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Another Banking Crisis?

Written by Jazz Ch'ng

June 22, 2024

This thorough analysis of the current affairs of banks, real estate, and the overall United States economy was largely written by Black Mountain Analyst Jazz Ch’ng, with editing and small editorial support from Elijah Levine. 

1. Executive Summary

2. Analysis of Initial Source

     a. “517,000,000,000 in Unrealized Losses”

     b. “63 Lenders on Brink of Insolvency”

3. Banking Sector

4. Banks’ Unrealized Losses

     a. Mitigating Factors

          i. Banking Crisis Analysis

          ii. “Ideal” Cases

          iii. Treasuries and MBSs

          iv. Positive Signs

     b. Unmitigated Risks

5. CRE’s Unrealized Losses

     a. Multifamily Stress

     b. Office Stress

     c. Banking Impacts

6. Extending and Pretending

7. Conclusion

Executive Summary

  • The basic claims that banks are facing $517 billion in unrealized losses with 63 troubled lenders are correct but the short-term analysis is somewhat exaggerated. While the number of troubled lenders is not a concern, the scale of rate-driven unrealized losses is. These unrealized losses are 11x pre-GFC levels and are particularly concentrated among residential MBSs and, to a probably far lesser extent, Treasuries. 
    • This is concerning because banks have historically invested deposits in residential MBSs and Treasuries, which have been considered “safe” despite their high interest rate risk. 
  • In the short term, the probability of a “second Great Financial Crisis” is low, as the present levels of unrealized losses have been sustained for over a year, a soft landing remains possible, some positive signs have been observed, and the practice of “extending and pretending” has enabled banks and some private lenders to push the maturities of some distressed loans later, staving off loss realization. 
    • Q1 2024 unrealized losses for US banks rose $39 billion or 8% to $517 billion, driven by devaluations in residential MBSs arising from higher mortgage rates. This is the ninth consecutive quarter of elevated unrealized losses. 
    • The ratio of unrealized losses over total bank assets for Q1 2024 (2.2%) is 11x greater than eve-of-crisis Q2 2007 levels (0.2%), though this ratio peaked in Q3 2022 at 3.0% or 15x. 
  • In the long term, extending and pretending is not a solution and continued declines in commercial real estate, particularly office and multifamily, could trigger an SVB-style collapse among smaller and regional lenders, which are disproportionately exposed to CRE at extremely high valuations given the declining interest (and cap rate) period of the last 40 years. 
    • This may lead to financial contagion and, in the worst case scenario, a “second GFC” involving both residential and commercial real estate, though larger banks are generally better capitalized and more secure. 
  • This is consistent with the analyses previously presented in our The Greater Recession and REITs articles, though extending and pretending will allow banks to defer discounted sales (realized losses) in the short term while they wait for rates to be lowered. Given the timing and other factors, this may end up being a very expensive gamble. Let’s dive in.  

Analysis of Initial Source

The initial source above draws from this article, which is mostly factual as it largely comprises block quotes from the FDIC’s Q1 2024 Quarterly Banking Profile

That said, the author unfortunately includes some misquoting. While the numbers are all correct, some edits are made and the given block quotes are slightly manipulated. Let’s begin. 

“$517B in Unrealized Losses”

Below is the actual text from the FDIC report, which the article purports to cite: 

Unrealized losses on available-for-sale and held-to-maturity securities increased by $39 billion to $517 billion in the first quarter. Higher unrealized losses on residential mortgage-backed securities, resulting from higher mortgage rates in the first quarter, drove the overall increase. This is the ninth straight quarter of unusually high unrealized losses since the Federal Reserve began to raise interest rates in first quarter 2022.”

Here is the quote that appears in the article, with meaningful alterations bolded and formatting adjusted for easier comparison: 

“Unrealized losses on available-for-sale and held-to-maturity securities soared by $39 billion to $517 billion in the first quarter. The surge was driven by higher unrealized losses on residential mortgage-backed securities, a result of rising mortgage rates in the first quarter. This marks the ninth consecutive quarter of unusually high unrealized losses since the Federal Reserve started hiking interest rates in the first quarter of 2022,” the FDIC reported.

