The $1.5 trillion ‘property iceberg’ that has set off alarm bells

With a $US1 trillion ($1.5 trillion) wall of commercial real estate loans scheduled to mature over this year and next, the extent of the losses, and their impact on the banking sector, should progressively become clearer.

Anecdotally, based on a relatively small sample size of transactions, office properties in major cities have been sold for as much as 50 per cent of their previous valuations.

Donald Trump’s lawyers pointed to the distressed state of the market recently when they told a New York judge that he would have to raise capital “under exigent circumstances” if he had to hand over the $US454 million of penalties (plus interest) in his civil fraud case in full ahead of his appeal of the judgement.

New York’s attorney-general, Letitia James, has made it clear she will seize Trump properties if he doesn’t pay the penalties or post a bond and specifically mentioned one of his “trophy” assets, 40 Wall Street. That building was valued at $US540 million in 2015. Bloomberg recently valued it at only $US270 million.

If the value of a trophy asset in New York has fallen by anything remotely close to that much – and it could be even worse in a forced and rushed sale – heaven help the owners and financiers of second-tier properties.

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The $US1.05 billion than Mnuchin and his co-investors have stumped up for New York Community probably averts, or at least defers, what was fast developing into a crisis for that bank that could have spilled over into a second wave of stress for the regional and small US banks that, while accounting for only around a third of the US banking system’s assets, provide more than two-thirds of the system’s commercial real estate funding.

The first wave came last year when Silicon Valley Bank became the largest US bank to fail since the 2008 financial crisis. Its distress sent shockwaves through the smaller bank sector, with the Signature, Silvergate and First Republic banks falling over soon after.

Then, of course, with depositors in banks perceived as risky cashing out as fast as they could, Credit Suisse was forced into a merger, on distressed terms, with arch rival UBS.

Whether the commercial real estate problems exposed within New York Community have the potential to spread similar contagion won’t be clear until after the event, if indeed there were an event.

The problems New York Community has experienced were exposed after it, ironically, acquired assets from the detritus of Signature bank, which took its asset base above the $US100 billion level that attracts more intense regulatory scrutiny and tougher capital and liquidity requirements.

The big US banks are regulated more stringently, and have significantly tougher regulatory capital and liquidity requirements, than their smaller counterparts.

They were supposed to be exposed to even more onerous rules as the Federal Reserve Board implements the final Basel III requirements formulated by the Basle Committee, the global banking standards-setter.

There has been a fierce backlash from the big US banks against what the Fed was proposing, including a television advertising campaign and threats to sue the Fed, because it would have meant a steep increase in the amounts of capital the biggest bank had to hold.

They would also have to regard some customer deposits differently from others – some depositors, particularly large ones, are more likely to yank their funds more quickly than others if the bank comes under pressure – which would force the banks to hold more and higher quality liquidity.

An issue in the Silicon Valley “run” was that it was forced to sell bonds, valued at face value because they were classed as “held-to-maturity,” at considerable losses.

The Fed planned to change the approach to dealing with those bonds, which could have forced the banks to mark their value to market (as Australian banks do) and therefore hold more capital against them.

Addressing the US Congress in his semi-annual testimony on monetary policy on Wednesday, the Fed chair, Jerome Powell, effectively said the Fed has crumbled in the face of the banks’ opposition.

He said he expected there to be “broad and material” changes to the proposed reforms and conceded, as the banks have argued, that there were concerns that the proposals could increase risks to the system and undermine competition.

The big banks may not have big direct exposure to commercial property, which seems the most vulnerable segment of the US economy, with their share of the lending to the sector in the singe digits. Significant distress in that market would, however, have spillover effects throughout the US economy and financial system, as Australians discovered in the early 1990s.

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Shares in regional banks and real estate investment trusts have been falling this year and the spreads on bonds issued by the banks and trusts have been blowing out. The commercial property market does have lines into other parts of the system.

In the Fed’s “Beige Book” released this week, in which it describes the current economic conditions, there are numerous references to declining real estate prices, the rising tide of loan maturities and the likely increase in defaults over the next few years.

Whether or not the proposed changes to big bank regulation were sensible, you’d hope the Fed and state banking supervisors have ratcheted up their levels of diligence. Last year’s regional bank crisis, the scare New York Community has just experienced and the disturbing insights into its credit processes its problems have provided could be just the tip of a proverbial iceberg.

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