Following the failure of three regional banks last March, Treasury Secretary Janet Yellen and Federal Reserve Chairman Jerome Powell took to repeating that the US banking system is “sound”. Otherwise stated, the closure of the institutions was due to their own erroneous management — aka “idiosyncratic” behavior — rather than on account of systemic weakness.
The Treasury Secretary’s message appears to have shifted somewhat this month after the travails of New York Community Bank which cut its dividend, experienced a sharp fall in share price, and underwent a credit downgrade by Moody’s. The rating agency took note of the bank’s exposure to multifamily dwellings which, in many cases, were also rent-controlled. Yellen anticipates further stress in the commercial real estate sector, but believes that the problems are isolated rather than systemwide.
In contrast, readers will recall that SriKonomics reports have repeatedly expressed concern about the occurrence of a “credit event” because of the volatile nature of US monetary policy. The Fed’s balance sheet doubled during the two years ending early 2022 accompanied by a cut in interest rates to near zero. This was followed by a 5 1/4 percentage point increase in interest rates, and a steady reduction in the central bank’s balance sheet. These moves devastated the portfolios of several regional banks that purchased long-dated Treasurys and mortgage-backed securities believing the Chairman’s message that the inflation pickup was “transitory.”
The sharp increase in the Federal Funds rate, and continuation of the post-covid practice of working from home, turned out to be a double whammy for commercial real estate, especially for office buildings. The combination of a reduction in rental income and higher interest expenses was what led me to believe that the problems were becoming systemic. The difficulties do not stem just from individual institutions’ follies.
Another statistic to keep in mind: Data firm Trepp estimates that commercial debt maturities will keep rising, and that $2.2 trillion in repayments will come due between now and the end of 2027. That would make it difficult to sustain the Yellen statement that the stresses on banks are likely to be individual issues. Hopefully, she does not believe her own statements!
Concern about problems in the commercial real estate sector comes with further support from a respected research institution, the National Bureau of Economic Research, in a report published in December 2023. “Our analysis, reflecting market conditions up to 2023:Q3, reveals that CRE distress can induce anywhere from dozens to over 300 mainly smaller regional banks joining the ranks of banks at risk of solvency runs,” says the report. It adds that “these findings carry significant implications for financial regulation, risk supervision, and the transmission of monetary policy.”
Of course, if policy had not followed the path of being extraordinarily expansionary at the start of covid, followed by extreme tightness, the boom-and-bust scenario could have been avoided. My prescription for such a course would be to have a rules-based policy that would hold little mystery on what the Fed would do at its next meeting. Jerome Powell may want journalists and traders to hang on every word he utters at press conferences, but that does not make for good policy!
What would be the fallout from the “stresses” that Secretary Yellen has finally acknowledged do exist? In addition to the problems for banks, she told the Senate Banking Committee on Thursday that she is concerned about the health of nonbank mortgage lenders that do not have access to a cheap deposit base. She recognized that the short-term borrowing that these institutions resort to in order to fund their lending activities is less stable than bank deposits. Consequently, failure of one of the nonbank lenders is possible if market strains developed, Yellen conceded. Does she have a candidate in mind?!
What do Commercial Real Estate problems mean for Federal Reserve policy? Recall that following the failure of the regional banks in March 2023, the central bank abruptly ended Quantitative Tightening, and switched to providing liquidity. The temporary resort to Quantitative Easing took Fed assets immediately up to the November 2022 level. If one or more regional lenders fail in today’s context, expect a repeat of last year’s switch in policy, only that the increase in the Fed’s balance sheet would be much greater, accompanied by a large reduction in the policy interest rate.
Long-dated Treasurys would be winners, joined subsequently by risk assets that benefit from the flood of liquidity.
The succinct message from recent developments is this: Monetary tightening may be coming to an end but not because the fight against inflation has been won. As has always been the case with the unstated objective of the Federal Reserve, “saving the system” will take precedence over stable prices.
Dr. Komal Sri-Kumar
President
Sri-Kumar Global Strategies, Inc.
Santa Monica, California
srikumar@srikumarglobal.com
@SriKGlobal
February 10, 2024
Sri-Kumar Global Strategies, Inc. advises multinational investors and sovereign wealth funds on global risk and opportunities. Dr. Sri-Kumar is regularly featured on business TV and Radio media, and is a frequent speaker in global financial centers on major topics that affect markets and investments.
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All spot on. One of the ironies is that the balance sheet of the Fed, if accounted per GAAP, would likely show negative equity for 100bn. So the regional banks who followed the FED shouldn’t be a surprise. Add to it the CRE exposure and disasters are happening. And by the way, the FED balance sheet will never go back to reasonable levels unless we are prepared to see a sort of depression.
We can always count on Sri to tell it like it is! Thank you sir!