Observe that the substance/facts are the same; only the wording has been altered to make the numbers seem more significant and dramatic. While acceptable as opinion or analysis, it is misrepresented as a direct quote, when it is in fact altered. If this is paraphrasing, it ignores (1): the use of quotation marks around the whole text, or (2): that surrounding sentences are taken nearly verbatim. Unrealized losses from 2022 to now can and should be called a surge (see Banks’ Unrealized Losses), but Q1 2024 itself should not. 

The article title and tweet are similarly misleading; while completely factual, the use of “hits” rather than “reaches” implies that unrealized losses increased by $517B rather than increasing by $39B from $478B to $517B, or 8%. If “reaches” contains too many characters for a tweet, “US Banking Systems’ unrealized losses hit $517,000,000,000” is clearer, more accurate, and contains the same number of characters. 

Overall, it is entirely correct that Q1 2024 unrealized losses hit $517B, despite some active misquoting. While this continued increase is certainly concerning in the long term (see “Overall Analysis and Impacts”), the Q1 2024 results specifically are only an 8% increase over the previous quarter. 

“63 Lenders on Brink of Insolvency”

Below is the text from the article. The second paragraph is a largely accurate paraphrasing of the actual FDIC report: 

The FDIC also highlighted a rise in the number of lenders on its Problem Bank List last quarter. These banks are teetering on the brink of insolvency due to various weaknesses. 

“The number of banks on the Problem Bank List, those with a CAMELS composite rating of ‘4’ or ‘5’, rose from 52 in the fourth quarter of 2023 to 63 in the first quarter of 2024. This figure represents 1.4% of all banks, a range considered normal for non-crisis periods, typically between 1% and 2%. The total assets held by problem banks increased by $15.8 billion to $82.1 billion during the quarter,” the FDIC stated.

CAMELS, called CAMEL prior to 1997, is an FDIC and NCUA measure of a bank or credit union’s financial and operational soundness in the dimensions of capital adequacy, asset quality, management capabilities, earnings sufficiency, liquidity position, and sensitivity to market risk. A good rating is 1-2, and a poor rating is 3-5 (higher numbers are worse).

As stated, the FDIC’s Problem Bank List includes banks with CAMELS rating of 4 or 5, which exhibit “serious financial or managerial deficiencies” and, with ratings of 5, require “immediate outside financial or other assistance.” 

As before, while the numbers are correct, the description is somewhat exaggerated. I conclude this because: 

(1): 63 lenders are indeed troubled, 

(2): it may be fair to call these lenders “distressed,” though that is often understood to mean financial distress specifically whereas the Problem Bank List measures operational and managerial deficiencies as well, such that it is possible for a financially sound bank with exceptionally poor controls and management to receive a high CAMELS rating, 

(3): describing those banks with ratings of 5 as being “on [the] brink of insolvency” seems reasonable to me, and 

(4): the FDIC does not break down how many of those 63 banks have ratings of 4 versus have ratings of 5, so it remains theoretically possible, but unlikely, that all 63 banks have 5s and are “on the brink of insolvency.” 

Note that it is standard practice for the FDIC to not release a breakdown of exact ratings and to not name its problem banks (so as to avoid sparking any bank runs). In those regards, the Q1 report is not an outlier. Perhaps that itself is a big issue.  

As the article mentions, this is only an increase of 11 banks or 21% over the previous quarter (1.4% of all banks total) and is well within the normal 1% to 2% of all banks range for non-crisis periods.

Switch to Risk-On

Bitcoin vs Interest Rates Historically

Overall, the number and assets held by problem banks are solidly within normal levels. The raw data for this chart is available here in Excel. 

Those 63 lenders represent $66.3B in assets, an increase of 24% over last quarter. The report indicates only 0.3% of total US banking assets are under concern, though in reality this number is probably higher given the imperfect record of US financial regulators (recall that SVB boasted a CAMELS rating of 2). Finally, the increase in the number of troubled banks is proportionately roughly equal to the increase in those banks’ assets, so we do not (yet) observe a “snowball” effect of increasingly larger banks failing or becoming distressed. 

Banking Sector

In the short-term, the banking sector appears secure, with Q1 2024 net income rising 79.5% or $64.2B from Q4 2023. However, none of this negates longer-term concerns regarding higher rates or CRE distress.

