A commercial real estate crisis is hiding in plain sight

In a May 15 testimony to Congress, Federal Reserve Vice Chairman for Supervision Michael Barr states, “Overall, the banking system remains sound and resilient.”

“The banking sector as a whole should be prepared to absorb loan losses that may materialize and continue fulfilling its vital role providing credit to households and businesses,” Barr said. 

A closer look at the data suggests that a widely anticipated wave of commercial real estate loan defaults could spark enough bank failures to overwhelm the federal deposit insurance safety net. Commercial real estate loan concentrations and banks’ diminished capital loss-absorbing capacity have primed the system for a sequel to the 1980s Savings and Loan Crisis.

According to year-end 2023 regulatory data, the banking system had $2.1 trillion in total regulatory capital to provide loss-supporting capacity for about $23.7 trillion in reported assets. Many bank assets have fixed interest rates and long maturities and were purchased before the Federal Reserve increased interest rates.

I estimate that banks’ fixed-rate loans, leases and securities have $1.07 trillion in unrealized market value losses as of year-end 2023, when the 10-year Treasury yield was about 3.9 percent. Today, with 10-year Treasury rates over 4.4 percent, banks’ market-to-market losses are probably closer to $1.4 trillion. 

Regardless, at least half of the banking system’s Tier 1 capital loss-absorbing capacity has already been consumed by unrealized interest rate losses on its assets. Many banks in the system are ill-prepared to absorb additional losses from commercial real estate loan defaults.

According to December regulatory data, the anticipated wave of commercial real estate loan defaults had not yet hit the banking system. There is some evidence of bank “extend and pretend” behavior in some commercial real estate loan categories, primarily non-owner occupied, nonfarm, nonresidential loans made by some large banks and “other acquisition, development and construction” loans made by many smaller banks, but no evidence of widespread commercial real estate loan defaults.

December 2023 banking system commercial real estate loan concentrations and loan performance are nearly identical to the banking systems’ commercial real estate profile in December 2019, long before COVID lockdowns accelerated the trend toward remote work by emptying office buildings and shopping centers. 

The demand for some commercial properties also suffers from post-COVID inflated commuting and out-of-home meal costs in addition to actual and perceived spikes in urban crime caused by criminal justice “reforms” championed by liberal district attorneys and some elected officials.

Higher interest rates impact both the demand for and the ability to refinance bank commercial real estate loans. Today, interest rates are much higher than when many existing bank commercial real estate loans were struck. 

Commercial property cash flows may not justify refinancing some properties at new higher interest rates since banks typically require minimum interest coverage ratios to qualify loans. In some cases, banks and borrowers may choose to modify loan terms in a troubled debt restructuring, but there is widespread anticipation that, in many cases, default will be the preferable option.

Bank regulators measure bank commercial real estate loan concentration as the ratio of total bank commercial real estate loans to the sum of a bank’s Tier 1 regulatory capital plus its provisions for loan losses. Regulatory guidance identifies a commercial real estate concentration ratio above 3 as potentially excessive and deserving of additional examiner scrutiny. 

Using this regulatory measure, as of year-end 2023, there were 1,763 banks with commercial real estate concentration ratios greater than 3, including 274 with concentrations greater than 5 and 77 with concentrations over 6. Most of these are at smaller banks, but two banks have assets over $50 billion with supervisory commercial real estate concentration ratios above 5. 

A more realistic measure of a bank’s ability to sustain commercial real estate losses and remain viable is the ratio of a bank’s total commercial real estate loans to the sum of its Tier 1 capital adjusted for unrecognized interest rate losses plus its provision for loan losses. Recent bank failures like Silicon Valley Bank, First Republic Bank and Signature Bank show that, regardless of reported regulatory capital adequacy, a bank risks depositor runs and failure when it is insolvent or close to insolvent on a market-value basis. 

Using market value Tier 1 capital estimates in place of regulatory Tier 1 capital, as of year-end 2023, the number of banks with a commercial real estate concentration ratio greater than 3 swells to 2,667. These 2,667 banks manage 27 percent of all banking system’s total assets and include 231 banks with 0 or negative market value adjusted Tier 1 capital. 

My estimates suggest that commercial real estate loan losses as small as 10 percent could render over 700 banks holding more than 6.5 percent of all banking system assets market-value insolvent. Larger commercial real estate loan losses would inflict greater carnage on the banking system.

Should the widely anticipated wave of bank commercial real estate loan defaults materialize, it could easily overwhelm the federal deposit insurance safety net. The FDIC deposit insurance fund balance of $121.8 billion is equivalent to only 0.51 percent of the banking system’s total assets. 

The FDIC cannot manage hundreds of simultaneous bank failures. Losses will compound and economic growth will lag as zombie banks continue to operate while the FDIC spreads bank resolutions out over the course of years, as happened following the Great Financial Crisis, and as the Federal Savings and Loan Insurance Corporation did during the 1980s Savings and Loan Crisis. 

Commercial real estate concentrations and unrecognized bank interest rate losses have created systemic risk in the banking system, and it is hiding in plain sight.

Paul Kupiec is an economist and senior fellow at the American Enterprise Institute.