There is an apocryphal story about the sinking of the Titanic. At the inquest, the captain was asked why he did not steer the ship from the iceberg. To which he replied, “What iceberg?”
A similar but true story occurred after the September 2008 Lehman Brothers bankruptcy triggered the Great Economic Recession. When Charles Prince, the former head of Citibank, was asked why his bank kept lending on the eve of the worst economic recession in the postwar period, he replied, “As long as the music is playing, you have to get up and dance.”
Fast forward to today, we have to wonder whether financial markets are dancing on the eve of another financial market crisis that could trigger a meaningful economic recession. This time, the trigger might be a full-blown regional bank crisis caused by the lethal combination of high interest rates and a wave of commercial property loan defaults.
The importance of the regional banks for the U.S. economy cannot be overstated. According to Goldman Sachs, banks with less than $250 billion in assets originate half of the loans made to businesses and corporations for capital expenditures. These smaller banks also account for 60 percent of all U.S. mortgages, 80 percent of all commercial real estate loans, and 45 percent of all consumer loans.
The last thing a slowing economy needs is a credit crunch in the regional bank sector that would crimp aggregate demand. Unfortunately, it is difficult to see how such a crunch can be avoided, given the sharp spike in long-dated Treasury bond yields and the troubles in the commercial real estate sector.
The regional banks, along with the rest of the banking system, have taken a significant hit from a decline in the value of their bond portfolios due to the spike in Treasury bond rates. Even before the most recent spike in interest rates, a Social Science Research Network study found that bank asset values declined by 10 percent on average between early last year and early this year. It also found that the $2.2 trillion aggregate decline in bank asset values was on the order of aggregate bank capital. The recent spike in 10-year Treasury yields toward 5 percent will only add to those losses.
With such significant losses on their bond portfolios, anyone doubting that the regional banks have a solvency problem need only reflect on the heavy exposure of those banks to commercial real estate loans. That exposure is estimated at 18 percent of those banks’ loan portfolios.
Property developers are widely expected to have serious trouble rolling over the $500 billion in loans that mature over the next year. They will do so due to the combination of low-occupancy rates in a post-COVID world and the higher interest rates they will now have to pay on their loans.
This means that the regional banks will soon be in real trouble when property developers start defaulting in a big way. The loan write-offs they will be forced to do will compound the problems that high interest rates are already causing to their profitability and balance sheets. When that occurs, those banks will be forced to cut back on their lending faster than they are already doing. That could be especially damaging to the prospects for small- and medium-size businesses that account for 45 percent of our country’s economic activity and employment.
In 2008, the Federal Reserve was caught flat-footed by the Lehman bankruptcy despite many indications that should have been informing it that a financial crisis was brewing. It will be inexcusable if, once again, the Fed misses the clues of another such crisis, especially after the failures of First Republic Bank and Silicon Valley Bank, the second- and third-largest U.S. bank failures on record.