The bulk of this increase, 65.2%, was due to decreases in non-recurring expenses, not intrinsic increases in bank performance. Q4 profits were suppressed by one-off FDIC special assessments and goodwill write-downs, both relating to last year’s regional banking crisis, but Q1 saw net interest income—the actual revenue driver for banks—fall, with net interest margin also falling from 3.27% to 3.17%. To compare, the pre-COVID average margin was 3.25%. 

Observe below that loan yields (interest earned by banks, in blue) have decreased, while deposit costs (interest paid by banks, in gold) have increased. Consequently, net interest margin (and income) have fallen. The rise in deposit costs is largely due to continued competition between banks. 

While asset quality remained generally favorable, the FDIC report highlighted material deterioration in CRE portfolios, as well as credit cards. 

Increases in non-owner occupied noncurrent loans (CRE loans 90 or more days delinquent) were driven by office loans at large banks with assets above $250 billion, with lesser stress among medium-sized banks, with assets between $10 billion and $250 billion. 

Low demand has suppressed office prices while higher rates are limiting the refinancing ability and credit quality of existing office and other CRE loans. Consequently, the delinquency rate for non-owner occupied CRE loans is at its highest level since 2013.

As the FDIC report concludes, “the banking industry still faces significant downside risks from the continued effects of inflation, volatility in market interest rates, and geopolitical uncertainty,” as well as ongoing deterioration in office property and credit card loan portfolios. 

Banks’ Unrealized Losses

Total unrealized losses have risen dramatically since the Fed began its rate hiking campaign in Q1 2022, averaging $536 billion from 2022 onward compared to $27.8 billion of unrealized gains over the previous decade of easy money.

The unrealized losses of 2022 onward are mainly concentrated in residential MBSs, which have been devalued by elevated mortgage rates, and include both held-to-maturity or HTM securities in blue and available-for-sale or AFS securities in gold. 

HTM securities are those a bank intends and is able to sell at maturity; they are thus reported at their book or purchase value. AFS securities, in contrast, are reported at their fair market value, the difference between the two comprising unrealized gains or losses that are not reported on the income statement (hence “unrealized”) but do appear on the balance sheet. So if investments were to decline in value, as rising rates have caused fixed-rate debt securities to, banks classifying those investments as HTM would not recognize any unrealized loss while banks classifying them as AFS would. Essentially, reclassifying AFS securities as HTM securities allows banks (and others) to “hide” their unrealized losses

For example, the Fed’s rate hikes beginning in 2022 devalued the large number of fixed-rate Treasuries and MBSs held by banks as “safe” investments, since higher interest rates make existing fixed-rate bonds, which were issued at previously-prevailing lower rates, less attractive. Since banks largely hold longer-term Treasuries and MBSs based on 30-year mortgages, neither security can be quickly “waited out” and sold at maturity to reduce interest rate risk. Consequently, recorded unrealized losses on AFS securities rose dramatically beginning in 2022, as did the implied but unstated unrealized losses for HTM securities. Note that the concept of unrealized losses can still be applied to HTM securities, even though such losses are not included in financial statements. 

Average unrealized losses among AFS securities after 2022 are nearly 11x greater than average unrealized AFS gains from 2012-2021, and this multiple rises to over 55x for HTM securities.

While this multiple is stark and implies banks have reclassified some securities as HTM to avoid admitting unrealized losses, it is important to recall that, as seen in the graph, absolute average 2022-onward HTM and AFS losses are only $54 billion or 22.3% apart, and the 55x vs 11x multiple difference arises mostly from the fact that pre-2022 HTM unrealized losses are much lower, which is to be expected. 

Banks actually did reclassify AFS securities as HTM (and/or increase their purchase of securities they then designated as HTM) in 2022 to the tune of about $750 billion or 12.5% of their total $6 trillion in securities, according to a recent working paper.

Reclassifications in 2021, prior to rate hikes, were roughly a third of that number, around $220 billion. Collectively, banks were able to avoid recognizing $175 billion in unrealized losses from 2021-2022 by “simply slapping [on] a new accounting label.” 

