The best thing for all of us, for the world, would be for this article not to exist. We wrote back in July about the issues banks face in bond losses as the FED continues to raise rates. Many of the largest banks face serious issues related to future capital needs as paper losses mount. Strange accounting quirks keep these losses from straining the capital requirements of banks for now. These concerns are somewhat academic for the largest banks but pose some unknown level of risk once you get out of the ten largest. Collectively the risk in the smaller banks may be larger, but also an academic exercise until they have an immediate need for capital.
So far, so good because the banks are just ignoring or justifying the accounting quirks. Only newer dark clouds on the economic horizon could cause the FED to tighten capital requirements on banks, right! A move by the FED to require banks to hold more capital is a signal that they know the economy is not in as good a shape as advertised.
More Risks Are Evolving
In an article by David Benoit on July 28, 2023, he explained banks are heading into a period of real uncertainty. When banks fall on hard times such as in 2008, they must draw on reserves to stay solvent. Already hit will paper losses on bonds, if loan losses were to hit at the same time the resulting losses could be catastrophic. The FED raised interest rates last week and this puts even more pressure on bond and loan losses, and future capital needs.
On July 27, 2023, the FED announced that it was proposing increased capital requirements for all banks, but the most in the largest banks. The banks will bark loudly but I think they have little room to maneuver. But history tells us these are hollow arguments, and it is time to prepare for difficult challenges in the economy.
What is the concern?
Commercial Real Estate
The COVID restrictions period ushered in a new era of working from home and this does not seem to be ending well. If employers were expecting employees to return to the office, it would not happen. Workers seem willing to forego the benefits of corporate culture, raises, and promotions for the convenience of working from home. This is leaving companies with millions of square feet of office space that is no longer needed. When leases come up for renewal, they will negotiate for much less space, leaving landlords with lower rents.
The double whammy is that loans on much of the commercial property is coming up for renewal at roughly the same time as interest rates rise and workers opt to stay at home. Many companies will reduce their rental space by as much as 50%. In major cities like Los Angeles, Philadelphia, San Francisco, and New York City vacancies are already starting to mount.
Rising crime in many major cities will also put pressure on companies to move, abandoning 100% of their leases. Lower real estate values mean lower tax revenues, a whole different kettle of fish. Many of our major cities face declining population among taxpayers and a rise in population from non-taxpayers. This is a formula for financial failures much like Chicago, Detroit, Seattle, and New York. One of the latest cities to “hit the skids” is San Francisco where rising crime, taxes, and woke politics are forcing merchants and individuals to seek safer and more financially workable locations. Much of San Francisco has become a ghost town with merchants closing and no replacements on the horizon. San Francisco has been a tourist mecca for decades, but no more. These are self-inflicted wounds that can be fixed with different leadership.
Facing lower rental income and higher loan payments, many landlords will simply default and leave the banks to own and manage the property at a loss. Even if the banks resell the property there will be losses, big losses. With fewer rentals and lower income, the value of commercial real estate plummets. This will place further pressure on the banks and property owners to reduce loans or offer more collateral.
Real estate analysts at Costar estimate that there is $44.6 billion in office loans that will come due before the end of 2024. Of this total they estimate that the banks are already dealing with $12.6 billion in troubled situations. Over the past five years brokers have only been able to resell $1.9 billion of these troubled properties. Many of these loans involve the markets through Mortgage Back Securities, and if this sounds familiar just remember back to 2008.
FED Actions and Reactions
The FED is doing only what its powers give it the ability to do and it cannot forestall the pain forever. They must slow inflation by raising rates and another of their tools is to shore up the banks in preparation for the onslaught of losses. They can force banks to stop stock buybacks, restrict bonuses, curb dividend increases, suspend voluntary acquisitions, and most importantly building reserves from current earnings. So far, they have avoided raising reserve requirements which would slam the breaks on the economy in unpredictable ways, but it may be coming to halt lending completely.
Other Concerns
The consumer has been amazingly resilient over the past few years and their spending has continued unabated to now. But COVID money is starting to run out and for many families spending must slow or stop. We see this in consumer debt as it reaches record levels, but that is a discussion for another day.
There is another looming issue that is bubbling up and will have a devastating effect on both consumers and banks. The push for unwanted electric vehicles is unsustainable financially and environmentally. When these forces come together there will be some dramatic failures that are well below the surface for now. But the music will stop at the doorsteps of the banks either from consumers or corporations.
The FED’s proposed shift is dramatic, and it needs to be. Is it dramatic enough for the banks to withstand bond losses, commercial real estate revaluing, and consumer issues? Time will tell!
Resources Used in This Article
Annual Reports of Banks, Banks Cited in this article as of December 31, 2022, and Quarterly reports of select banks as needed.
BankFind Suite, banks.data.fdic.gov, various searches for banks cited and others researched.
Banks Are Halting Stock Buybacks Again as New Capital Rules Loom, by David Benoit, The Wall Street Journal, July 28, 2023.
Bank Runs Trash Long-Held Assumption on Deposits, By Jonathan Weil and Peter Rudegeair, The Wall Street Journal, May 22, 2023.
Call Reports, Federal Financial Institutions Examination Council, March 31, 2023.
Commercial real estate woes weigh on New York City recovery, NY Fed says, by Michael S. Derby, reuters.com, April 13, 2023.
Consumer debt hits record $16.9 trillion as delinquencies also rise, by Jeff Cox, CNBC.com, February 16, 2023.
Don’t Look Up – Why A Commercial Real Estate Crash Might Be Streaking Toward Us, by Jim Scheinberg, forbes.com, Forbes, July 26, 2023.
Drug dealing, defecation: SF street causing ‘chaos’ for homeowners, ABC7, youtube.com, July 2023.
It’s Time to Accept That Higher Mortgage Rates Are Here to Stay, by Holden Lewis, nerdwallet.com, June 28, 2023.
Owners of Distressed Office Properties Struggle to Find Buyers, by Mark Heschmeyer, costar.com, July 5, 2023.
Recharged Bond Rout Unnerves Investors, by Sam Goldfarb, The Wall Street Journal, July 9, 2023.
San Francisco Faces Major Store Closures, NBC News, youtube.com, July 2023.
Understanding Bond Prices and Yields, by Barry Nielson, Investopedia.com, May 24, 2023.
U.S. Banks are sitting on $1.7 trillion in unrealized losses, research says. That’s not a problem—until it is, by Will Daniel , yahoo Finance, March 23, 2023.
