The slow burn that is a big problem for the world

A Chinese investor in London’s once-glittering Canary Wharf financial hub experiences a 60 per cent loss on the sale of an office building. A third of the market capitalisation of a Japanese bank and 60 per cent of the value of a US regional bank are wiped out within a week. The chief executive of a venerable Swiss bank resigns.

Swiss private bank Julius Baer’s CEO, Philipp Rickenbacher, resigned after announcing a provision of just over $1 billion for losses on loans to an Austrian property company.
Swiss private bank Julius Baer’s CEO, Philipp Rickenbacher, resigned after announcing a provision of just over $1 billion for losses on loans to an Austrian property company.Credit: AP

The common denominator for those events is commercial real estate, where what has been the slow burn of tumbling property prices is starting to produce some visible flames.

In London, China’s Cheung Kei group sold a building that it had bought for £270 million (about $520 million) in 2017 for £110 million.

Tokyo-based Aoazora Bank’s share priced crashed and its chief executive resigned after it announced its first loss – 28 billion yen (about $270 million) – in 15 years, after experiencing losses in its $US1.9 billion ($A2.9 billion) US commercial real estate (CRE) portfolio.

Swiss private bank Julius Baer’s CEO, Philipp Rickenbacher, also fell on his sword after announcing a provision of just over $1 billion for losses on loans to an Austrian property company.

The share price of a relatively small US bank, New York Community Bank, which has about $US116 billion of total assets, imploded over the past week after it added about $US500 million to its provisions for loan losses and wrote off $US185 million that related to just two CRE loans. It lost $US260 million in the fourth quarter of last year.

Last month the International Monetary Fund warned of the risks to the US banking and financial systems of rising signs of distress in its CRE sector, where the value of office space has been tumbling as relatively high interest rates and the post-pandemic shift towards remote working flow through to increased vacancy rates and loan defaults.

Much of the funding and the valuations of commercial property before interest rates started rising two years ago was driven by the post-2008 financial crisis era of globally low interest rates.

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During the pandemic years, central bank policy rates in the major economies were negligible or, in Europe and Japan, negative. That drove funding costs for CRE deals down and values up. Those trends have reversed over the past two years as central bank monetary policies have been tightened aggressively.

Earlier this week the US Treasury Secretary, Janet Yellen, said she was concerned about losses in US CRE markets, although she believed that they were manageable.

“Commercial real estate is an area that we’ve long been aware could create financial stability risks or losses in the banking system and that is something that requires careful supervisory attention,” she said.

In an interview with 60 Minutes in the US at the weekend, the Federal Reserve Board chairman, Jerome Powell said the central bank was very aware of, and focused on, the problems within the CRE sector but also described them as “sizeable” but “manageable.”

“To the extent that it’s well distributed, then the system could take losses. We do expect that there will be losses, but there will be banks that have concentrations, and those banks will experience larger losses,” he said.

The nature of CRE loans, which tend to have 10-year plus maturities, and the leases that generate the CRE income to service them, with five to 10-plus terms, means that problems within the sector surface slowly.

If there are significant and systemic issues in CRE lending, they will be increasingly visible over the next few years. About $US560 billion of US CRE loans are due to mature this year and next, with $US2.2 trillion due by 2027.

With, anecdotally, the values of some major office buildings in major US cities selling for 40 to 60 per cent below their purchase prices, the potential for large-scale losses is significant, even if Powell played down the potential for a banking crisis of anything like the scale experienced in the 2008 global financial crisis.

Nevertheless, the threat of large-scale losses within the US regional and small bank sectors has been apparent for some time and UK and European regulators are watching their property markets very closely.

While the big US Wall Street banks are heavily capitalised and (like the major Australian banks) don’t appear to have large exposures to the CRE markets – and the most-vulnerable B-grade properties within them in particular – the regional banks and thrifts (similar to Australia’s building societies) are heavily exposed. They do most of the property-related lending in the US and aren’t as well capitalised or as tightly regulated as the big banks.

China’s Cheung Kei group just sold a building that it had bought in London’s Canary Wharf business district for £270 million in 2017 for £110 million.
China’s Cheung Kei group just sold a building that it had bought in London’s Canary Wharf business district for £270 million in 2017 for £110 million.Credit: Getty

The scale of the New York Community Bank’s provisioning for losses spooked the market even though its executives had a rational explanation for it.

After buying most of the assets of Signature Bank – one of the regional banks that failed last year after a massive run on its deposits – New York Community Bank, now with more than $US100 billion of assets, moved into a more heavily regulated regime, requiring more capital and liquidity than regulators required in the past.

Nevertheless, the scale of the provisions and the size of the losses on the two CRE loans triggered the massive sell-off in the bank’s shares.

So far that hasn’t destabilised the wider regional banking sector, although regional bank indices show shares prices in the sector have fallen nearly 12 per cent in the past week.

Much of the funding and the valuations of commercial property before interest rates started rising two years ago was driven by the post-2008 financial crisis era of globally low interest rates.

With the pre-existing investor caution from last March’s collapse of several regional banks and the knowledge that about a third of the smaller banks’ balance sheets are tied up in CRE-related lending, however, the value of the sector is down more than 20 per cent over the past year even as the wider sharemarket has been posting records.

The vulnerability of CRE markets and lenders and the scale of losses that could flow if the worst fears of analysts, investors and regulators were realised might not be of global financial crisis proportions but would have implications for systemic stability and monetary policies.

Large losses in CRE markets by investors and their lenders – Powell acknowledged some banks could fail – would have wealth and confidence effects and could significantly tighten the availability and cost of credit.

At present the Fed and most major central banks have adopted conservative monetary stances, leaving interest rates at decades-high levels even though the spikes in inflation rates that caused them to significantly tighten monetary policies have been subsiding steadily.

If the CRE-related losses accelerate, as seems likely in most of the major economies, they could force the central bankers’ hands, causing them to ratchet interest rates significantly lower and reversing the tightening of financial conditions that has been caused by their responses to the outbreaks of inflation.

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