The Rabid Capitalist

Professor Glenn A. Okun

NYU Stern School of Business

Federal Reserve data from July 21 casts a bleak view of bank lending activity. Although some journalists have cited anecdotal evidence of lending reduction at specific banks, the Fed data illustrates that the reduction in lending is far more widespread, both in terms of the capital and range of loan types affected.

This does not appear to be a short term, nonrecurring event (see the highlighted data below). If the loan maturity wall triggers a default wave by borrowers due to elevated interest rates and reduced fair market values relative to previous loan underwriting specifications, the liquidity squeeze and potential liquidity freeze that I described in my previous post to LinkedIn last month (see below) will be upon us.

The Liquidity Squeeze

Glenn A. Okun

NYU Stern School of Business

Professor of Management, Entrepreneurship and Finance

Professor of Management Practice

While the 2022 interest rate shock courtesy of the Fed was the catalyst for the current liquidity squeeze, additional distinct actors are driving this growing calamity.  Bank regulators, banks, institutional asset owners, commercial tenants and labor are currently or will shortly perpetuate this economic problem.

A liquidity squeeze should not be confused with a liquidity shock.  Shocks can be caused by a single decision maker (for example, the Fed or OPEC).  Squeezes have many culprits, each operating independently that collectively can wreak havoc on the performance of the real economy.

Shocks generally occur quickly (for example, a twelve-month, 400 basis point move in interest rates).  Squeezes are slow and sporadic—initially appearing as a series of isolated events that ultimately are recognized as a menacing trend, significant in size and effect.

We are enduring the early phase of a liquidity squeeze.  The consequences will occur slowly, as will the resolution.

The Regulators

Following a wave of midsize bank failures this year, U.S. regulators, primarily the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency, are preparing to compel large banks to strengthen their financial position. The next proposal is the final set of capital regulations that international policymakers agreed to put in place following the financial crisis of 2007–2009.

They are also anticipated to advocate for the abolition of a regulatory loophole that allowed some midsize banks to conceal losses on securities they held, which contributed to the collapse of SVB.

It is rumored that the adjustments, which regulators aim to propose as early as this month, may increase overall capital requirements at larger banks by about 20% on average. The exact amount will depend on a company’s business operations, with the largest hikes anticipated for U.S. megabanks with significant trading operations.

It is anticipated that the effort to increase capital will be the first of numerous steps to tighten regulations for Wall Street, a change from the more relaxed regulatory approach used during the Trump administration.  To complete the adjustments, regulators would have to cast another vote, and they would probably apply them over a number of years.

Before Silicon Valley Bank and another bank’s failures in March sent shockwaves across the sector, stricter regulations for the largest lenders were already in the works. Regulators have since stated that they want to apply the new restrictions to a wider variety of banks.

Institutions with assets of at least $100 billion may be required to abide with the guidelines, thereby lowering the $250 billion barrier for which authorities have reserved the strictest regulations.

The squeeze: a relatively large increase in bank-capital requirements could raise costs for consumers and lead banks to stop offering certain services, burdening businesses and borrowers, hampering the economy at the wrong time.

The Banks

In an effort to lessen their exposure to the shaky commercial real estate market, some US banks are planning to sell off property loans at a discount even when borrowers are current on their payments. Following numerous cautions that the asset class is the “next shoe to drop”, some lenders are now prepared to accept losses on so-called performing real estate loans.

Banks typically don’t like to take losses on large amounts of loans that will still have value as long as payments are made on schedule. However, others are being persuaded to make the move due to worries about a rise in delinquencies, particularly for debt secured by office properties, which have seen diminishing demand due to the popularity of working from home.

In the meantime, banks of all sizes are holding on to more real estate debt than they or regulators would like as a result of a slowdown in the demand for commercial mortgage-backed securities. Although the practice of selling performing loans is less common than it was before the 2008 financial crisis, many market participants anticipate an uptick in the number of transactions this year and the following year.

Banks are doing less lending and holding more loans for sale.  Until it is obvious where real estate values will settle, banks, which typically provide about half of all commercial real estate loans in the U.S., are taking a back seat.

The squeeze: the bank credit supply will decline and loan sales at discounts will pressure real estate values with the potential for this loop to occur repeatedly.

The Institutional asset owners

Institutional investors, who would typically provide debt and equity money, are becoming less prevalent in these capital markets as a result of portfolio management and asset allocation issues.

Expectations for investment returns are a major factor in portfolio management.  Real estate investment return predictions have been lowered as a result of the aforementioned actors and activities.  Top-tier asset managers are skipping payments on mortgages and leaving investment properties vacant rather than investing more money in needed repairs or to pay off principal balances on maturing mortgages that cannot be fully refinanced due to falling property values, rising interest rates, and stricter loan-to-value underwriting standards.

Plans for allocating assets have been broken.  Rebalancing is necessary because real estate allocations have reached their maximum exposure due to a decline in bond and stock prices. To bring the real estate asset class into line with asset allocation criteria, properties or partnership interests in real estate investment funds must be sold.

The squeeze: liquidating assets and reducing investment commitments further reduce capital availability and property values.

The Users (tenants and labor)

Commercial real estate-based economic activity is declining.  The cash flows of office and retail real estate are decreased both directly and indirectly as a result of downsizing brought on by hybrid and remote work models.

Reduced real estate needs are an advantage to tenants of hybrid and remote work.  Due to this, vacancies and sublease availability have increased.  Reduced consumer activity and sales have been noted in and around office centers’ retail outlets.

The squeeze: the real economy has a lower demand for physical office and retail space.  Property values ultimately will fully reflect this reality.  Loan books will require adjustment.  The degree of devaluation will determine the extent to which bank and nonbank lending levels decline and the degree of damage to the real economy and economic growth.

How it ends

A liquidity squeeze can cause liquidity gaps: the freezing of capital markets (responsible for trillions of dollars of funding annually) upon which firms and consumers rely for the short- and long-term capital requirements of their operating activities.  This absence of capital can cause otherwise healthy economic actors to fail.  Failures may begin in real estate capital markets but are unlikely to be limited to this sector.  Capital providers damaged by real estate valuation corrections will have diminished capacity to invest elsewhere.  Other private asset classes (venture capital, private equity and commodities) are the likely victims.

Will this occur? How many capital market segments will freeze? When will they thaw out?

I expect significant freezing of the real estate debt and equity capital markets for office and retail real estate property types.  Multifamily residential real estate will not emerge unscathed.  Valuation corrections accompanied by liquidity shortages will plague apartment owners that unfortunately own properties located in areas where the secular changes to work mode have had a major impact on population levels and migration rates.

When assets become irrationally inexpensive and interest rates reset at much lower levels, risk capital will return selectively, thawing out the frozen that were in a state of hibernation, rather than a coma.