Banking crisis is quietly looming, again

Investors know how to focus on one thing at a time: NVIDIA earnings, booming market, new industry data, the list goes on... Longer trends are easily forgotten. One of these is the slow digestion of the Chinese real estate bubble.

The second is the global collapse in commercial real estate values, which threatens to spill over into a minor banking crisis.

In a nutshell, the problem is as follows. In the post-financial crisis period of zero interest rates, real estate investors borrowed massively on the cheap. As there was no return on fixed rate instruments, demand for real estate investments increased. This boosted real estate values around the world.

A global pandemic wreaked havoc on economies, while massive public stimulus fueled the return of inflation. This is why interest rates have risen. So the fuel of the decade, cheap money, has dried up for the real estate market. Investors' assessment of losses is well reflected in real estate stocks. On the home stock exchange, for example, Kojamo’s share has halved and Citycon, which owns banal shopping centers and carries out share issues (but still pays dividends), is flatlining  The share of eQ, a wealth management company focused on real estate funds, has also halved.

During the pandemic, many workplaces switched to teleworking and workers have not returned to the office. Thus, the need for office space has fallen and it’s hard to find tenants.

Debt-ridden property owners are thus caught in the crossfire of high interest rates and low rental rates, where the value of the properties used as collateral for their debt is melting away. As values melt, banks will demand more collateral which could trigger foreclosures, putting further downward pressure on prices in a weak market.

Charleston Financial estimates that the ratio of a typical real estate loan to value ratio can be as high as 75%. A fall of more than 25% means that banks' collateral is below the amount of the loan. A certain American billionaire suggested that commercial real estate is seeing as much as a trillion dollar depreciation.

When debtors are in trouble, suspicious eyes turn to the banks that financed them.

The banks are back in the line of fire. It’s less than a year since the last banking crisis when a rapid rise in interest rates took careless banks by surprise last March. The saga began with the collapse of Silicon Valley Bank and culminated in the fall of Swiss bank Credit Suisse into the arms of a rival. Ironically, last spring, an American bank called New York Community Bank took on one of the banks in crisis, Signature Bank. The joy was short-lived, however, because now this bank's loan books are turning sour with real estate loans and its stock has plummeted on the stock exchange.

Real estate is local, but debt problems are global. For example, American offices have also been lent to by European and Japanese banks. The stock of the Japanese bank Aozora collapsed as its real estate loans in the US exploded. Germany's Deutsche Bank, which has a masterful ability to be where the trouble is, has quadrupled its loan loss reserves for U.S. real estate. Europe's largest bank, Britain's HSBC, has halved its exposure to US real estate loans. The company suggests that the real estate market will not be the same after the pandemic.

So what kind of sums are we talking about? In America alone, there is a total of $5,800 billion in real estate loans. Roughly half of this amount, or $2.8 trillion, comes from banks. By the end of 2025, $560 billion of loans should be renewed.

The risks are particularly concentrated in smaller banks, with real estate loans accounting for as much as 30% of their loan portfolios in the US. The corresponding figure for large banks is less than 7%, according to JP Morgan. It is no wonder that the stock index of small banks in particular has performed poorly, while among the big banks, JP Morgan's stock, for example, has soared to new highs.

Banking crises must be taken seriously, because banks have a nasty habit of falling like dominoes. Banks generally have around 5% equity on the balance sheet, so they are really leveraged. Even a small blip in loans is a storm for bank solvency.

But there are also bright spots. The authorities are wide awake, as the decision in the spring of 2023 showed. US Treasury Secretary Yellen said a few weeks ago that the situation is bad for some banks (without naming anyone in particular), but that the situation is being closely monitored. The ability of small banks in particular to lend could deteriorate if the problems persist. An official of the investment company Fortress said that more small banks will fail. 

So far, however, the contraction in U.S. banks' loan portfolios appears to be bottoming out and credit managers have become more accommodative in their lending decisions. Credit losses on commercial real estate loans are now only 0.24%, compared to 3% during the financial crisis.

Real estate pressures are also deflationary, so there may also be a small silver lining to inflation. If the Fed were able to lower interest rates at some point, that would help the sector. However, as I have warned on many occasions, we will have to wait a while for rate cuts.

One more perspective. Although bank crashes sound drastic, the stock market can manage even with them. For example, the boom of the 1980s was accompanied by the collapse of small banks and did not hurt the economy too much.