by Bryan Perry
February 21, 2024
Among the more debatable topics when professional and retail investors gather, the health of the banking sector is often a front-and-center discussion. Will the heavy loan exposure to commercial office space – which requires broad refinancing over the next two years – trigger some sort of systemic calamity in the financial markets? Or will the regional banks catch a break with lower interest rates and a rebound in property values that gets them to the other side of what many believe to be a pending crisis?
Currently, there doesn’t seem to be a notable wave of high-profile foreclosures or bank closings drawing serious attention away from major areas of market interest – led by AI, earnings, persistent inflation, and concerns of slowing Chinese economy and geopolitical events in the Middle East. Election year politics are not really being factored in yet, but what is evident is that after two years of reducing holdings, U.S. banks have been increasing their purchases of mortgage-backed securities (MBS) and collateralized mortgage obligations (CLOs), and doing so for the past three months, according to the Federal Reserve.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
After selling some $800 billion in debt securities over a two-year period during the Fed’s rate tightening cycle, banks and Wall Street firms added $41 billion in debt obligation purchases, which fueled the fourth quarter 2023 rally in domestic credit markets. That buying pressure, based on a hope of six Fed rate cuts, took the yield on the 10-year Treasury down to 3.8% from 5.0% before the reality of a Fed pause in the bond market last month triggered fresh selling pressure, taking the yield back to 4.29% as of February 16.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
Banks finally came around, offering higher yields on customer deposits, attracting fund flows back to their coffers. With tighter lending standards enacted after the regional bank selloff of March 2023, loan volumes are down, forcing banks to find other places to find decent Net Interest Income (NII).
Banks have dodged disaster: The hard landing never materialized, and the Fed’s 2% inflation target has been elusive, with the latest inflation readings moving in the wrong direction. It makes one wonder why there aren’t more bank failures when the banking sector is largely operating through a rear-view mirror.
Forbes reported: “In the wake of the Great Recession, it was typical to see dozens—if not hundreds—of bank failures each year. This slowed significantly from 2015 to 2020, when the U.S. saw an average of fewer than five bank failures per year. Zero banks failed in both 2021 and 2022. Bank collapses were similarly uncommon in the early 2000s. From 2001 to 2007, the U.S. saw an average of just 3.57 bank failures per year. For all of 2023, there were five failures, still well below the long-term norm.”
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
The question now is whether (and when) market participants will consider the nearly $1.5 trillion of U.S. commercial real estate debt coming due before the end of 2025, of which $929 billion (20% of total outstanding commercial real estate debt) comes due by the end of 2024 (Mortgage Bankers Association).
According to MSCI Real Assets, commercial property prices are down 21%, from their peak reached in 2022, before the Fed began hiking interest rates. MSCI reported: “Office prices have had the biggest decline, falling an average of 35%. An estimated $85.5 billion of debt on commercial property was considered distressed at the end of 2023, with an additional $234.6 billion of potential distress.”
The big question being asked by borrowers – big and small – is who is going to lend to them?
“Refinancing risks are front and center” for owners of properties from office buildings to stores and warehouses, Morgan Stanley analysts including James Egan wrote in a note this past week. “The maturity wall here is front-loaded. So are the associated risks.” The investment bank estimates office and retail property valuations could fall as much as 40% from peak to trough, increasing the risk of defaults.
It is understood that currently, among the lenders, issuers of commercial mortgage-backed securities (CMBS), collateralized loan obligations (CLO), and investor-driven lenders (private credit) are the biggest players, packaging distressed and potentially distressed loans into bundled securities and resold.
The current situation is like when the late Anthony Bourdain, in the movie “The Big Short,” used the example of making fish stew from good fish that is going bad. Investors should be wary of banks that pile into high-yield buckets of distressed securities, thinking that diversification somehow reduces risk.
Can the larger economy manage a reset in commercial real estate to the tune of several hundred billion dollars? Probably, but not without the likelihood of elevating market volatility, as this next wave of debt comes due for refinancing. We must now wonder whether the appetite for these bundled securities dries up just as the issuance of this wave of debt is rapidly coming to market – in vast amounts.
Just as the regional bank blow-off of March 2023 created one of the best buying opportunities in recent years, the coming great commercial real estate reset might well offer the pullback that provides the same opportunity to buy into today’s greatest stocks. Time will tell, but it sure feels like it is setting up again.
All content above represents the opinion of Bryan Perry of Navellier & Associates, Inc.
Also In This Issue
A Look Ahead by Louis Navellier
Most Economic Indicators Tell Me the Fed Should Cut Rates Sooner, Not Later
Income Mail by Bryan Perry
Are Banks Prepared for a Commercial Real Estate Reset?
Growth Mail by Gary Alexander
Presidents’ Day Reality: Big Promises, Few Results
Global Mail by Ivan Martchev
Geopolitics May Start to Move the Markets Again
Sector Spotlight by Jason Bodner
For Market Timing Guidance, Put on Your “Quant Goggles”
View Full Archive
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Bryan Perry
SENIOR DIRECTOR
Bryan Perry is a Senior Director with Navellier Private Client Group, advising and facilitating high net worth investors in the pursuit of their financial goals.
Bryan’s financial services career spanning the past three decades includes over 20 years of wealth management experience with Wall Street firms that include Bear Stearns, Lehman Brothers and Paine Webber, working with both retail and institutional clients. Bryan earned a B.A. in Political Science from Virginia Polytechnic Institute & State University and currently holds a Series 65 license. All content of “Income Mail” represents the opinion of Bryan Perry
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