Importantly, unrealized losses do not threaten banks’ solvency unless the devalued securities are actually sold and the losses written down on their income statement; this process also reduces assets on the balance sheet.

If banks are forced to sell securities at a loss to raise and return funds to depositors, the resulting losses can lead to a bank failure. If banks simply hold on to the devalued securities (bonds, since banks do not hold deposits in equities), they will not suffer losses but will simply suffer decreased profitability, since their bond yields are below current rates. 

Banks that hold capital against those losses are at lower risk of insolvency (the exact degree is the subject of Basel III debate), and banks may also hedge against the rate rises that fuel unrealized losses by purchasing interest rate swaps. However, only 25% of banks in 2022 used swaps, and only 6% of assets were secured by hedges of any kind. 

Comparing unrealized losses to quarterly net income, present unrealized losses of $517 billion are roughly equal to the past 8 quarters of net income (collectively $536 billion). While pre-2008 unrealized loss data was not immediately available, this FDIC quarterly puts Q2 2007 unrealized losses at $20.6 billion, up 238% from Q1 levels of $6.1 billion.

Adjusting to 2024 dollars, this is about $31 billion today, though actual Q1 2024 unrealized losses are $517B, or just under 17x greater. Normalizing by total bank assets for June 1, 2007 and May 29, 2024 (the latest available data), Q1 2024 unrealized loss levels (2.2%) are 11x greater than their Q2 2007 eve-of-crisis levels (0.2%)

In March 2024, an Office of Financial Research report indicated 185 banks with a total $524 billion in assets had unrealized losses exceeding their shareholders’ equity. If those losses were to be realized (or, potentially, if enough investors or depositors were to fear they would be), those banks would become insolvent. 

Mitigating Factors

Q1 2023 unrealized loss levels also sat at 2.2%, so YoY change is 0%.

That said, Q1 2023 also saw the brief regional banking crisis and the successive failures of SVB, First Republic, and Signature Bank. The ratio of unrealized losses to total assets actually peaked in Q3 2022 at 3.0%, five months before the crisis began. 

Banking Crisis Analysis

While this could imply the US banking system is susceptible to another similar shock, there are some mitigating factors to note: first, that SVB was idiosyncratically as well as systematically vulnerable. It lent disproportionately to a few industries, had the second-highest rate of uninsured deposits (93.9% exceeded the FDIC’s $250k limit), and unwisely invested 94.4% of deposits in long-term fixed-rate HTM securities and loans that rapidly lost value as surging inflation prompted the Fed’s rate hike campaign.

A late-2021 drop in tech stocks led to rapid deposit withdrawals that forced SVB to liquidate cash and reserves, then finally those securities and loans on which it had suffered unrealized losses. Realizing those losses led to the institution’s insolvency. (Interested readers can find a longer analysis in this Howard Marks memo). 

In summary, the systemic environment was only partly responsible for the regional banking crisis; a series of stunningly poor financial and managerial decisions—as well as regulatory failures—also contributed. It is possible that the most unsound institutions have already failed or been improved, but it is also possible that many more have not. Importantly, the bank failures of 2023 stemmed partly from the rapid increase in interest rates, not necessarily the absolute level of interest rates

“Ideal” Cases

If inflation eases (a prospect that may have already begun) and prevailing predictions of no future rate hikes hold (which seems quite likely), the same confluence of factors is unlikely to occur. In the present environment, with inflation having retrenched somewhat—but certainly not completely—and rates generally expected to hold or fall, the same degree of purely rate-driven risk seen in 2022 and 2023 is unlikely to repeat at the same level. Those years faced high unrealized losses in part because rates were higher and rising, while we today face high unrealized losses in part because rates are higher, but not necessarily rising. 

Given the nature of monetary policy, a possible “off-ramp” exists if the present high rate environment reduces inflation, allowing the Fed to safely cut rates and raise security valuations, leading non-bank investors to buy now less-devalued securities from banks (that is, invest in Treasuries or MBSs). A slight non-exclusive alternative is that wary investors take note of banks’ high unrealized losses and charge them higher risk premia (for debt or equity), forcing banks to pass on the higher cost of capital via higher loan rates, thus slowing the economy, allowing rate cuts, and leading to the same result as above. Thus, the resolution of banks’ unrealized losses may depend on a smooth soft landing and continued investor—and depositor—confidence. 

