Wednesday, July 13, 2016

The Biggest US Bank Risk

Posted on July 12, 2016 by Yves Smith

ZIRP and a flat yield curve are leading to all sorts of imprudent behavior. The latest, flagged by the Office of the Comptroller of the Currency, is profligate commercial real estate lending. The OCC warned that the rise in risky real estate lending is far more dangerous than subprime auto loans, which have been a pet worry of analysts for some time.

The reason commercial real estate lending is so hazardous is banks routinely lose more than 100% of the loan when the projects go bad. Not only do all the loan proceeds go “poof,” but when they foreclose, they are typically stuck with a completed or partially completed project. If it is completely and not fundamentally unsound (say an office building in an up-and-coming area), it’s possible to get a partial recovery. But for a white elephant or a half-finished building, the bank will need to clear the property, which means throwing good money after bad, and is stuck with land plus perhaps some general previous owner improvements (if a subdivision, getting zoning and running in plumbing; in an urban setting, doing the assemblage).

Moreover, commercial properties are idiosyncratic, so liquidating them is also inherently time-consuming.

Finance-savvy readers will notice the signs of froth in the article, such as the far-too-borrower-permissive terms, like interest only loans (!!!) and the fact that the commercial mortgage backed securities market, the normal exit for bank loan originations, was looking toppy a couple of years ago and has recently dried up. From the Financial Times:

A top US regulator has sounded a new alert over banks’ commercial real estate lending, adding to concerns that bubbles may be forming in parts of the country’s property market.

Thomas Curry, comptroller of the currency, used the watchdog’s twice-yearly report on financial risks published on Monday to warn about looser underwriting standards and concentrations in banks’ CRE portfolios….

CRE loans originated by banks in the first quarter leapt by 44 per cent from the same period in 2015, according to Morgan Stanley. Banks’ share of CRE originations has risen from just over a third in 2014 to more than half in the first quarter of 2016 — a record…

“Our exams found looser underwriting standards with less-restrictive covenants, extended maturities, longer interest-only periods, limited guarantor requirements, and deficient-stress testing practices.”…

The impact of low oil prices and the rise of online marketplace lending were “not at the same level of risk”, Mr Curry added.

Banks have pushed into CRE as other lenders — notably capital market investors — have retreated from the market. Issuance of commercial mortgage-backed securities has dropped to four-year lows.

The Financial Times story also discusses a Morgan Stanley analyst report, issued the same day, that argued the party must continue, that if regulators intervened, commercial real estate prices would decline. Gee, to preserve market values, officials must allow likely-to-be-bad loans to be made? How well did that work out in the runup to the financial crisis?

The report pointed out that lending to retail properties was at risk. Given that the US has been overinvested in retail space for decades (even in the early 1990s, selling space per capita was way out of line with other advanced economies, and only continued to grow from there) and bricks-and-mortar retailers have been hit hard by competition from the Internet, it does not take much in the way of powers of observation to discern that lending to retailers is not a smart place to be, unless there is a solid case for a particular property (real estate is always and ever local).

Morgan Stanley also indicated, somewhat contradicting its “regulator back off” pitch, that big banks were already becoming more stringent. But not their smaller brethren:

While two-fifths of banks with more than $20bn in assets said lending standards for apartment blocks had “tightened somewhat”, for instance, only one-fifth of smaller banks said they had…

Morgan Stanley identified 25 institutions that “may face pressure from regulators given rapid growth and high concentrations”. This “could lead smaller banks to pull back on CRE lending, raise equity and/or drive M&A”, said its report

Mind you, these warnings are not new. Wolf Richter pointed out that commercial real estate had started to stall out in the first quarter, which makes it look like Morgan Stanley may be trying to finger regulators for a downturn that was baked in. From a May post:

Commercial real estate has experienced a dizzying price boom since the Financial Crisis. It goes in cycles. Rising rents and soaring property prices along with cheap credit drive up construction, which takes years from planning to completion, and suddenly all this capacity is coming on the market just as demand begins to sag…. That’s when the cycle turns south.

On a nationwide basis, the boom has been majestic. But now, after posting “nearly double-digit gains for each of the past few years,” according to Green Street’s just released Commercial Property Price Index (CPPI) report, “property appreciation has come to a halt.”

The index was essentially unchanged in April from March – actually microscopically down for the third month in a row, after having soared 23% past its prior crazy-bubble peak of 2007.

While there is “no evidence” that prices of Class A properties have fallen, prices of Class B properties “are probably lower than they were at the start of this year,” the report explained.


It’s typical in a downturn in a credit cycle for the weaker borrowers to take a hit first. So the weakness in B properties is consistent with an inflection point.

Keep in mind if that if the OCC’s fears are correct and banks eventually have lots of bad loans on their hands, the result would be a painful regional or national downturn and not a global financial train wreck, since derivatives are not amplifying the exposure to a large multiple of the real-economy lending. But with the US economy showing underwhelming growth and a lot of the rest of the world under deflationary pressures and facing the risk of Brexit-induced damage,even a mere moderately bad problem will have much more serious impact than if they economy was in adequate health.

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