#1. Don’t panic. Only three banks have failed: Silicon Valley Bank (SVB), Signature Bank and Silvergate Bank—three out of 4,236 FDIC-insured commercial banking institutions in the U.S. Moreover, the three banks that collapsed had a heavy depository and lending exposure to the tech (SVB) and crypto (Signature, Silvergate) sectors. Most banks have more balanced portfolios and are not overly dependent on one sector. It is likely that more banks will come under pressure due to duration mis-matches, creating liquidity issues but as of this writing, only three have failed, and those are all unique cases, and that does not equal a crisis.
#2. This is not the Great Financial Crisis (GFC) all over again. There are five main differences:
- It’s not clear the current situation is a crisis but rather intervention by regulators is likely to avert a more systemic or broader fallout. The most pressing challenges thus far are concentrated in a few regional banks. While SVB and Signature Bank represent the second and third largest bank failures in U.S. history (behind Washington Mutual), their assets were $209 billion and $118 billion, respectively—far less than the biggest banks in the U.S., the four largest of which have over $9 trillion of assets. During the GFC, even the largest banks were under pressure.
- The current economy is much stronger today vs. during the GFC when the first wave of bank and non-bank failures commenced. For example, the U.S. was already well into recession when Lehman Brothers collapsed, and the unemployment rate had already risen from 4.7% to 6.8% when the Fed announced its first round of quantitative easing. Today, the U.S. is still creating jobs, and unemployment is near an all-time low—at 3.6% as of February 2023.
- The financial system is much stronger today vs. before and during the GFC. In fact, in response to the global financial crisis, the banking system underwent massive reforms so there wouldn’t be a repeat. Banks are more capitalized and are widely considered better protected for downside scenarios. For example, the 2022 Dodd Frank stress test results show that large banks—specifically those with systemic importance—have sufficient capital to absorb more than $600 billion in losses (of which $75.4 billion were tied to CRE). Aggregate capital ratios in 2022 all exceeded the minimum regulatory thresholds at their trough.
- There has been a faster response by policymakers today vs. during the GFC. SVB collapsed on March 10, and just two days later the Treasury and Federal Reserve set up an emergency credit facility for banks facing liquidity issues (coined the Bank Term Funding Facility), thereby protecting all deposits and providing some initial confidence to the markets. This historic program, unveiled by the Fed, will redefine how banks are able to confront and tackle liquidity crises brought on by interest rate risk. Further, the FDIC is conducting normal, orderly liquidation operations, as it does during any bank failure.
- The current issues facing the select banks under pressure stem from interest rate risk on held-to-maturity assets, which is not linked to performance of their credit or outstanding loan portfolios. In contrast, during the GFC, banks were instead facing a credit crisis through the largest and most important debt market—that of single-family residential mortgages. These were two very different challenges, with very different underlying causes. While a credit cycle is underway and in its early stages, the recent failures of the three aforementioned banks have nothing to do with credit and instead relate to the ramifications of a rising-rate environment and the resulting impact on bond and securities values.
#3. The lending environment just got tougher. It was already tough. According to the Fed’s Senior Loan Officer Opinion Survey, the percentage of banks that say they are tightening lending standards for CRE loans and other business loans is the highest it’s been in 13 years. Other than 2020, this is the toughest lending environment since the GFC. That was all pre-SVB collapse, too. In the days since, Bloomberg’s Financial Conditions Index (a composite of 10 financial market indicators) has contracted sharply, meaning that financing conditions are tighter across a broad array of credit metrics, not just bank lending. Collectively, financial market conditions have tightened, equity markets have weakened, and credit spreads—perceived risk—have widened. CRE borrowers who were looking for financing from small- and mid-sized banks (such as community and regional banks) were already facing constraints. Community and regional banks were known to have greater CRE concentrations in their loan portfolios, in some cases these concentrations were high enough to flag supervisory criteria to assess that exposure. We now believe these banks’ lending constraints will become greater as they are likely to exercise even greater caution in the wake of these events to evaluate their capital conditions. This comes at an inopportune time given that regional and community banks have stepped up as one of the more active CRE lending sources in recent quarters, all as the large banks, CMBS and life insurance companies have largely taken to the sidelines. Banks typically capture or contribute upwards of 40% of total CRE lending activity, across the lender types captured in the chart below. Ultimately, less activity on the part of banks would mean that CRE transaction activity will be even more measured, which we were already expecting to a certain degree. A more stringent and conservative lending environment should be considered a reassurance in the long run, though.
#4 The Fed may ease up. There is little doubt the bank failures will factor into the calculus when the Federal Open Market Committee (FOMC) meets again next week from March 21-22. Prior to the three bank failures, investors in interest-rate fed funds futures were pricing in nearly an 80% probability of a 50-bps rate hike in March. As of today, there is now a two-in-three probability the hike is 25 bps, and a one-in-three chance that the FOMC will hold rates steady as it sees how conditions unfold. Counterintuitively, it’s possible that the isolated collapse of these banks may lower the outlook for interest rates for remainder of the year, because the added uncertainty might help to tighten financial market conditions, ease macroeconomic momentum and thereby do a bit of the Fed’s job for it.
#5 Watching isn't the worst strategy. This could still go in many different directions. In fact, as we assess CRE in the context of the recent bank failures, there are reasons to be both cautiously optimistic and concerned. On the glass-is-half-full side, CMBS delinquency rates remain low—3.1% in February, which is lower than a year ago and much lower than the 10.3% observed during the GFC. Loan-to-value ratios today are in the 55-60% range vs. 70-80% during the GFC. Debt service coverage ratios remain very healthy, in the 2-2.5 range on average. In other words, if their rate is fixed, the typical owner has more than double the NOI needed to pay their monthly mortgage. Inflation expectations remain very low: the 5-year, 5-year forward rate—the market’s view of average expected inflation over the five-year period that begins five years from the date data are reported—is anchored below 2.5%. This is right at the Fed’s target rate. From a debt market perspective, today’s yield over long-term inflation is more attractive than it has been in years, and as uncertainty fades, there are scenarios where the debt markets may fire up quickly, creating stronger refinancing options. It is also notable that 10-year Treasury rates are down in the 3.4% range, from 3.9% pre-SVB, which should help some on refinancing front as uncertainty fades. Lower rates can also pass through to new commercial mortgages, too, but we expect this pass-through to be marginal. On the glass-is-half-empty side, there is a wave of commercial mortgage loans maturing in 2023 and 2024—$1.1 trillion, up from $750 billion the prior two years. Despite the recent decrease in interest rates, they are expected to remain elevated (and above the rates on maturing loans), which will make refinancing more difficult as those loans mature in the next two years. Moreover, across most sectors, the CRE leasing fundamentals are weakening; vacancy is gradually drifting higher and rent growth is decelerating. Segments of the office sector remain challenged as businesses continue to adopt hybrid and remote strategies.
The sky isn’t falling; at this stage, it’s more overcast than anything else. During periods like this, watching to see what real trends emerge is a better strategy than overreacting to headlines. We will continue to monitor developments and update our analysis as the situation becomes clearer.