R. Christopher Whalen
May 17, 20235 min
May 17, 2023 | Premium Service | Bank stocks have stabilized at low levels over the past week. PacWest (PACW) closing above 0.2x book value is a victory of sorts for the smaller banks, but don't start celebrating just yet. As we noted in our last comment, maintaining the long large banks/short regional banks trade that is currently popular on the Street grows more problematic as market caps fall. Is this the time to buy credit?
The first response to our question is to orient readers as to where markets are today vs 24 months ago, when 1-month Treasury bills were yielding 0.00% (May 17, 2021). Today T-bills are around 5.5%. If we think of what a move of 5.5% implies for credit spreads and, by connection, credit ratings, we refer you to the legacy ratings breakpoints from S&P.
AAA: 1 bp
AA: 4 bp
A: 12 bp
BBB: 50 bp
BB: 300 bp
B: 1,100 bp
CCC: 2,800 bp
Default: 10,000 bp
A move of 5.5% takes you from high investment grade to junk in terms of credit spreads and default probabilities. This is one big reason why a parade of Wall Street managers are focusing on credit and particularly 1) corporate credit and 2) commercial real estate, two related asset classes that are headed for an historical reset in terms of valuations and therefore capitalization rates.
When we talk about commercial real estate, the cap rate is generally calculated as the ratio between the annual rental income produced by a real estate asset to its current market value. As rents on legacy office buildings in cities such as New York, San Francisco and Chicago fall, the values fall. Falling rent rolls lead to reduced market value and eventually lower property taxes, which attacks the basic fiscal viability of these cities.
So let’s say that in 2020, your building had $1 million in net operating income (NOI) and a cap rate of 4%, resulting in a value of $25 million.
But if in 2023 the NOI of the building falls to $500,000 due to lease concessions to tenants, the value of the building is cut in half to $12.5 million at a 4% cap rate. But what if investors now want a higher yield? At an 8% cap rate, the value of the building with the $500,000 NOI falls to $6.25 million. This is precisely the calculus that is leading to some building sales well below the published valuations of only several years ago.
When the value of the building is cut in half, the holder of the mortgage is going to want to see more equity to bring the loan back to 50% loan to value (LTV). But if the rent roll is falling and the “owner” of the building already knows that NOI is likely going to fall further, the incentive is compelling to hand the lender the keys and walk away.
Without a substantial reduction in interest rates, many commercial buildings in urban areas face foreclosure. The Fed's 5.5% increase in short-term interest rates has thrown the pricing for trillions of dollars in real estate into disarray. The same math that caused investors to question the solvency of US banks is likewise attacking the credit position of real estate assets and corporate credits.
A bank that made a 50 LTV mortgage loan on a commercial building in 2020 can in 2023 potentially face a foreclosure and sale of the building at a valuation that may result in loss given default over 100% of the loan. Remember that banks operate at 15:1 leverage, so such large percentage losses can quickly consume the bank's earnings and capital. When banks take possession of defaulted urban real estate, they must support and preserve the asset until it is sold.
Commercial real estate is not the only sector being negatively impacted by higher interest rates. Bloomberg reports that the declining fortunes of highly leveraged companies and startups has squeezed the arbitrage to such an extent that new issuance of collateralized loan obligations is suffering.
If early-stage firms cannot offer the prospect of an IPO to incentivize lenders and particularly the equity portion of CLOs, then they are cut off from financing. If you cannot sell the equity piece, then the deal does not get done. Of note, Bloomberg reports that 80% of the CLOs done in Q1 2023 were funded with captive equity vehicles of the largest banks.
As the credit markets tighten further this year, we look for increased default activity from early-stage companies that relied upon leverage loans as a bridge to an IPO. Whether we look at corporate credit or commercial real estate or bank loan portfolios, the change in the interest rate environment suggests a degree of credit losses that we have not seen in the US since the oil bust of the 1970s and the S&L collapse in the 1980s.
While the 2008 financial crisis was certainly horrific in terms of credit losses and bank failures, the basic narrative for higher valuations for commercial real estate remained intact. Junk loan defaults could reach double-digits by Q1 2024. Net loss rates on relatively prime bank C&I loans peaked at 2.75% in Q4 2009. Loss rates in 2009 were over 90% of the original loan amount.
In this cycle, however, we are seeing a rapid repricing of commercial risks, suggesting that banks, nonbanks and even municipal credits will be affected adversely. The rapid normalization of losses on commercial loans held by banks and rising defaults in commercial real estate and corporate credits suggest a perfect storm of credit losses facing investors.
In such an environment, we have a hard time justifying a long position in bank stocks and other equity exposures in real estate. We expect to see credit losses for banks rise well-above long-term average rates and losses on commercial real estate generally setting new records commensurate with the magnitude of the past Fed market intervention.
We can take some comfort from the stabilization of bank stocks, but not too much. It is important to recall that Western Alliance (WAL) at current levels is right back where it was before COVID and QE distorted the credit markets. The adjustment in credit that follows from this fact will be extraordinary and painful for banks and other investors.
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