Karl Marx once said, “History repeats itself: the first time as tragedy, the second time as farce.”

Marx’s assessment of history’s cyclical nature feels strangely appropriate for describing the state of the nation’s regional banking system in early 2024.

Eleven months after the demise of Silicon Valley Bank precipitated several of the largest commercial bank failures in U.S. history, another banking crisis appears to have been narrowly averted earlier this month — but with zero indication that the regional banking system as a whole remains strong enough to withstand a slowly unfolding generational shift around CRE asset values.

New York Community Bank (NYCB), one of the nation’s largest commercial real estate lenders, saw its stock fall 38 percent in one day on Jan. 31, hours after the Queens-based regional bank reported a $252 million loss tied to loans on its office and rent-regulated properties. Also, NYCB’s credit losses in fourth quarter 2023 — in other words, its unrecoverable debts — reached a staggering $552 million, up from $62 million in the third quarter.

By Feb. 6, NYCB’s stock reached an all-time low of $4.20. Whispers abounded that the bank — a 164-year-old institution with 420 branches — faced possible bankruptcy or even a merger. While NYCB staved off any fatal depositor outflows (as of Commercial Observer’s print deadline), the stock had yet to rise above $5 per share more than three weeks since its tumble. The problems at NYCB led to an immediate 6 percent drop in the KBW Regional Banking Index, a composite of 50 midsize lenders.

“What happened at NYCB is not unique: They had to take dramatic write-downs. We’ve seen that there’s not an appetite in the marketplace for rent-stabilized multifamily, and office’s problems have obviously been well documented,” said Lonnie Hendry, chief product officer at Trepp, a CRE data analytics firm.

For a regional bank like NYCB, which doubled its size through an acquisition of Flagstar Bank (and its 395 branches) in 2022, and the headline-grabbing purchase of Signature Bank’s $34 billion deposit base (and $13 billion CRE loan book) last spring, the thought of being at the center of a new banking storm seems odd, if not inconceivable.

“NYCB is a little unique in that they had just moved up in asset size, got over $100 billion [in assets], so there was additional scrutiny from regulators on their portfolio, which forced them to take charge-offs and start accruing higher reserves,” explained Hendry. “It doesn’t negate the fact their portfolio had a heavy concentration of rent-stabilized multi-

family in New York City and office, and, just given the environment for those two asset classes, there’s a potential challenge if you’re a bank who has exposure there.”

Other experts carefully watching the health of NYCB and its regional banking competitors are less enthused with the state of its balance sheet. Carrying $116 billion of assets (i.e. loans), NYCB has only $11.4 billion in cash on hand and $9.1 billion in securities for sale, according to its most recent 8K financial statement. Its $37 billion multifamily housing portfolio includes $18 billion in loans backed by New York City rent-regulated apartments, which have been thrown into disarray since a 2019 state law limited how much landlords can charge for rent on those apartments.

“I’m not surprised they got so much heat. They are really more loaded on commercial real estate than most of the regional banks,” said Tomasz Piskorski, professor of real estate finance at Columbia Business School. “They have very little cash position — cash is less than 1 percent of the assets — so if depositors were to ask them for money, they just don’t have much money to pay. They’d have to liquidate assets at lower values than they carry on the balance sheet.”

Steven Bodakowski, a spokesperson for NYCB, cited the bank’s “strong deposit base and liquidity” and “unified business model” under the larger Flagstar brand when asked about the health of the bank.

“We remain confident in the strength of the bank and believe as the market continues to appreciate the value enhancing actions Flagstar has taken, the share price will rise,” said Bodakowski in a statement.

‘The lurking problem’

What’s scary to economists and CRE professionals is not that a lender like NYCB nearly failed following a quarterly earnings call. Rather, it’s that so many other banks are facing the same existential risk on their balance sheets.

A recent study by Trepp found that some of the nation’s most prominent regional lenders carry CRE loan ratios that exceed their total capital by more than 300 percent: Valley National Bank’s $60.9 billion in assets are dwarfed by a CRE loan concentration ratio of 479 percent; Bank OZK (OZK)’s $34.2 billion in assets carries a CRE loan concentration ratio of 355 percent; and Washington Federal Bank, with $22.6 billion in assets, holds a CRE loan concentration ratio of 363 percent, according to Trepp.

While holding a large amount of CRE exposure isn’t inherently risky, Hendry said that many lenders are sitting on large portfolios of both office and transitional multifamily loans that “could potentially be problematic” if things don’t break right as billions in maturities come due and buildings are revalued through either sales or refinancings.

