R. Christopher Whalen
Jan 187 min
Updated: Jan 19
January 18, 2024 | Premium Service | In this issue of The Institutional Risk Analyst, we mourn the passing of David Stevens, former FHA Commissioner, President of Long & Foster, and head of the Mortgage Bankers Association. Dave represented the mortgage industry at MBA from 2011 through 2018, and dealt with some of the most challenging times following the 2008 market collapse. The IRA interviewed David back in 2022 and collaborated with him on many initiatives.
Meanwhile, as earnings roll out for Q4, one reader commented about the obvious question: Why do the banks go first with earnings?
The short answer is that banks are prepared to drop their minimal quarterly disclosure early in the quarter, then file the full quarterly data with regulators and the SEC about 20 days later. Since banks are seen as higher quality credits, they tend to go first in terms of public disclosure. The less attractive names or issuers that simply need more time to prepare interim financials tend to hide in the back of the disclosure period.
This week’s earnings are confirming a number of trends for banks that we have noted over the past year. The down trend in industry earnings is confirmed by the results from JPMorgan (JPM) and other large commercial banks. The hiatus on credit build seen in Q3 2023 clearly is at an end. We discuss our takeaway on earnings so far below.
The folks at Goldman Sachs (GS) managed to bring in a decent quarter and annual result down “only” 8% YOY. The stable results in wealth management help bolster GS overall, but the sharp 30% decline in advisory fees illustrates the state of Wall Street. We like seeing the provision for credit loss falling, just $570 million vs almost $1 billion in 2022.
The big issue coming out of Q4 2023 earnings is not whether investment banking revenues will come back at GS and Morgan Stanley (MS). Rather, the BIG question is how large will be the haircuts on commercial real estate exposures by banks and REITs. A good benchmark for what is happening with commercial real estate (CRE) lenders is Brookfield DTLA Fund Office Trust Investor Inc. (DTLAP), which was trading at $21 per share in 2019 and is now hovering above $0.04 per share.
Back in April of last year, DTLAP disclosed that one of its trophy properties in Downtown Los Angeles lost more than a quarter of its value due to recent legislation passed by CA progressives. The law passed by the City of Los Angeles taxes CRE transactions 5% for deals above $10 million in value. Our colleague Nom de Plumber summarizes: “The Brookfield CRE REIT writedown is a good reference point for BREIT hidden losses.”
If we impute a similar or larger haircut to all of the CRE assets of DTLAP, then the REIT is clearly insolvent as the stock price suggests. But a more interesting question is what is going on inside similar, higher profile REITs such as Blackstone Mortgage Trust (BMXT), which has similar assets to DTLAP but has so far avoided the ugly disclosure that has caused the value of the less known REIT to crater. The chart below from Yahoo Finance shows BMXT vs DTLAP.
Source: Yahoo Finance (1/18/23)
Many observers have commented on the fact that BXMT has showed no pain from the secular drop in CRE values around the country. The problem with REITs, of course, is that they are passthrough vehicles with little in the way of permanent equity capital. This is why REITs cannot own banks or act as issuers of Ginnie Mae MBS. Because they must pay out at least 90% of income to investors to qualify as a pastthrough for tax purposes, a REIT has a difficult -- but not impossible -- task accumulating equity capital.
Over the past century, as CRE valuations basically rose every year, a REIT could easily invest in the equity or debt of office buildings and have relatively minor concerns about loss. In today’s market, however, with asset values falling, equity REITs focused on CRE are facing an extinction event. Losses on asset values could wipe out their meager capital and leave the REITs upside down. The same deflationary dynamic that will destroy much of the thin equity of CRE REITs will also cause losses to bank lenders.
The question, however, is the timing of the loss recognition. Looking at the iShares CMBS ETF, investor sentiment regarding commercial real estate has been on the rise. Look at JPM, for example. Loan loss provisions doubled in Q4 2023, albeit from a low base of the $1.4 billion in reserve build in Q3 2023. Note that JPM was actually pulling provisions back into income in Q3 2023, a measure of the GAAP adjustments required by auditors given low loss rates last year. But in Q4, JPM doubled provisions on the consumer line and tool commercial exposures up three-fold.
Like all banks, JPM is slow walking a lot of commercial and CRE defaults. The example of Texas Capital Bank (TCBI) and the Reverse Mortgage Investment Trust default in November 2022 is extreme but by no means unusual. In Q1 2024, TCBI has still not reported the loss to investors because of the litigation. Banks and REITs have substantial leeway as to when and how they recognize commercial losses, especially if the obligor has filed bankruptcy.
JPM CEO Jamie Dimon noted on the Q4 2023 conference call:
“[C]redit costs were $2.6 billion, reflecting net charge-offs of $2.2 billion, and a net reserve build for $474 million. Net charge-offs were up $1.3 billion, predominantly driven by Card and single-name exposures in Wholesale, which were largely previously reserved. The net reserve build was primarily driven by loan growth in Card and the deterioration in the outlook related to commercial real-estate valuations...”
Banks tend to hold senior positions in commercial and CRE loans, but the magnitude of loss that we are seeing in some commercial markets suggests that JPM and other lenders will face significantly higher losses in commercial exposures in 2024. The location and quality of these assets, however, varies widely with each bank, REIT or investor.
CFO Jeremy Barnum noted that JPM avoids high-priced assets, “higher-end stuff in much less supply-constrained markets that is under more pressure. And as you know, our multifamily portfolio is much more affordable, supply-constrained markets. And so the performance there remains really very robust.”
Wells Fargo (WFC) CFO Mike Santomassimo likewise noted a rising rate of loss coming from commercial exposures:
“As expected, net loan charge-offs increased, up 17 basis points from the third quarter to 53 basis points of average loans, driven by commercial real estate office and credit card loans. The increase in commercial net loan charge-offs reflected the higher losses in commercial real estate office, while losses in the rest of our commercial portfolio were stable from the third quarter.”
As reflected in the valuations for JPM, WFC and BXMT, institutional investors are still not that concerned about commercial real estate losses even though the flow of valuation comps coming from the special servicing industry is decidedly bearish. The chart below confirms the relatively positive investor sentiment regarding CMBS over the past year, but we think this rally may provide some opportunities for short-sellers.
Source: Google Finance (01/18/24)
Most equity investors are not focused on credit and especially commercial and CRE credit, which is largely obscured from public view. As and when this changes, we expect to see that increased level of awareness reflected in stock valuations.
The progression of loss from commercial exposures will be piecemeal because every commercial real estate asset is different. Every asset has a diversity of equity owners, creditors and also secured lenders who ultimately own the asset in a declining market. As one banker in Dallas told us years ago, "anything about 50% loan-to-value ratio in commercial real estate is unsecured."
We think that the loss rates on commercial loans owned by banks could be higher than the loss severities seen in 2008. More, the unrealized losses that banks have taken on all assets from the 2020-2021 period weaken the bank's ability to absorb loss. Unless we see interest rates fall pretty dramatically, it will be difficult for banks already hobbled by unrealized losses to sell properties taken on a defaulted commercial mortgage. The NBER paper we referenced previously concludes:
"The median value of banks’ unrealized losses is around 9% after marking to market. The 5% of banks with worst unrealized losses experience asset declines of about 20%. We note that these losses amount to a stunning 96% of the pre-tightening aggregate bank capitalization."
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