Banks may also be able to reduce the danger by selling off devalued securities during opportune times, such as last year’s bond rally (see “Positive Signs”). Large banks may also acquire or peer banks merge with distressed regional banks to mitigate losses or stave off insolvency during runs. Finally, even if regional banks do fail, large banks are unlikely to follow, given their vast capital buffers, superior resources, and millions of fully-insured depositors unlikely to panic. That said, contagion remains a possibility and the failure of even one large bank, though very unlikely, could be catastrophic

Treasuries and MBSs

Astute readers may note the Q1 2024 FDIC report attributed that quarter’s unrealized losses to residential MBSs, not Treasury bonds. I mention both because (1): both have been key parts of the unrealized losses story, particularly at SVB, (2): both are often bought in tandem, as the latter are often government-backed [interested readers may find an explanation of such agency MBSs here], and (3): the relative distribution of Treasuries and MBSs in previous quarters’ losses is not readily available. 

Both the relevant Treasuries and MBSs are long-term, fixed-rate (thus highly rate-sensitive), and low-risk (ideally, ignoring interest rates), hence their historic role as investments for the largest US banks. While Treasuries have always been popular, MBSs declined after the regional banking crisis but have since rebounded alongside top-rated CLOs, the floating payouts of which may act to mitigate the interest rate risk accrued by investment in MBSs. Purchases of CMOs have also increased. 

If the MBSs in question are indeed sound, rates abate, and hedging with CLOs is properly executed, risk may reduce. If any of those elements are absent or deficient, banks’ continued investment in real estate backed securities (MBSs, CMOs) may only further the ongoing real estate driven surge in unrealized losses. 

Given the scenarios outlined above, the exact combination of Treasuries and MBSs responsible for present unrealized losses is of particular interest.

However, the FDIC does not publish that information. 

I am able to surmise from the Q1 2024 and other quarterly reports that unrealized losses from residential MBSs are likely a majority of such losses, since they are described as the primary culprits and high mortgage rates are often credited alongside high interest rates generally.

In tandem with interest rates, the 30-year US fixed-rate mortgage has also risen since 2022, peaking above 7% late last year and in early 2024. 

Despite this, the exact contribution of MBSs to total unrealized losses is never stated (a plurality, a slim majority, a large majority, etc.) and the ratio of MBSs to Treasuries held by banks was not immediately available.

Finally, other fixed income instruments or asset backed securities may also be key or growing contributors to unrealized losses, but I consider this unlikely because none are mentioned in any FDIC quarterly or media reports. The uncertainty, nevertheless, necessarily limits my analysis. 

Positive Signs

Recall that YoY Q1 unrealized losses are unchanged. This may actually indicate improvement rather than stasis, as said losses have remained constant despite rises in long-term yields over the past 12 months. That indicates the quality of banks’ security portfolios has increased: post-SVB, many banks appear to have enacted appropriate risk management measures to mitigate exposure to devalued bonds. Deposits also increased in Q1 2024, providing a greater liquidity buffer against similar runs. 

Secondly, many banks used a brief rally that boosted bond valuations in Q4 2023 to restructure parts of their securities portfolios, usually between 10% and 25%, intentionally recognizing losses (that were minimized by the rally) to improve net interest margins and accelerate asset yield normalization, which should ideally reduce risk. 

Unmitigated Risks

That another SVB exists and precipitates another crisis is not impossible. While the probability cannot be given with certainty, it is always possible that some bank somewhere is forced to sell securities at a loss, re-awakening investors and depositors to banks’ historically high unrealized losses and leading to greater financial troubles. 

It is also possible that unrelated political or economic turmoil may ignite crisis or distress, for instance if sudden shocks relating to the upcoming presidential election, geopolitical events, or global macroeconomy occur. 

Finally, the above banking sector analyses do not account for all systemic problems arising from debt already accrued, particularly longer-term debt or more highly-levered projects, such as those common in commercial real estate. To more fully validate the analysis presented in The Greater Recession, it is necessary to also examine CRE-driven unrealized losses. 

CRE’s Unrealized Losses

Commercial real estate divides chiefly into industrial, retail, multifamily, and office properties, with the latter two—office in particular—being of greatest concern. 