“The underlying issues of commercial real estate property values [for those two sectors] haven’t abated,” said Hendry. “It’s premature for anyone to say what will happen in the next 90 days, or even 120 days, but the ingredients are there for us to have some more challenges in 2024.”

Eric S. Rosengren, former president of the Federal Reserve Bank of Boston, said that banks with significant exposure to office, multifamily or long-duration assets like Treasurys will likely need to use their capital to support the losses that will be reported over the next several quarters. He added that banks that have this exposure will need to increase their loan/loss reserves this year and next.

“That process can probably be handled through less earnings, and that’s a problem for shareholders, but it won’t be a problem for solvency of the bank,” said Rosengren. “But, for a bank that has large exposures in that area, there’s potential risk that problems are significant enough they’ll have to get a merger partner if they want to avoid failing.”

The number of banks at risk might number into the hundreds if we are to go by Federal Deposit Insurance Corporation (FDIC) data, according to Lawrence J. White, professor of economics at the Stern School of Business at New York University.

The harsh truth is that a large portion of individual and corporate deposits in U.S. banks are uninsured beyond the FDIC limit of $250,000, and the value of commercial real estate loans made by the entire banking system is around 80 percent of its total capitalization.

Of the 4,614 FDIC commercial banks and savings institutions in the U.S., non-CMBS commercial real estate lending stood at $1.8 trillion, compared to a total bank equity capital of $2.2 trillion, according to the FDIC’s banking profile from 2023’s third quarter. (Fourth-quarter data is due to be released in March.)

“On the balance sheet of the entire banking system, not counting CMBS, just the CRE loans themselves make up 80 percent of the overall capital,” said White. “All of the loans won’t incinerate tomorrow, but it’s still a sizable fraction of the overall net worth that makes this a particularly worrisome category.”

White noted that the nation’s 4,166 community bank lenders, which are smaller than regional banks and carry $5 billion (or less) in assets, are most at risk of failure because their aggregate CRE lending is more than twice the level of their net worth.

Total community bank CRE lending stood at $568 billion in the third quarter of 2023, compared to community bank equity capital of $249.6 billion in the same quarter, according to FDIC data.

“To me, that is the lurking problem in the banking system right now,” said White. “All of this is intertwined with 40 percent of deposits that are uninsured. And that makes the system much more fragile than was true 30 years ago, when it was only 20 percent of deposits that were uninsured.

“CRE loans are twice the size of the community bank equity capital,” he emphasized. “If I were at the FDIC or the Federal Reserve or the [Office of the Comptroller of the Currency], I would have trouble sleeping at night.”

Federal Reserve Chairman Jerome Powell appears to be on the same wavelength as this canary in the coal mine. During a Feb. 1 interview with “60 Minutes,” Powell said that smaller lenders and regional lenders are the ones most “challenged” by the decline in values of CRE collateral, while it appears to be “a manageable problem” for the nation’s largest banks.

“Certainly, there will be some banks that have to be closed or merged out of existence because of this,” said Powell. “That will be smaller banks, I suspect, for the most part.”

White added that he is “truly puzzled, maybe even mystified,” that we haven’t seen another regional or community bank go under since First Republic Bank collapsed last May — especially considering the amount of risk attached to CRE across the entire system.

“If you asked me last March would we have gone through 11 months where there would be no new major failures with all the uninsured depositors heading for the exits, I would’ve said, ‘Come on,'” he said.

Confidence game

As the stock price catastrophe at NYCB implies, the risk of bank failures remains an omnipresent reality. And it might turn from threat into an event within the next month due to the expiration of a federal lifeline.

At the outset of last spring’s regional banking crisis — which saw Silvergate Bank, Silicon Valley Bank and Signature Bank all fail within five days — the Federal Reserve and Treasury Department instituted the Bank Term Funding Program (BTFP) on March 15, 2023.

This short-term credit facility essentially allowed banks to exchange collateral — primarily long-duration assets like long-maturity Treasurys and mortgage-backed securities — for Federal Reserve loans for up to one year, using the par value rather than the market value of the collateral. Primarily a liquidity measure, the BTFP ensured that even if a security held by a bank went down in price, it would still be financed at par even though the market value of the securities was well below par because of the increase in interest rates.

“It basically allowed banks to access additional funding to keep themselves solvent to prevent taking immediate write-down on held-to-maturity exposure,” explained Trepp’s Hendry. “It was a lifeline to stabilize the banking sector.”

Within three weeks of opening this emergency discount window, the U.S. banking system borrowed $79 billion against the BTFP, including $13.8 billion borrowed by First Republic Bank alone (prior to its untimely May 2023 demise), according to S&P Global. By Aug. 2, borrowings from the BTFP rose to $105.6 billion from 21 U.S. banks. And, as late as Feb. 14, 2024, the U.S. banking system has borrowed a cumulative $164.7 billion from the Fed through this program.

