While last month’s banking crisis seems to have stabilized, the effects of the extraordinary event are likely to have long-term implications.
March madness this year brought three banking failures: Silvergate Bank, Signature Bank, and Silicon Valley Bank, which all collapsed within a week of each other, sending shockwaves through the entire banking system and broader financial markets.
“As a reminder, two of these failures represented two [of the three] largest bank failures in U.S. history,” Harbor Capital Advisors President and CIO Kristof Gleich said during a webinar for investors at market close on April 19th, 2023.
“As the month played out a little bit longer, what happened? Systematic risk was very high, confidence was extremely fragile, and fears of a broader-based GFC, or global financial crisis, sort of full-blown 2008 type scenario, really worried the market,” Gleich added.
As the banking crisis unfolded in the U.S., the epicenter then shifted to Europe due to the quickly forced takeover of Credit Suisse by rival UBS.
While phase one of the banking crisis has ended, the overall crisis is ongoing, with some of the implications just beginning. Looking ahead, Gleich said he thinks the two most impacted areas will be U.S. regional banks and office real estate, as credit creation, lending, and the broader economy at large is impacted by the fallout.
The Banking Crisis Has Long-Term Impacts for U.S. Regional Banks
Dan Zimmerman, portfolio manager at Connacht Asset Management, said whether or not the systemic risk has faded, the reality is that it has already had a big impact, particularly in the form of rate tightening across all asset classes and banks.
“This is going to have a pretty outsized impact on growth, particularly at the regional banks, but also credit because tightening generally begets more tightening, which generally equates to more losses down the road,” Zimmerman said. “So, the growth and credit impact and the semi-permanent or permanent degradation of earnings power is very real, and that will persist regardless.”
Zimmerman said the bigger takeaway, however, is actually outside of the Fed and in the individual regional home loan banks, and how much liquidity they put in the system. As part of the crisis, banks drew over $300 billion of liquidity from the Federal Home Loan Banks (FHLB), according to Zimmerman.
“That’s going to have, in some cases, a 10-20% earnings impact, not just this year, but into next year and the year after for the regionals,” Zimmerman added. “So just another area where the regionals’ earnings power is going to be so severely impacted. Whether or not we’re out of the woods yet in the crisis, the impacts will be felt for some time.”
Spenser Lerner, head of the multi-asset solutions team at Harbor, said the firm believes the U.S. has moved past the initial acute stage of this banking crisis, triggered by deposit flight and corresponding asset losses, and the next phase in the banking crisis will be more chronic and driven by tightening of lending standards and reduced credit availability.
How Real Estate Is Implicated in the Banking Crisis
Lerner said the current environment is difficult for highly levered asset classes, including real estate broadly, but office space, in particular, will likely experience significant pain in the coming years.
“Real estate is a very capital-intensive industry, so debt availability is crucial,” Lerner said. “The Fed tightening cycle has already been restricting credit and creating tougher financial conditions for real estate property owners. The failure of Silicon Valley Bank, Signature, and the effective failure of Credit Suisse will only serve to amplify this trend.”
Real estate is a critical part of the U.S. economy, with $4.5 trillion in outstanding commercial and multifamily mortgage debt, and office space is the second largest subsector of real estate at 20% of the outstanding property debt, according to Lerner.
Already experiencing secular headwinds due to COVID and remote work, office is now hindered by rising funding costs and tightening credit availability. Net operating income, or property level cash flows, were already decelerating quite meaningfully prior to the banking crisis, Lerner said.
“Property fundamentals had been deteriorating for the last year,” Lerner said. “But in addition to that, we have a wall of maturing loans across the commercial real estate ecosystem, amounting to about $700 billion in 2023 alone, and then… $650 billion in 2024, and of those numbers, office comprises 23% of the maturing loans.”
Lerner said commercial real estate loans to values — or a measure of debt for a property — are typically struck between 50 and 70%. Falling property prices, which is being seen now as cash flows are beginning to roll over and cap rates are beginning to rise, is going to pressure loan to higher values, which may then breach loan covenants and require landlords to post additional equity.
“In some cases, particularly for office real estate, this could cause landlords to walk away from the property and opportunistically default, thus hurting the banks that lend to the property,” Lerner said. “This is exactly what we saw during the Global Financial Crisis, and we do believe that we will see that to some extent this year and in the coming years since regional banks are the primary lenders to commercial real estate.”
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The views expressed herein are those of Harbor Capital Advisors, Inc. investment professionals at the time the comments were made. They may not be reflective of their current opinions, are subject to change without prior notice, and should not be considered investment advice. The information provided in this presentation is for informational purposes only.
This material does not constitute investment advice and should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy.
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This article was prepared as Harbor Funds paid sponsorship with VettaFI.
Harbor Capital Advisors, Inc.