New York Federal Reserve Predicts More Bank Failures

The New York Federal Reserve believes that several regional banks throughout the country are at risk of failure due to their overexposure to commercial loans. The Fed cited an analysis by the Klaros Group, which studied 4,000 American banks and found 282 could go under if their commercial loan portfolios were to fail. The good news for American consumers is that most of those banks are smaller and hold less than $10 billion in assets.

Although, it's never good news to hear that nearly 300 American banks are in danger of going out of business, the larger take-away is that the commercial loan crisis may not spell the kind of major risk to America's economy that existed in 2008. The current commercial loan crisis is being driven by several factors. However, the main culprit is historically high vacancy rates in America's office space.

By some estimates, America's current commercial/office property vacancy rate is almost 20% and some markets are even worse off than that. The high vacancy rates are proving to be a major issue for both the developers who own the buildings and the banks who lend them capital. In the past, they would simply have been able to refinance the debt, but that is proving to be much more difficult in today's banking climate.

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After the financial crisis, many of America's regional banks turned toward commercial lending because they viewed it as a safer option than residential mortgages. On the surface, that gamble made sense for several reasons. First, commercial borrowers tended to be more sophisticated and better resourced than residential homebuyers from a capital standpoint. Second, the long-term structure of office leases provided both banks and developers with what looked like a consistent source of revenue.

It was all going according to plan until COVID-19. The crisis pushed millions of Americans out of their office cubicles and turned them into remote workers. What no one could have foreseen at the time was that millions of those remote workers would never return to the office at all. That new reality had an incredibly damaging effect on the commercial office market by creating millions of square feet worth of vacant office space.

Commercial property developers suddenly found themselves facing double-digit vacancy rates on buildings that could only cover their debts and make profits with occupancy rates below 5%. It wasn't long before the regional banks, who made the loans, found themselves seated next to cash-strapped developers on the struggle bus. By this point, the Federal Reserve had begun raising interest rates and refinancing was no longer an option.

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Pretty soon, it became clear that many regional lenders were overexposed to commercial real estate defaults and some of them began to go under. One of the most surprising bank failures was by California-based First Republic who languished on the verge of insolvency for weeks until it was purchased by JP Morgan Chase. Since then, nerves have been rattled, and the fact that almost one trillion dollars in commercial loans maturing in 2024 isn't helping.

The good news, if it can be called that, is that the Klaros study indicates that America's largest banks (like JP Morgan Chase) are at comparatively less risk than the regional lenders. It's also a good sign that the 282 banks on Klaros' watch list are not on the verge of collapse.

In an interview with CNBC, Klaros' co-founder Brian Graham said, "Most of these banks aren’t insolvent or even close to insolvent. They’re just stressed. That means there’ll be fewer bank failures. But it doesn’t mean that communities and customers don’t get hurt." Overall, it's a positive assessment, but Graham's sunny outlook must be tempered by the knowledge that the commercial loan crisis is at its beginning, and not anywhere near the end stage.

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