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SEC Doubles Down On Bank CRE Loan Scrutiny

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Commercial real estate got some indirect bad news.

The Securities and Exchange Commission sent letter exchanges to several community or regional banks about potential exposure to CRE loans, as the Wall Street Journal reported.

The agency contacted Alerus Financial and the holding companies behind Mid Penn Bank, Ohio Valley Bank and MainStreet Bank. The letters were “to request more clarity in their disclosures around the potential consequences from the failures of First Republic Bank, Silicon Valley Bank and Signature Bank.”

The three banks were closed and put into receivership by the Federal Deposit Insurance Corporation. Certain long-term bond assets that the banks held lost a lot of value as the Federal Reserve drove interest up in an attempt to curb inflation. When interest rates rise, bond values at previous lower interest rates lose value. These bonds were classified by the banks as held-to-maturity, meaning they could be treated as keeping their face value. But concerned depositors pulled large amounts of money out of the banks. That forced the institutions to sell bonds, which then were marked to market, losing liquidity and pushing the banks toward insolvency.

CRE loans aren’t the same as bonds, but there are two ways they could lose value. One is that increased interest rates could put borrowers with loans coming to maturity into a position where they can’t get refinancing. The lending bank would at least have to modify the loan, which could affect depositor trust and willingness to leave their deposits in place. Or the borrower could outright default.

The other way they could suddenly lose value is if the valuation of the property dropped — something happening broadly across all asset types, as GlobeSt.com has reported. That could leave the loan underwater, increasing risk and leaving depositors concerned and, again, possibly pulling out money and threatening the bank’s liquidity and potentially solvency.

Small, mid-size, and regional banks were the originators of many of the existing CRE loans. Unlike consumer mortgages, the banks don’t sell off the loans, leaving them holding all the risk.

“The SEC is worried that some of the banks may not be disclosing as much of their risk or exposure as they should to their investors,” Kenneth Chin, a partner at law firm Kramer Levin Naftalis & Frankel, told the Journal.

The SEC asked the banks to provide a more specific breakdown of CRE loan portfolios by property type, geography, and other factors.

Although the SEC has only made direct requests of these banks, the thousands of other institutions could see this as a pressure they too could face. Banks might further restrict their lending activity in 2024, increasing scrutiny and tightening underwriting standards, like loan-to-value ratios, even more than has previously happened.

 

Source:  GlobeSt.

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The Nightmare Scenario for CRE Bank Loans

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A lot of discussion in business and economic circles is around whether 2024 will bring a soft landing or some degree of recession. The optimists have been out in force for some time and are expecting a Federal Reserve rate cut as soon as the first quarter of next year.

But there are still those who think a recession could happen and that victory is far from clear. If that proves to be true, Yale School of Management’s Professor of Finance and Management Andrew Metrick says to prepare for some serious trouble for commercial real estate and the banks that hold the loans.

“Historically, for every one percentage point increase in the policy rate from the Fed, banks take 1% hits to their capital over the next eight quarters,” Metrick said in an interview with Yale Insights. From the zero-interest rate to the current baseline federal funds rate range of 5.25% to 5.50% has been a large and rapid leap. “If banks lose 5% of their capital, there are going to be a lot of banks in trouble.”

“If we manage to avoid a recession and get a soft landing, the banks will recover,” Metrick says. “Past commercial real estate downturns have been slow moving things,” he explained. “We spent 10 years after the global financial crisis working out a whole lot of problems.”

At issue is the deep intertwining of banks and commercial real estate. As Metrick notes, the banking system holds about $3 trillion in CRE loans on their book sheets, $2 trillion of which is held outside the largest 25 financial institutions. To date, the loans have performed because their interest rates have been low. Refinancing is drastically changing that.

If a soft landing skips and slides into a recession, the processing of CRE loans would kick into high gear because banks don’t typically sell them on as they do with residential mortgages. Under a 2016 change in accounting standards called Current Expected Capital Losses (CECL), “banks are supposed to take seriously what they think the probability is of something paying off in the future, even if it’s current,” Metrick says.

His “nightmare scenario” starts with banks as yet having to provision adequately for potential losses. In a recession, banks are even more reluctant to lend into commercial real estate than they have been. Many loans don’t get refinanced, and some bank somewhere becomes the “Silicon Valley Bank of commercial real estate” that suddenly fails. Congress investigates and finds that the bank not only failed to have reserved enough, but also didn’t warn shareholders.

“That next quarter, every accountant in the world is going to tell their banks, ‘I’m not going to be the one blamed if you fail.’ They’re going to get very tough on CECL, and what looked like a slow-moving downturn suddenly crystallizes as an expected value disaster that everybody has to put in their balance sheets at the same time,” Metrick says.

