LEGAL CORNER: What a Difference a Few Months Makes
John Dolgetta, Esq. | May 19, 2023
The Banking Crisis, Commercial Real Estate, the Debt Ceiling, Fears of Recession
In January and February, the stock market had rebounded nicely from a difficult 2022, and while interest rates remained at elevated levels, they were off of the highs reached in November. Both the stock market and real estate market seemed to stabilize somewhat and, while it was evident that the growth experienced in 2020 and 2021 would not be matched, 2023 started off in a positive direction.
Two of the major headwinds, at the time, facing the economy and the real estate market were the continued high rate of inflation, which was on a steady downtrend from its peak of 9.1% in mid-2022, and the Federal Reserve continuing to raise interest rates. There was little discussion or concern about the debt ceiling debate. Fears of recession had also subsided a bit, and many were of the opinion that if there was going to be a recession, it would be a mild one and the market would experience a “soft landing”.
On March 10th, however, everything changed. Silicon Valley Bank, a San Francisco-based bank with more than $200 billion in assets, which focused primarily on lending to start-ups and venture capital funding, literally collapsed overnight and was seized by the Federal Deposit Insurance Corporation. In the days and weeks that followed, Signature Bank and First Republic Bank were also closed and seized by the FDIC, leaving the entire banking system, particularly the regional banking system, extremely fragile and vulnerable. The positive sentiment that had begun to take hold at the beginning of the year quickly dissipated.
The Collapse of Regional Banks: SVB and Signature Bank
At the time, the collapse of SVB was the second largest bank collapse (overtaken by First Republic in May) in U.S. history, behind Washington Mutual Bank’s failure during the 2007-2008 Financial Crisis. This collapse was primarily due to a “bank run” induced by fear (and the higher interest rate environment), which caused depositors to withdraw more than $42 billion from the bank within hours. The speed with which depositors withdrew their money from SVB was unprecedented. Unlike “bank runs” of the past, where customers remained in long lines for hours and days, these withdrawals were made from smartphones and computers instantaneously.
This new modern day “bank run” forced SVB to sell low-yield treasury bonds that had not yet matured, at a significant loss (due in part to one of the fastest and most aggressive interest rate hikes in U.S. history), in order to raise the funds necessary to cover the withdrawals. According to CNBC, “The roots of SVB’s collapse stem[med] from dislocations spurred by higher rates. As startup clients withdrew deposits to keep their companies afloat in a chilly environment for IPOs and private fundraising, SVB found itself short on capital. It had been forced to sell all of its available-for-sale bonds at a $1.8 billion loss.” [See https://cnb.cx/3LNohq1]. Ultimately, on March 10th, the FDIC seized SVB’s assets and the bank was closed. Two days later, on March 12th, Signature Bank, with assets of approximately $118 billion, also collapsed and was seized by the FDIC.
Both SVB and Signature Bank were established and well-known regional banks. However, a primary reason why these banks failed was because their businesses were focused on a “niche” customer and deposit base, which ultimately proved to be very vulnerable. According to the New York Times, “Silicon Valley Bank, a lender to start-ups, imploded…after some ill-timed financial decisions left it struggling to meet customer withdrawal requests—and just as slowing venture capital funding prompted fledging companies to tap their accounts more. Similarly, Signature became one of the few banks to welcome cryptocurrency deposits, just before the overheated industry blew up last year.”
Signature Bank also had a large real estate lending business, but nonetheless the “Regulators said keeping open the 24-year-old institution, which held deposits from law firms and real estate companies, could threaten the financial system’s stability.” [See https://nyti.ms/3HTcS6Q]. In both instances, the regulators, invoking emergency powers, stated that all of SVB’s and Signature Bank’s customers’ deposits would be fully protected which provided some stability to a market which, in a matter of days, was shaken to its core.
The Contagion of Fear: The Failure of First Republic Bank
On May 1st, First Republic Bank became the latest casualty of the loss of faith in the regional banking sector stemming from the collapse of SVB. The FDIC offered the assets of First Republic for sale and JP Morgan Chase emerged as the winning bidder and acquired the bank’s deposits and substantially all of its assets. CNBC reported that “Like SVB, which catered to the tech startup community, First Republic was also a California-based specialty lender of sorts. It focused on serving rich coastal Americans, enticing them with low-rate mortgages in exchange for leaving cash at the bank.” [See https://cnb.cx/42J2LcG]. Similar to SVB, First Republic also experienced a “bank run,” and on April 24th, its quarterly earnings report revealed that more than $100 billion had been withdrawn by customers.
One key difference with the sale of assets of First Republic to JP Morgan Chase, was that the regulators did not make the same affirmative statement they made in connection with the SVB and Signature Bank failures—that all deposits would be protected if other banks failed. While the result was basically the same (i.e., that JP Morgan Chase would be taking over and guaranteeing all of the customers’ deposits), the lack of an affirmative assurance from regulators that all deposits would be insured and guaranteed, regardless of amount, if another regional bank failed, has left the market jittery. Another negative result from the JP Morgan Chase deal was that all of the First Republic’s shareholders (invariably including employees who received stock in employee retirement and stock option plans) lost their entire investment.
