US banks continue facing severe financial pressures, with First Republic’s failure now being followed by intensified pressure on PacWest, Western Alliance and others previously thought to be healthy. A key driver is banks’ exposure to falling commercial real estate values, driven in part by the rise in working from home and reduced demand for commercial office space.
The scale of the growing banking crisis is raising concerns about a larger financial meltdown that could pull the rest of the economy down. The New York Times reports the three recent large failed banks had a total of $532 billion in assets (First Republic, $213 billion; Silicon Valley Bank, $209 billion; Signature Bank, $110 billion.) That’s bigger than the $526 billion “held by the banks that collapsed in 2008 at the height of the global financial crisis.”
Initial reports treated each recent failure as unique events. Silicon Valley Bank and First Republic had large accounts from start-up firms not fully covered by FDIC insurance. Signature took risks with crypto. And the Federal Reserve has admitted to not taking “forceful enough action” in regulatory oversight.
But more banks keep getting into trouble, with PacWest’s share price falling by 50% on May 4, hitting “a record low.” Just nine days ago, some analysts were saying PacWest’s “deposit situation” had “stabilized,” and the bank’s stock was a “high-potential recovery bet.”
What’s causing this pressure? One key is the heavy exposure PacWest, Western Alliance, and other regional banks have in commercial real estate (CRE). That sector, especially offices, remains troubled as working from home puts downward pressure on office rents and building valuesAnd high exposure to residential lending is suffering from the Fed’s ongoing interest rate increases.
The Real Deal reports “almost 80 percent” of PacWest’s portfolio “is dedicated to commercial real estate-backed loans and residential mortgages.” As I noted in March, “CRE leases often are long term” and “many CRE loans are coming due in the next few months.” Banks face a toxic brew of lowered building values, higher refinancing rates due to the Fed’s continued rate increases, and tightening credit standards as federal regulators worry about bank lending quality.
It’s hard to see any of these factors improving soon. The Fed may pause its interest rate increases after its May 3rd raise of .25%, but its base rate is now at its the highest level in over 15 years. And rates were just above zero in March of last year. We’ve seen ten rate increases in just over one year, further pressuring banks holding older federal debt with low interest rates. Real Estate Capital notes the rate increases are creating “rising refinancing risks” for a “more than $400 billion maturity wall this year.”
Credit standards also will tighten, as the relaxed supervision contributing to recent bank failures will encourage tougher regulation going forward. The Fed’s Vice Chair for Supervision, Michael Barr, said a recent report found Federal Reserve weaknesses in supervision contributed to Silicon Valley Bank’s failure, promising to improve the “speed, force, and agility of supervision.”
And downward pressure on CRE values will continue in the face of persistent working from home (WFH). Stanford Economist Nicholas Bloom, who tracks WFH closely, has found that “only around 5% of the typical U.S. workforce worked from home” before COVID-19. But now close to 30% work from home at least some of the time, and that share seems to be stabilizing at levels higher than many (including me) anticipated.
That’s bad news for commercial office space, rents, and values. Although most WFH is moving towards a “hybrid” model with workers splitting time between home and the office, that still means less demand for office space. Less demand translates into lower rents, meaning lower values for office buildings. And that puts downward pressure on banks—like PacWest—with significant CRE exposure.
Sectoral problems aside, the overriding fear is that bank pressures and failures will lead to wider economic distress via a process of “contagion.” Problems first spread through the financial sector and then can bleed over to the rest of the economy. Financial failures can lead to a lack of credit which in turn can choke off investment and growth.
I’ll again point to economist Hyman Minsky, who told us how “financial fragility” under capitalism systematically produces these threats. Minsky saw how crises erupt in different parts of the financial system when undue sectoral risks flow into the rest of the system. He told us “stability leads to instability” by encouraging these risks and that profit-seekers will “always outpace regulators.” The history of crises from developing world debt, mortgage-backed securities, savings and loans, the “dot com” bubble, and residential real estate leading to the Great Recession all underscore Minsky’s warning.
But our current pathway might have surprised even Minsky: a global pandemic leading to reduced office occupancy, which in turn hammered CRE values to the detriment of regional banks with high CRE exposure. Let’s hope we don’t get the entire cycle, and the CRE problems of regional banks don’t turn into a full-fledged financial panic or a deep recession.