Hello and welcome you are listening to Patrick Boyle on Finance, a podcast exploring ideas from quantitative finance, examining events occurring in markets right now and financial history to see what lessons can be taken away, including interviews with some of the most interesting people in the world of finance. To learn more about the podcast,
visit on finance.org. Office mortgage default rates are rising around the world, which could mean problems for the banks, insurance companies and pension funds who lend money to real estate investors. No one loves leverage more than real estate investors, who aim to amplify returns as much as
possible with borrowed money. Commercial mortgages differ from residential mortgages in that they're generally interest only loans, meaning that the investors get to make small monthly payments but are then faced with a balloon payment of the initial loan amount on the date the mortgage comes due. This lump sum needs to either be repaid or refinanced when the
mortgage expires. With an interest only mortgage, the borrower gets to keep the property consistently leveraged and the risk to the lender does not get reduced over time because the principal is never paid down until the mortgage expires. Commercial real estate investors, and in particular office real estate investors, are struggling with changes to how and where people work in the wake of the pandemic because workers have been reluctant to return to the office five days a week.
This means that employers don't need to rent as much office space. It also means that shops and restaurants in business districts are closing down due to fewer customers. On top of that, higher interest rates are making it more and more expensive to buy a building with borrowed money or to refinance a mortgage.
According to the Mortgage Bankers Association, many commercial mortgages that were set to mature last year were extended or otherwise modified, and as a result, the amount of commercial mortgage debt maturing this year rose from $659 billion as of the end of 2022 to $929 billion as of the end of 2023. Many of those loans are on partially empty office buildings and were taken out in a low interest rate environment which has now passed.
Commercial mortgage rates have almost doubled since many of these loans were taken out, and the value of many of the underlying properties have fallen considerably, raising the prospect of billions of dollars of losses for real estate investors and thus losses for those who lend money to them.
A recent paper on commercial real estate and U.S. banks found that 44% of office loans are likely already in negative equity and that the majority of office loans are likely to encounter substantial cash flow problems and refinancing challenges in the coming years. About 1/3 of the expiring office loans are funded with commercial mortgage-backed securities, which are often held by insurance companies, pension
funds, and individual investors. The remaining 2/3 are held by banks, and these tend to be higher quality, lower risk loans than the ones backed by commercial mortgage-backed securities. According to the FDIC, delinquencies on bank loans backed by offices were at 1 1/2% at the end of the third quarter of 2023, which is quite low, but
it is rising well. Delinquencies on the equivalent but riskier CMBS loans reached 6.3% in January, up from 1.9% from a year earlier, according to the real estate data firm TRAP. According to Moody's Analytics, owners of 224 out of the 605 large buildings with mortgages expiring this year will struggle to refinance, either because the properties are over leveraged or because their rental performance
is poor. Let's discuss the distressed sales of office buildings that have been happening over the last few months, Why New York Community Bancorp is down more than 65% year to date, what banking regulators are saying about loan portfolios at large U.S. banks, and how banks are
hedging their loan books. OK, so while workers around the world have been reluctant to return to the office since the pandemic, return to office rates have been much lower in the United States than in Asia and Europe. And so the problem is more concentrated in big U.S. cities than anywhere else. According to Commercial Edge, office space use is only around half of what it was before the pandemic. For this reason, values for institutional quality offices are down 27% since this time
last year. There are some big distress sales occurring on some iconic buildings. Cigna Holding, an Austrian property company which fell into insolvency, is selling its 50% share in the Chrysler Building in New York after being ordered to do so by an Austrian cord.
According to the Insolvency Administrator, just €250 million of the €5.26 billion debt owed by the property group has been secured against tangible assets, raising questions about how much lenders to the group can expect to recoup in the bankruptcy.
In Washington DCA 13 story building with ground floor retail sold in December for $18.2 million, down 70% from the price it last traded at in 2017. In London 5 Churchill Place, a Canary Wharf office building, was recently sold at a 60% discount to its last sale price, showing how much office real estate has fallen in London. This was one of the largest distressed sales in London since interest rates started rising.
