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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