American Banks Are Hiding The $1.5 Trillion Commercial Real Estate Crisis

Me: Example - NYC Building worth 335 Million in 2006 sells for 8.5 Million in 2024 with low occupancy rates

American Banks Are Hiding The $1.5 Trillion Commercial Real Estate Crisis

August 7, 2024

A new set of accounting rules was designed to make banks recognize credit losses earlier, but recent events suggest it might not be working as planned. Despite the changes, commercial real estate loans are showing troubling signs of trouble, with a massive $1.5 trillion in loans coming due soon. Office buildings, hit hard by the pandemic and plummeting values, are especially problematic. While the new rules were supposed to catch losses sooner, some banks are still slow to report problems. This raises questions about whether the new system is any better than the old one, and whether we might be in for another financial mess.

How American Banks Are Hiding The $1.5 Trillion Commercial Real Estate Crisis 1

After the big financial crash, when many banks had to get government help despite looking financially healthy, America decided it was time to change how banks report their losses. They wanted a system that would make banks acknowledge losses sooner.

The old system was called the “incurred-loss model.” This meant that banks had to be pretty sure—about 70% sure—that a loss had happened before they could record it. Banks often said they would have reported more losses if the rules allowed it.

In 2020, a new system was introduced for most big companies. This system is supposed to make banks report losses earlier. Instead of waiting until a loss seems certain, banks are now expected to estimate potential losses from the beginning and record them as soon as they expect them. The idea was that this would lead to quicker and more accurate loss reporting.

So far, investors are wondering if this new system is actually working. One big test of the new rules is happening with office loans. Many office loans are structured so that borrowers only pay interest until the loan matures, planning to refinance the loan rather than pay it off. When interest rates were very low, this was a common strategy. But with the rise of remote work during the pandemic, office property values in many cities dropped, and now refinancing is not an option for many borrowers because their buildings are worth less than what they owe. This situation is likely to lead to defaults.

In July, experts John Murray and François Trausch from Pimco warned about $1.5 trillion in commercial real estate loans that will need to be repaid in the next two years. They suggested that this could expose flaws in the new expected-loss model, as lenders might still be delaying recognizing losses to avoid bad news.

For example, New York Community Bancorp has seen a big increase in credit losses from commercial real estate loans, raising questions about why these losses weren’t reported sooner. Short seller Carson Block had previously predicted big losses for Blackstone Mortgage Trust, which eventually faced significant losses and had to cut its dividend. This shows that the expected-loss model might not be working as well as hoped.

Interestingly, loans backed by commercial mortgage-backed securities (CMBS) are showing higher default rates compared to similar loans held by banks. This suggests that banks may have more flexibility to work with borrowers than CMBS issuers, who have fewer options for managing troubled loans.

Banking regulators are aware of these issues but assure the public that this won’t be another financial crisis like 2008. Federal Reserve Chair Jerome Powell acknowledged that the problem with office loans would likely be ongoing. If Powell’s prediction was accurate, banks should have already recognized these losses under the new expected-loss model.

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Me: Example - NYC Building worth 335 Million in 2006 sells for 8.5 Million in 2024 with low occupancy rates