economy and politics

ANALYSIS | Three big risks that have the banking industry in suspense

( Business) — It’s been a month since Silicon Valley Bank collapsed, setting off alarm bells in the halls of global finance.

The initial panic has turned into a more tolerable state of tension. We can all take a deep breath, knowing that our money is safe and that banks have the tools they need, courtesy of the US federal government, to weather the storm.

“We went from flashing red lights to flashing yellow lights,” Mike Mayo, a senior banking analyst at Wells Fargo, told me recently. “I think it is time for hyper-awareness and vigilance of anything else” which could further undermine trust.

Regulators and investors are certainly on high alert. And they don’t have to look too far to find things to worry about.

Here’s what happened: SVB’s red flags—its blistering growth, lax risk management, and overreliance on uninsured deposits, among other things—should have been easy to spot before it collapsed. Now everyone is looking for the next risk hiding in plain sight.

A consensus is forming around three key areas that analysts fear could create a systemic problem: commercial real estate, underwater bond portfolios and the industry with the most metallic moniker in history, shadow banks.

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The cost of the remote work era

Commercial real estate (offices, apartment complexes, warehouses, and shopping malls) has been under considerable pressure due to remote work. Commercial property valuations could drop roughly 20 to 25% this year, according to Rich Hill, director of real estate strategy at Cohen & Steers. For offices, the falls could be even more pronounced, exceeding 30%.

Office properties are a particularly trouble spot here. The average office occupancy in the United States still is less than half of March 2020 levelsaccording to data from security provider Kastle.

About $270 billion in commercial real estate loans held by banks will mature in 2023. Almost a third of that, $80 billion, is for office properties.

The signs of tension are increasing. The proportion of commercial office mortgages where borrowers are behind on payments is rising, according to Trepp, which provides data on commercial real estate, and high-profile defaults are making headlines. Earlier this year, a landlord owned by asset manager PIMCO defaulted on nearly $2 billion in debt for seven office buildings in San Francisco, New York, Boston and Jersey City, New Jersey.

This is a potential problem for banks, given their extensive credit to the sector. Goldman Sachs estimates that 55% of US office loans are on bank balance sheets. Regional and community banks, already under pressure after the failures of Silicon Valley Bank and Signature Bank in March, account for 23% of the total.

“I’m more worried than I’ve been in a long time,” said Matt Anderson, Trepp’s CEO.

unrealized losses

Back when interest rates were close to zero, US banks gobbled up long-term Treasury bonds and mortgage-backed securities. (And typically that’s a safe move if you make sure you hedge against the risk of those assets losing value, which SVB didn’t.)

But as the Federal Reserve and other central banks have raised interest rates aggressively, the value of those bonds has eroded.

US banks now have an estimated $620 billion of unrealized losses: their assets are now worth less than what they paid for them, making it a problem if the bank is forced to sell those assets in a crisis (like, say, a bank run).

That $620 billion is a conservative estimate, experts say. And it’s unclear where those unrealized losses hang out, whether they’re spread across the industry or concentrated among certain types of lenders.

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benches in the shade

As we discussed here last week, shadow banking refers to financial institutions that lend money (such as a bank) but do not accept customer deposits.

They are a large and diverse cast that includes investment banks, hedge funds, insurance companies, private equity funds, all sorts of Wall Street power players.

The threatening nickname can be interpreted broadly. They’re in the shadows because they’re unregulated, for sure. But are they shady? Yes and no. Hedge funds and private equity types get a bad rap that is sometimes deserved, but they also provide financing to young companies that can’t get the time of day from regular banks.

The key to remember is that they are not subject to the same strict rules as banks, which means they can take on more risk. They also don’t get the benefit of government backing if the wheels start to come off.

But bank-banks and non-banks overlap in all sorts of real and perceived ways, and when trust erodes on either side, that creates the potential for panic to spread.

The mere perception that the banking sector might be connected to a struggling non-bank entity could trigger a broader financial crisis.

Conclusion

One of the many haunting reminders to emerge from the SVB debacle is that banks are large, sprawling operations run by human beings, serving other human beings, none of whom are entirely rational. That may sound simplistic, but it’s especially relevant for an industry that relies solely on trust like banking.

“This is not an industry without flaws,” Mayo says. “This is an industry that tries to minimize losses from errors, just like any other industry… The reality is that there will be errors.”

He added: “This is a time when banks can reinforce the importance of their most important asset, which is trust.”

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