US banks continue to face severe financial pressures, with the First Republic bankruptcy now being followed by intensified pressure at PacWest, Western Alliance, and others previously thought to be healthy. A key driver is banks’ exposure to falling commercial property values, driven in part by increased work-from-home and reduced demand for commercial office space.
The scale of the growing banking crisis is raising concerns about a larger financial collapse that could engulf the rest of the economy. The New York Times reports the three recently failed big banks had a total of $532 billion in assets (First Republic, $213 billion; Silicon Valley Bank, $209 billion; Signature Bank, $110 billion). That’s more than the $526 billion “held by banks that collapsed in 2008 at the height of the global financial crisis.”
Initial reports treated each recent failure as a single event. Silicon Valley Bank and First Republic had large start-up accounts that were not fully covered by FDIC insurance. Signature took a risk on cryptocurrencies. And the Federal Reserve has admitted failing to take “strong enough steps” in regulatory oversight.
But more banks continue to struggle, with PacWest’s share price plummeting 50% on May 4, hitting “an all-time low.” Just nine days ago some analysts they said that PacWest’s “deposit situation” had “stabilized” and that the bank’s shares were a “high-potential payback bet.”
What is causing this pressure? One key is the heavy exposure that PacWest, Western Alliance and other regional banks have in commercial real estate (CRE). That sector, especially offices, continues to struggle as working from home puts downward pressure on office rents and building values. And the high exposure to residential loans is affected by the continued increases in interest rates by the Federal Reserve.
The real deal reports “nearly 80 percent” of PacWest’s portfolio “is dedicated to loans backed by commercial real estate and residential mortgages.” As I noted in March, “CRE leases are often long-term” and “many CRE loans are due in the next few months.” Banks face a toxic mix of lower building values, higher refinancing rates due to continued Federal Reserve rate hikes and tougher credit standards as federal regulators worry about the quality of bank loans.
It’s hard to see any of these factors improving anytime soon. The Fed can pause its interest rate hikes after its May 3rd .25% increase, but your base rate is now at its highest level in more than 15 years. And rates were just above zero in March of last year. We have seen ten rate hikes in just over a year, putting further pressure on banks that hold older federal debt with low interest rates. real estate capital notes that rate increases are creating “growing refinancing risks” for a “wall of more than $400 billion maturing this year.”
Credit standards will also tighten, as the lax supervision that contributed to recent bank failures will encourage tighter regulation in the future. Fed Vice President of Supervision Michael Barr said a recent report found that the Fed’s weaknesses in supervision contributed to the failure of Silicon Valley Bank, vowing to improve the “speed, strength, and agility of supervision.”
And the downward pressure on CRE values will continue in the face of persistent work from home (WFH). Stanford economist Nicholas Bloom, which closely follows the WFH, found that “only about 5% of the typical US workforce was working from home” before COVID-19. But now, close to 30% work from home at least some of the time, and that proportion seems to be stabilizing at higher levels than many (including me) anticipated.
That’s bad news for commercial office space, rents and values. Although most work-from-home jobs are moving toward a “hybrid” model with workers splitting time between home and the office, that still means less demand for office space. Less demand translates to lower rents, which means lower values for office buildings. And that puts downward pressure on banks, like PacWest, with significant exposure to CRE.
Sectoral problems aside, the prevailing fear is that pressures and bank failures will lead to further economic difficulties through a process of “contagion”. The problems first spread through the financial sector and then can spread to the rest of the economy. Financial failures can lead to a lack of credit, which in turn can stifle investment and growth.
I will point again economist Hyman Minsky, who told us how “financial fragility” under capitalism systematically produces these threats. Minsky saw how crises break out in different parts of the financial system when undue sectoral risks flow into the rest of the system. He told us that “stability leads to instability” by encouraging these risks and that profit seekers “will always outperform regulators.” The history of the developing world debt crises, mortgage-backed securities, savings and loans, the dot-com bubble and residential real estate that led to the Great Recession underscore Minsky’s warning.
But our current path might have surprised even Minsky: a global pandemic that led to reduced office occupancy, which in turn hit CRE stocks to the detriment of regional banks with high CRE exposure. Let’s hope we don’t have the full cycle and the CRE problems of the regional banks don’t turn into a full-blown financial panic or a deep recession.