There’s a new time bomb ticking underneath the United States economy: $1.5 trillion of interest-only loans on which the principal is coming due over the next two years. As rate hike increases make refinancing a problematic, if not impossible, option for borrowers and work from home and flight from cities make the real estate worth less, the repayment of those loans seems to many like something unlikely to happen. And, as many of those loans are owned by small, regional banks that serve real estate borrowers, the result could be a financial meltdown in small banks that worsens the recession many think is likely to soon occur.
Sen. John Kennedy, a senior Senate Banking Committee member, spoke about the risk in a recent interview, saying, “Am I worried? The short answer is yes. The long answer is hell yes.”
Continuing, Sen. Kenney called on the Federal Reserve to be better prepared for this issue than it was for the bank failures of March, saying, “I hope the Federal Reserve and the banking regulators are worried as well, and I hope they won’t be caught flat-footed like they were with the bank failures that we’ve had so far.”
On the other side of the aisle, Sen. Mark Warner is ringing the alarm bell as well, particularly as regards regional banks. “Right now, we have the double whammy of much higher interest rates and the commercial real estate market going through a shock post-Covid,” he said to POLITICO. “So I don’t think we can presume that… we’re going to be able to simply glide through [without a crash],” he added, emphasizing the likelihood of the situation ending badly.
Then, though he did not say what ideas he had for stabilizing the situation, he did claim to encourage the White House to look into helping regional banks weather the storm, saying, “I’m still trying to sort through some of the policy options. I have encouraged the White House, though, that we need to do some more intervention on these regional banks right away.”
The Fed seems at least to understand the scope of the commercial real estate issue. In a recent report on financial stability, it noted that there are $23,796 billion in outstanding commercial real estate loans.
That report went on to note that some sectors of commercial real estate, namely office buildings, are particularly weak right now, saying, “While price declines were widespread across all property types, fundamentals in the office sector were particularly weak for offices in central business districts, with vacancy rates increasing further and rent growth declining since the November report.”
Continuing, the report later notes that the holders of commercial real estate debt could face steep losses as online jobs make office space less necessary and valuable and higher interest rates make refinancing an unlikely prospect, saying, “The shift toward telework in many industries has dramatically reduced demand for office space, which could lead to a correction in the values of office buildings and downtown retail properties that largely depend on office workers. Moreover, the rise in interest rates over the past year increases the risk that CRE mortgage borrowers will not be able to refinance their loans when the loans reach the end of their term. With CRE valuations remaining elevated (see Section 1, Asset Valuations), the magnitude of a correction in property values could be sizable and therefore could lead to credit losses by holders of CRE debt.”
The report then claims that the Fed is keeping an eye on the situation, saying, “Importantly, some banks may have more concentrated exposures to CRE mortgages than average and therefore may experience higher-than-average losses should CRE conditions weaken . In response to concerns about CRE, the Federal Reserve has increased monitoring of the performance of CRE loans and expanded examination procedures for banks with signifi cant CRE concentration risk.” Those banks with “more concentrated exposures” are likely the regional banks about which Sen. Warner warned.
However, what the Fed could do other than print money to temporarily help banks is unclear. As Politico quotes Dan Tarullo, a former Fed official as saying, the commercial real estate situation, particularly in now-deserted downtown centers, is “a train wreck waiting to happen.” He added, “All you have to do is walk through the downtown of a major American city.” Indeed, those empty skyscrapers hardly bode well for those holding the debt on them.
Sen. John Tester presented one potential solution, saying, “We are where we are, it’s going to be this way forever. I think the logical solution: We need to develop policies that would help convert commercial to housing, apartments, whatever it might be.” The likely issue with that purported solution is that rebuilding the large office buildings into residential buildings would be expensive and require loans, which banks would likely be loath to give when facing massive losses on other real estate loans.
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