Since 2021, loss rates have increased the most for office properties, which already had a high 20% loss rate, followed by apartment (multifamily), retail, and industrial. For the purposes of brevity, only multifamily and the more distressed office sectors are discussed below. 

Multifamily Stress

Multifamily properties are facing dual stresses from both oversupply, especially in the Southeast, as well as the present high rate environment, which has raised funding costs and depressed valuations.

In Q4 2023, multifamily loans delinquent past 30 days rose 43.1% over the previous quarter and 81.2% YoY to $3.46 billion, the highest level since Q2 2013.

Similarly, the loan loss rate on multifamily properties has spiked over 3x from 5% in 2021 to 16% in 2023. At the peak of COVID losses in 2020, it only reached 12%. 

Relatedly, loans made during the 2021 and early 2022 season of lower interest rates and higher valuations were naturally made with lower cap rates, around 3% or 4%.

Higher interest rates and over-leveraging today have led to higher cap rates and lower valuations, prompting opportunistic investors—particularly more transparent actors such as REITs, which Black Mountain has covered before—to await discounts on distressed property sales. While some such distressed sales have occurred, often at 20% discounts or more, the immediate number has been suppressed by borrowers and lenders’ collective efforts to “extend and pretend.” 

Office Stress

The story in office has been much the same, with higher interest and cap rates and falling valuations. The total decline in office sector value has been estimated at anywhere between 26% and an astonishing 50%, or between $832 billion and $1.6 trillion

Additionally, the structural adoption of work from home policies has cut vacancy rates, net absorption, and rental rates. Even after three years and a slow rally that ended in 2022, leasing volume has not recovered to pre-COVID levels. Post-COVID leasing volume has been about 33% or 20,000,000 sq ft lower, and this level has held with little sign of lasting recovery.

Office loans bundled into commercial non-agency (private sector-led) MBSs—even those with top ratings—have also begun to fail. These reputedly-safe CMBSs comprise about $700 billion of banks’ balance sheets, accompanied by an additional $3 trillion in unbundled commercial mortgages. CMBS delinquencies reached 6.4% in April, with 31% of all office loans bundled into CMBSs troubled in March, nearly double the rate in 2023. In Chicago, 75% of commercial office MBSs are troubled; in Denver, it is 65%. Even top AAA-rated CMBSs have been hit, particularly those concentrated in a single property, and CMBS losses generally are trending upward

In a simultaneous sign of structural distress, office utilization rates are down a staggering 50%, and builders have reacted by bringing new office starts close to zero. While this could in the long term “equal out” today’s decline in demand, reaching a new equilibrium would take years, even excluding the fact that the current demand shock is so great as to overpower any practical supply-side adjustments (that is, even ceasing all new construction would not be sufficient to match decreased demand for office space). 

As with multifamily owners, office owners with floating rate loans and expiring caps (limits on interest for floating rate loans) are particularly vulnerable given rate hikes, having seen their debt service costs rise dramatically and valuations fall double digits. Office loans in particular are 44% underwater, more than triple the average 14% rate for all CRE loans generally. Larger lenders have been able to set aside reserves to cover failures, but the regional lenders that originate most CRE loans have not. They have chosen instead to “extend and pretend.” 

Banking Impacts

Hundreds of banks are presently vulnerable with high CRE exposure and large unrealized securities losses. As the Treasury’s Office of Financial Research acknowledges, if CRE loan losses reach post-GFC levels, “there will be hundreds of banks [whose] realized CRE losses plus unrealized securities losses…exceed their shareholders’ equity,” potentially threatening their solvency. It is critical, then, that this scenario not be permitted to occur. 

Regional banks, the same actors roiled by 2023’s crisis, are the primary makers of multifamily loans and are heavily invested in office loans as well. CRE loans collectively comprise an average 44% of regional banks’ balance sheets, compared to only 13% for the largest banks. Office and multifamily loans in particular have been sold at discounts of up to 30%, often to private lenders who then originate new loans back to banks, a can-kicking approach described as “a slow wreck, [but] not a high-speed crash.” 

