The news for the past few weeks has been dominated by the debt ceiling deal, or more importantly the lack thereof. A lot rides on the ability for the U.S. government to be able to pay its bills, particularly if you are a government employee. But all of the talk about the debt ceiling has certainly overshadowed the ongoing conversation about the health of the country’s banking sector. Analysts and pundits are still warning about the possible systemic collapse that troubled commercial real estate loans could have on regional banks.
This week I wanted to explore a change that the Federal Reserve made that might help prevent the banking collapse caused by commercial real estate that so many are predicting.
The sudden collapse of Silicon Valley and Signature Bank rightfully raised alarms for many about the health of the banking system. There have been countless predictions that the next bank collapse might be caused by non-performing loans on overvalued commercial real estate. The struggles that office buildings are having across the country are certainly not a great sign for the banks that have lent to them. Thanks to an uptick in vacancy some of these buildings are already worth much less than they are underwritten for and others are finding it hard to pay their loan payments with the current rental rates. The thought is that banks with large exposure to bad loans could see disastrous bank runs similar to what happened to SVG and Signature.
There is certainly still a real threat that non-payment of commercial real estate loans could get more banks into trouble. But with all of the alarmism around bank failures, there is little talk of a change that the Fed made to their policy due to the SVB and Signature debacle that could ultimately help prevent a commercial real estate collapse. The change has to do with what is called the Federal Reserve “lending window.”
The lending window was part of the initial Fed charter and was meant to be a backstop for banks to buffer against bank runs. The idea is that the Lending Window can be a quick way to temporarily borrow from the Fed if no other sources of lending are available to banks worried about insolvency. Banks that need to use the Lending Window need to put up collateral and pay back the loans quickly. Usually, they are expected to be paid back in a few days but they can be extended to as much as three months. SVG and Signature didn’t use the lending window, probably because the rates were higher than they could afford and because of the bad optics of doing so.
In response to the bank collapses, which required bailouts from the Fed anyways, a few changes were made to policy around the lending window. First, the rate of the loans were lowered to 100 basis points over the Federal Funds rate. Next, the Fed has tried to get rid of the stigma against these kinds of loans which were historically seen as one step away from total bank failure. Lastly, and most importantly for this conversation, the types of collateral that were able to be used for the loans was expanded to include, you guessed it, commercial real estate loans.
Critics of the Federal Reserve’s lending window have argued that it creates a kind of moral hazard by encouraging banks to take excessive risks. Some have also expressed concerns about a lack of transparency in loan terms, market distortions, and the potential crowding out of private sector lending. But while opinions on the lending window vary, its supporters maintain that it serves as an important tool for maintaining financial stability and supporting the economy.
The lending window is not a perfect failsafe against collapse, if banks are not able to get deposits back before the loans mature banks could still fail. But it has been a valuable resource for the banking system. In 2008 during the great financial crisis, the Lending Window issued over $1 trillion in loans and likely prevented even more extensive bank failures. The lending window is certainly not a magic bullet that will prevent any possible troubles in the banking sector but the recent changes to the program are certainly going to help. At the very least I hope we will see more attention being paid to the lending window borrowing numbers, which are updated weekly by the Fed, as a way to gauge the health of our financial system.
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No longer lending
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