing trends – while those tagged as “Held to Maturity” (HTM) are not. This obscures losses on such holdings on banks’ balance sheets.
In the case of SVB, insolvency was hidden in plain sight because the bonds incurring the losses that ate up the capital needed to pay up depositors were mainly sitting in the HTM pile from the onset. Other major banks moved hundreds of billions from AFS to HTM over the course of 2022. Analysis by the Wall Street Journal shows Charles Schwab moved close to $190 billion, PNC did nearly $83 billion, and JPMorgan transferred close to $78 billion, just to name a few.Data Source: Bloomberg
AFS securities recorded a bruising 25.1 percent year-on-year loss in the fourth quarter of 2022. If the same performance were applied to HTM holdings – a crude but telling exercise – the overall decline in total assets looks to be understated by about $1.2 trillion. Adjusted accordingly, this would amount to a 5.5 percent year-on-year decline against a 2.5 percent drop in deposits.
This seems to put much of the banking system in a dangerously precarious position. The mismatch between assets and deposits is weaponized if customers decide to withdraw at scale. That makes smaller banks catering to a concentrated, niche clientele particularly vulnerable.
For SVB, financing the tech world of Silicon Valley made for skewed gearing to a capital-hungry industry that suffered outsized pain amid the rapid rise in interest rates. Commercial real estate (CRE) appears to be another such area.
Assets in the space have suffered as borrowing costs swelled, as with the tech sector. The legacy of Covid lockdowns compounds the pain. Publicly traded REITs linked to office space are down 51 percent in just 15 months as hybrid and work-from-home arrangements become more common. Some 80 percent of CRE mortgages are held at banks outside the big, “too-big-to-fail” money centers.
Accelerating withdrawals from such banks could make for another SVB-like episode, and probably more than one. Meanwhile, emergency borrowing from the Fed’s discount window – a lender-of-last-resort liquidity outlet – has mostly flowed through the US central bank’s San Francisco branch. That suggests the scramble for cash has been concentrated in the tech space, while banks geared to CRE have been reluctant to appear weak by beefing up cash access via the central bank. Another last-minute scramble in the event of trouble may well follow.
Data Source: Bloomberg
Ilya Spivak is the Head of Global Macro at tastylive, where he hosts Macro Money every week, Monday-Thursday.
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