It was owned by a Chinese real estate group and sold after being put into receivership by its lenders. Urban Land reports that most office buyers in this environment are private equity groups, family offices and ultra high net worth individuals who bring cash to the table or can
negotiate seller financing. Three US regulators, the Federal Reserve, the FDIC and the Office of the Comptroller of the Currency, announced late last year that they would scrutinize banks whose commercial real estate loan portfolios are more than triple their capital. Within that group, they would focus on loan portfolios that had grown at least 50% in the past three years, according to Bloomberg.
Under this standard, there are about two dozen banks in the United States that have portfolios of commercial real estate loans that would merit greater regulatory scrutiny. A lot of the stress is showing up in regional banks.
The KBW Regional Banking Index is down about 12% year to date, and shares of the most leveraged regional banks are down even more, as investors worry both about the losses associated with commercial property exposures and the risk that regulators might force these banks to increase their reserves or cut
their dividends. Shares of New York Community Bancorp are down 26% today alone on news that the regional lender has replaced its CEO and disclosed that it has identified material weaknesses in internal controls that guide how loans are reviewed. The stock was already down more than 50% year to date after reporting higher than expected losses from real estate loans and a dividend cut which was needed to meet tougher regulatory requirements.
The bank's chief risk officer had quit his job weeks before the big losses were announced. NYCB had appeared to be one of the big winners of the 2023 regional banking crisis that sank Signature Bank, Silicon Valley Bank and First Republic as they bought the operations of Signature Bank in a deal arranged by the FDIC. The problems at NYCB have reawakened investor fears about regional banks, but investors are also beginning to worry about loan loss provisions at
some of the largest U.S. banks. Loan allowances are the capital that banks set aside to cover future losses on delinquencies, and when a bank increases its loan allowances, this reduces earnings. So banks try to avoid doing this if at all possible. Regulators said different loan loss allowances for different types of loans.
Higher allowances are set for risky unsecured loans, while loans with historically lower default rates, like commercial real estate loans, require significantly lower allowances. The problem with using historical loss rates is that they're a backwards looking metric and the risk of losses on office real estate loans has increased significantly in recent years due to falling property values and higher
interest rates. Some are arguing that banks should base their reserves on current levels of delinquencies. But the problem with doing that is that bank reserves would become pro cyclical, where they declined during booms, allowing banks to lever up even more and then increase in a slowdown, requiring banks to recapitalize at a time when investors are
backing away from the sector. One way or another, though, the reserves should relate to the riskiness of the loans on the books, and these loans are a lot riskier today than they appeared
to be five years ago. According to FDIC filings, the average reserves at JP Morgan Chase, Bank of America, Wells Fargo, Citigroup, Goldman Sachs and Morgan Stanley have fallen from $1.60 to $0.90 for every dollar of commercial real estate debt on which a borrower is at least 30 days late, meaning that bad property debt today exceeds reserves at the largest U.S. banks. This was driven by a spike in delinquent commercial real estate loans, which more than
doubled last year. Stephen Gandel at the FT pointed out in a recent article that while Bank of America's FDIC filing showed that delinquencies on loans tied to office, apartment and other non residential buildings have jumped to 50% in the final quarter of last year, the bank cut its loss reserves for those loans by $50,000,000 to just under $1.3 billion. You have to be impressed with
whoever worked their way through that regulatory loophole. 50% higher delinquencies leading to a lower reserve requirement? Someone really earned their bonus on that one. When people say that AI will replace white collar workers, I just don't think that ChatGPT will ever reach that level of creativity. Well done. Now, to be clear, the expected losses on commercial real estate at this point are much smaller than the losses that occurred
during the 2007 mortgage crisis. But there still could be billions of dollars of losses for developers, investors, and lenders, and we could see more forced sales of office
buildings. A recent NBER paper called The Secular Decline of Bank Balance Sheet Lending, which analyse trends in financial intermediation, estimates that the market share of U.S. banks in all private lending has almost halved since 1970 and that loans as a percentage of bank assets have fallen from 70% to 55% over the same time
period. The paper shows that private credit is increasingly intermediated through arms length transactions, where a lender originates and then sells the resulting loan through debt securities. The paper highlights that the share of household wealth held in deposit accounts at banks has also fallen from 22% in 1970 to 13% in 2023, as savers are increasingly putting their savings in money market funds, Treasury securities and retirement accounts, cutting out banks as middle men.