Total banking sector exposure to CRE loans is estimated at $1.76 trillion (REITs, in comparison, hold only about $94B). The majority of bank exposure is concentrated in those under $10B in assets, primarily regional lenders, among whom some CRE-driven failures are expected. The banks most vulnerable to CRE loan losses also carry high unrealized securities losses and large numbers of uninsured depositors (note these are the same factors that led to SVB’s failure). 

Multifamily loans, for instance, comprise nearly a third of CRE loans due in 2024, and banks’ lending to the sector has grown a similar 32% from 2020 to 2023. Because regional banks are by definition concentrated in specific regions, those with major cities where rent control predominates may be particularly threatened (see the famous case of NY Community Bancorp, for instance). The most capital constrained banks are likely to sell their loans at a loss, realizing once-unrealized losses and—in the worst-case scenarios—threatening their solvency. 

Additionally, from mid-2022 to early 2024, commercial property prices across all sectors fell 18%, with higher devaluations in the office and multifamily sectors to which regional banks are disproportionately exposed. Lower prices will make it more difficult for banks today to sell off delinquent property and adequately cover losses. 

Extending and Pretending

To avoid realizing unrealized losses, lesser-resourced regional banks in particular have engaged in a practice called “extending and pretending:” rather than allowing a delinquent, distressed, or otherwise devalued loan to fail or selling it off at a steep discount, they have simply modified and extended the terms to pretend as if the fundamental distress does not exist. Though perhaps overly derisive or simplistic, one may compare this to a gambler who never stops gambling so he is technically yet to lose. 

The delinquency rate for CRE loans held by banks is presently just above 1% while market-traded delinquencies exceed 6%, indicating banks have either sold off lower-quality loans or, perhaps more probably and concerningly, extended and pretended to artificially lower delinquency rates. A recent NBER working paper estimates 300 primarily regional banks could suffer runs as a result of CRE distress, totalling about 6% of all banks nationally.

Recall that regional banks are disproportionately exposed to CRE—especially multifamily and office, sectors that together comprise over half the $600 billion of the CRE loans maturing in 2024 alone. Both the CRE market and banks’ exposure is consequently being monitored by regulators, with Fed Chair Jerome Powell describing the present problem as “sizable” and stating “there will be losses.”

In the short-term, banks may be able to extend loans to avoid selling failing properties at steep discounts and recognizing losses on CRE loans.

There is already ample evidence that this is occurring, with close cooperation between lenders and borrowers as both are incentivized to stave off actual losses. 

In the long-term, however, extending and pretending is not a solution. To see the short-term effects already present, observe that 28%, about $929 billion, of all outstanding commercial mortgages are to come due in 2024.

This number was originally going to be $659B, but rose 41% because loan terms were modified to extend maturities to 2024. Loans for office and multifamily properties—the most distressed—comprise 23% and 20% of all extensions, respectively. 

Over the next 5 years, 48% or $505B of the total $1.1 trillion in US multifamily loans are expected to mature, with uncertain consequences.

Extending and pretending is liable to continue as long as rates remain elevated, since the alternative is for foreclosing lenders to realize an average 33% loss of value in office properties per square foot since 2019. For major business districts like Seattle, Los Angeles, and San Francisco, that number rises to over 60%—obviously unacceptable for lenders. 


The US banking sector and financial regulators are certainly better prepared for an office price collapse in 2024 (or later) than they were for a housing price collapse in 2008. Some metrics like CRE loan loss rates and real estate loan exposure have yet to reach pre-GFC levels and the largest banks are less exposed to the industry, but it bears remembering that CRE loan losses, not residential losses, were responsible for most GFC-era bank failures. 

Though some positive signs exist, the scale of present unrealized losses, the ubiquity of those unrealized losses in both residential and commercial real estate sectors (particularly office and to a lesser extent multifamily), the present macroeconomic environment, and the lack of obvious solutions to structural factors for CRE distress are not to be ignored. 

A crisis is unlikely, at least in the short term, but this is partly attributable to the can-kicking practice of extending and pretending. Key to determining the future is determining the extent to which such a practice is “bandaging over” present stresses, though actors are obviously reluctant to disclose that information. While there are some promising signs, in the long term the probability of continued systemic distress or even a new crisis cannot be discounted.


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