CRE Analyst Dec 26, 2023 10:00:00 AM

Are 300 Banks at Risk? Debunking Flawed Predictions of CRE Distress

A group of economists recently warned that 300+ banks may fail. We believe their approach is flawed and borders on fearmongering...

Their findings: 

"...after more than $2 trillion decline in banks’ asset values following the monetary tightening of 2022, additional 231 (482) banks with aggregate assets of $1 trillion ($1.4 trillion) would have their marked to market value of assets below the face value of all their non-equity liabilities."

"Our analysis, reflecting market conditions up to 2023:Q3, reveals that CRE distress can induce anywhere from dozens to over 300 mainly smaller regional banks joining the ranks of banks at risk of solvency runs."

----- What's wrong with this approach? ------

1. Declining bond values aren't realized losses.

Mark-to-market losses go away if/when borrowers continue to pay.

2. They assume 2x actual property value declines.

They use a CRE value index that assumes downside pricing (down 22% from peak) instead of a transaction-based index (down 10% from peak). Assuming that all borrowers would completely capitulate to today's potential buyers is a stretch. 

3. No sanity check relating to real estate credit quality

The researchers ignore meaningful differences in commercial mortgage credit quality between now and the GFC. e.g., LTVs are 10% lower, DSCRs are 20% stronger, and retail and industrial subsectors (50% of the industry) are strong. 

----- Volcker's perspective -----

Paul Volcker famously "broke the back of inflation" by raising rates in the early 1980s. Here's what he had to say in 2008 about MTM insolvency...

VOLCKER: The S&Ls had certain capital requirements. They were low, but they had some. If they’d marked all the stuff to market, they would have been lost. And there was no explicit requirement that they mark to market. They were under whatever the regulator said. ...which I thought was the appropriate policy. 

INTERVIEWER: This whole idea about forbearance—you can put them all out of their pain, but the effects of that…

VOLCKER: Put them out of their pain, but [we] would have run out of money in a hurry.

INTERVIEWER: And it would have gone to the taxpayers, ultimately.

VOLCKER: Ultimately, somebody would have had to pick it up.

INTERVIEWER: Assume that some years from now we are going to have another problem with high interest rates. Having gone through the experience, would you advocate that some things be put into place initially?

VOLCKER: This gets into this whole question of mark-to-market accounting... Partly growing out of this experience, I do not think mark-to-market accounting—to make a sweeping statement, and it’d have to be a lot more nuanced—is appropriate for regulated depository institutions, because this problem will recur. If they mark everything to market, the only way they can defend themselves is by selling all their loans... And it seems to me that, in the end, you end up with a weakened banking system.... 

 

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