The professors argue that most of the decline in bank lending and household savings being held at banks happened in the 1990s and was not significantly impacted by the global financial crisis, despite all of the additional regulation that came in its wake. They go on to analyse how the changes in the nature of credit intermediation have impacted the financial sector's sensitivity to regulation and capital
requirements. Their analysis shows that the impact of raising bank capital requirements would have had twice the economic impact in 1963 than it would have today. Now in their stress test, they find that raising bank capital requirements to 25% would cause bank balance sheets to contract
dramatically. But the effect on overall lending in the economy would be much more muted today because of an offsetting increase in lending through shadow banks that substitute for bank balance sheet lending. Essentially, they show that as lending has moved away from banks and into private and public markets, the availability of loans is less sensitive to changes in bank regulation.
This possibly explains why the overall share of bank lending didn't change much after the introduction of all of the new regulations that came in the wake of the global financial crisis. Banks are still making the same amount of loans today, but they're less risky loans, and risky lending is being done by less regulated lenders.
It might be reasonable, based on this research, to expect that any increase in banking reserve requirements brought about by delinquencies in commercial real estate loans would have less of an impact on the overall economy today than it would have had in
the past. Significant risk transfer, also known as SRT, which should not be confused with the cars that tailgate you on the highway, is a balance sheet strategy that's been approved under the European and UK banking framework and has been used for some time on a small scale to hedge credit risk
at European banks. The Federal Reserve clarified its rules on the use of this strategy last September, which involves the sale of credit link notes that carry the risk of losses on bank loan portfolios to investors. Canadian banks have started using this strategy too. In Europe and the UK, each SRT transaction is examined by regulators to ensure that a real transfer of risks is occurring and getting this regulatory approval transaction by
transaction can be slow. SRTS allow banks to reduce their risk rated assets and free up capital held against these assets, which are mostly loans on their balance sheet. U.S. Banks like JP Morgan have already started using these deals to cut their exposure to risky loans. Shedding risk this way does cost banks money, but it does reduce their risks and thus their
capital requirements. These products are usually bought by specialist investors with expertise in credit risk, who feel that they're being adequately compensated for the risk that they're taking. U.S. banks can and likely will use these structures to reduce their exposures to risky loans, but doing so will lower their earnings.
Profits in the US banking sector fell almost 45% year on year in the final quarter of 2023. This was the biggest year on year drop in quarterly profits since the second quarter of 2020. Some of this was driven by the government imposed special assessment, which replenished a Deposit Insurance fund depleted by the regional bank failures
earlier in the year. Increased bad loan provisions, losses on securities and higher costs due to redundancy payments to laid off staff also cut into profitability. While profits fell at the biggest banks, they did better than their smaller peers. In the final quarter of 2023, JP Morgan earned 22% of the entire industry's profits. It'll be sometime until the problems in commercial real
estate are worked out. While there is an excess of office real estate, there's also a shortage of residential housing in the United States. This imbalance has LED commentators to question whether empty office buildings can be rezoned and repurposed as housing. The economists at Goldman Sachs build a model showing that the current prices for struggling office buildings are still too high for conversion to residential use to make sense.
They estimate that office prices would need to fall an additional 50% for conversion to housing to be financially feasible, meaning that offices will likely remain underutilized in the near term. Thanks for tuning into this week's podcast. We've seen amazing growth in our number of listeners over the last few months, so thank you. If you've told your friends about the podcast, it seems that word of mouth is how these things grow. Have a great week and talk to you again soon. Bye if you.
Enjoyed this episode? Be sure to subscribe so you're notified when a new episode is posted. Thank you to everyone who is supporting this content on Patreon. If you enjoyed this content, you can find more like it on YouTube, on the Patrick Boyle on Finance channel or follow us on Twitter at Patrick E Boyle. Thanks for listening. Bye.