Failing to Raise the Debt Ceiling and the Effect of a Default
Another major issue facing the U.S. and the market is the potential of a default. The United States has never defaulted in its history and such a default would immediately send the economy into recession. According to the White House, “History is clear that even getting close to a breach of the U.S. debt ceiling could cause significant disruptions to financial markets that would damage the economic conditions faced by households and businesses.” [See https://bit.ly/41mDdRI]. The real estate industry will also be directly affected by any default or even the threat of a default.
If there is a short-term default, the White House, Moody’s, states that it could lead to a decline in real GDP and nearly two million jobs could be lost. The White House also predicts that the unemployment rate could increase to 5% and “could lead to lastingly higher interest costs.” A short-term default would have a significant impact on real estate and lending, which have already been severely restricted in light of the tightening credit market resulting from the failures in the regional banking sector.
The Council of Economic Advisors predicts that if there is a protracted default, there would be a severe recession similar to the Great Recession. The White House states that by the third quarter of 2023, the stock market could plummet 45%, which would severely affect retirement accounts. Consumer and business confidence would also take a substantial hit and lead to a decline in consumption and investment. They predict that in a protracted default, the unemployment rate could increase by an additional five percentage points as employers lay off employees, ultimately leading to a potential loss of eight million jobs.
The Effect of High Interest Rates, Banking Crisis And Debt Default on The Real Estate Market
All of these headwinds are clearly having an effect on the commercial and residential real estate markets. According to an article published by Attom, the equity owners have in their homes has fallen in the first quarter of 2023, albeit a small percentage (i.e., 47.2%) as compared to the fourth quarter of 2022 (at 48%). Attom reports that “While that remained close to twice the level of just three years ago, the drop-off in the first three months of 2023 marked the second straight quarterly decline following 10 consecutive gains.” [See https://bit.ly/41w3IV2].
Redfin reported that “The median U.S. home sale price fell 3.3% in March to $400,528, the largest year-over-year drop since 2012. That follows February’s 1.2% dip, which was the first annual decrease since 2012.” [See https://bit.ly/3MevMro]. Redfin also reported that pending home sales dropped to the lowest level since the beginning of the pandemic due to higher mortgage and softening demand amongst purchasers.
CNN reported that “More lenders have stiffened their standards in the wake of increasing turmoil within the banking sector,” according to the recently released Federal Reserve’s quarterly Senior Loan Officer Opinion Survey. CNN further stated those surveyed “attributed the changes in lending standards to economic uncertainty, a reduced appetite for risk, deterioration in collateral values and broader concerns about banks’ funding costs and liquidity positions, according to the Fed report. Additionally, lenders reported that they expect to tighten standards across all loan categories for the remainder of this year, citing the above concerns as well as customer withdrawals.” The commercial and residential real estate markets are clearly being affected by all of these developments. It is critical that regulators and the Federal Reserve consider all of these issues when making decision on raising rates or assisting banks and the banking system.
A soft commercial leasing market will also have a direct effect on tightening lending standards. The Real Deal reported the Manhattan office space market reached a record of 94 million square feet of office space available. Obviously, the aftereffects of the pandemic are still lingering, and a soft commercial market will certainly cause a further tightening of credit markets.
Reuters, reporting on comments made by Scott Rechler, CEO of RXR, who also serves on the Board that oversees the New York Federal Reserve, noted that there “is $1.5 trillion in commercial real estate debt set to mature in the next three years….” Rechler tweeted that “The bulk of this debt was financed when base interest rates were near zero. This debt needs to be refinanced in an environment where rates are higher, values are lower, and in a market with less liquidity.” [See https://reut.rs/3nG2XLb]. Mr. Rechler is “calling for a program that provides lenders the leeway and the flexibility from regulators to work with borrowers to develop responsible, constructive refinancing plans.” He noted that “If we fail to act, we risk a systemic crisis with our banking system and particularly the regional banks, which make up 80% of RE lending. There will be pressure on our municipalities, which derive over 70% of their tax revenues from property taxes.” He noted that the aggressive rate hikes by the Federal Reserve will ultimately result in “breaking” the financial sector.
What Will Happen Now?
It is not an easy task to navigate through this economic obstacle course. There are clearly causes for concern. It is during these times of difficulty when we must resort to careful consideration of the path to take. Many of the obstacles outlined above are things individuals have no control over, but personal choices are critical to ensuring that one makes it through the turmoil.
No one could have foreseen a “bank run” taking place within hours, where nearly $48 billion was withdrawn from a single bank. It is truly frightening that something like that could take place. The fear that took over customers of SVB, in the weeks and months which followed, became a self-fulfilling prophecy, leading to other bank runs and the failure of several more banks. Confidence in our systems is critical to survival, and it begins with those in charge. Our government officials, regulators, and lawmakers need to promote confidence in the system and assure the public that they will do everything in their power to ensure that our economic and financial system does not fail.