Many banks, maybe hundreds, now become insolvent, creating a wave of closures not seen since the very worst of the Global Financial Crisis.

“Not to leave you super scared, but you should be a little scared because I’m a little scared,” he says.

 

Source:  GlobeSt.

 

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The Odds Are Stacked Against Maturities Refinancing

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Almost any problem can be solved if there’s a realistic plan and the necessary materials are at hand. But miss what you need for the repair and there’s only so far that you can go. That’s a problem facing commercial real estate right now.

There is an “historic volume of mortgage maturities,” as a recent Trepp analysis of Federal Reserve Flow of Funds data showed: $2.78 trillion in commercial loans coming due by 2027.

But will there be enough money to keep the bulk out of trouble? Up until Wednesday, the 10-year yields were moving tentatively toward 5% and have been at levels not seen since 2007. The higher Treasury yields go, the harder it is to argue for riskier investments without a lot of extra return. Shorter-term Treasury yields are even higher.

Even with a slight retreat of the 10-year yield with the Fed’s hold on interest rates and Treasury slowing expansion of planned new bond issuance, there is still abundant safety at respectable returns that becomes difficult to compete with. CRE property valuations have plummeted, with the Fed saying that after the reductions they were still elevated beyond where they should be.

Too many of the maturing loans were granted under easy money conditions and bigger amounts of leverage than are typically available at the present. Deals that need refinancing often make no financial sense because of the amount of capital needed to get new financing is prohibitive.

That is why the news on reduced funding for CRE is worrisome. Third quarter private real estate fundraising of $18.2 billion plummeted by 71% compared to the $63.4 billion of Q2, according to Preqin dataquoted by Bloomberg. Global property transactions fell from $31.9 billion in the second quarter to $26.9 billion in the third.

As the Wall Street Journal noted, CRE lending is at “historically low levels.”

“There is liquidity available,” James Muhlfeld, managing director at Eastdil Secured, told the Journal. “But it’s likely going to be more expensive, with lower leverage and with a different lender.”

All this raises the question of which projects will be able to afford refinancing — and if they can’t, who will be left holding the bag for the mortgages on those properties.

 

Source:  GlobeSt.

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Banks Expect To Tighten Standards For CRE Loans Even More

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A new Federal Reserve report noted that banks continue to get nervous overall and in particular about commercial real estate.

“Regarding loans to businesses, survey respondents reported, on balance, tighter standards and weaker demand for commercial and industrial (C&I) loans to firms of all sizes over the second quarter,” the report said. “Meanwhile, banks reported tighter standards and weaker demand for all commercial real estate (CRE) loan categories.”

The reactions to CRE lending was similar levels of tightening by large banks and others.

The July Senior Loan Officer Opinion Survey on Bank Lending Practices, or SLOOS, got responses from 66 domestic banks and 19 U.S. branches and agencies of foreign banks. Surveys went out on June 15, 2023, and were due back June 30, so all the data is more than a month old. It may be that conditions aren’t changing quickly enough to reduce the information’s meaning.

That said, according to the Federal Deposit Insurance Corporation (FDIC), as of the first quarter of 2023, there were 4,672 FDIC-insured institutions and 3,006 FDIC-supervised, so even though a concentration of the largest banks responding to the Fed’s survey might well be descriptive of that segment, the remainder isn’t nearly large enough for a comprehensive look at the banking industry.

The survey included two special sets of questions. One was about current lending standards compared to the midpoint of a range they have been in since 2005. The other question was bank expectations for changes in their standards in the second half of the year and the reasons for any change.

In the second quarter, “major net shares of banks” said they had tightened their standards on all categories of CRE loans. The same degrees of tightening were reported by large banks and other banks, though, again, without a representative sample, it’s impossible to say whether a majority of all banks were doing so.

Additionally, banks were largely reporting that there was weaker demand for all CRE loan categories. This was more pronounced in banks that were not the largest. Foreign-based banks reported similar responses on both questions.

According to the sample, standards tightening isn’t over. Major net shares of banks said they expect to tighten standards on construction and land development loans as well as on nonfarm, non-residential loans.

A moderate net share of banks said they would tighten standards on all residential real estate loan categories, including those that are GSE-eligible.

Also, the number of FDIC-insured and -supervised institutions in the first quarter of 2022 were 4,796 and 3,100 respectively. In the first quarter of 2021, there were 4,978 and 3,209. And in the first quarter of 2020, 5,116 and 3,303. While not a survey, the progression offers a partial different view of how the industry might be doing.

 

Source: GlobeSt.

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