Columbia’s Piskorski defined the BTFP as “a psychological game,” and said it’s only there to play a palliative role in maintaining faith in the banking system.

“The BTFP was part of confidence-building measures. It’s not how much people borrow from it. Rather, it’s to signal: ‘We are there to stabilize markets,’ ” he explained. “If they withdraw that funding, it will signal to the market that maybe the Fed is OK with some regional banks failing, so long as it doesn’t spill over to the rest of the system.”

A withdrawal of the BTFP is written into the legislation. The program was never set up to be a permanent discount window to exchange troubled loans — the Fed placed a strict one-year time limit on the BTFP, and the central bank has signaled it intends to follow through and wind down the program on March 11.

What happens next is anybody’s guess.

Trepp’s Hendry said that it’s “probably imprudent” for the Fed to cancel the program at this point, considering that the underlying fundamentals of commercial real estate — higher interest rates, entrenched work-from-home practices, the multifamily sector seeing 1.1 million in new deliveries in 2023 and 2024 — are likely to apply significant downward pressure on property valuations that serve as collateral on CRE loans.

He emphasized that in almost every instance, a CRE loan refinanced today is refinancing into a higher interest rate than what the current loan carries, which puts downward pressure on valuations of any property serving as collateral on the loan.

“Cost of capital is up significantly, occupancy is down, expenses are up, cap rates are up,” Hendry said. “All of those things don’t bode well for a growing base of property value increases. In fact, it’s actually the exact opposite of that.”

But Rosengren, formerly of the Boston Fed, isn’t too worried about the expiration of the BTFP, as it was primarily focused on helping banks with collateral well below par, and many banks reduced their exposure when long rates declined.

“The fact is, the program is expiring in March, and, as long as there’s no liquidity crisis in the banking system, it’s not much of an issue,” he said. “When the Fed decides to eventually lower interest rates, the market value of the securities should continue to improve.”

Try to unwind

So what, if any, options do banks have once the Fed’s honey jar evaporates, leaving a market still jittery toward commercial real estate lending?

One avenue that more banks are expected to be active in throughout 2024 is in the loan sales business. Fourth-quarter 2023 earnings reports indicate that many large lenders built up significant loan loss reserves that could conceivably allow them to take initial losses on CRE assets. Now that those reserves have accumulated, the banks can begin to trade loans at market-clearing prices.

Loan sales specialists who spoke to CO on condition of anonymity said that several banks have communicated to them that management or regulators have said they should hold off originating new CRE loans until the banks’ overall exposure to the industry is reduced in turn through sales.

Bank lending volume for CRE fell 49 percent annually in the third quarter of 2023, to $164 billion, according to GlobeSt. The fear is that as more sponsors have trouble refinancing and buildings continue to decline in value, borrowers will choose to hand back their keys to the banks, rather than servicing the loans.

“Banks are not set up to own real estate, particularly office, which is very capital intensive,” said one loan sales specialist.

Direct loans sales are the first and likely easiest avenue: a bank hires a broker to sell a portfolio of loans or even a single CRE loan at a market-clearing price. Another option is a short sale: a borrower stops making payments to the lender and the value on the property is now worth less than the amount of the loan. In that case, the borrower then hires a broker to sell the property and the lender agrees to take the proceeds from the sale, understanding they’ll get less than what they were initially promised.

In terms of the worst-case scenarios there’s a liquidated REO, in which a bank forecloses on a property and takes ownership after a borrower stops making payments. This is not ideal. But there’s also a discounted payoff, or debt forgiveness modification. That’s when a lender takes a haircut and accepts whatever the borrower can pay on an underwater loan, writing off the loss on its books and starting from scratch.

However, in all of these cases, the key is property transactions turning into legitimate price discovery, a formula that has thus far proved maddeningly elusive in a universe with benchmark interest rates at 5.25 percent. “It’s not a question whether there is capital out there. There is. The question comes down to pricing,” said the specialist.

This lack of price discovery is particularly worrisome to banks in this vulnerable hour.

Rob Gilman, a partner and an accountant at Anchin, a real estate advisory group, said that no one knows what banks have written their underwater CRE loans down to, especially as refinancings have occurred and borrowers have been forced to “extend and pretend” until 2025 or later. As banks have been forced to sock in reserve capital to make up for these CRE losses, a lending slowdown cloud has fallen across the industry.

“The more they mark down the debt, the worse their financials look,” explained Gilman. “Their equity goes down, and they need to put a higher amount of liquidity back into the banks — so they’re not making as many loans.”

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