Buried in the fine print of Signature Bank’s third-quarter earnings was a hint of the financial storm that could be about to break over the U.S. economy.
The Manhattan bank last month set aside nearly $53 million to cover potential loan losses largely due to the coronavirus pandemic’s impact on the U.S. economy.
Loaning money to shopkeepers, landlords and hoteliers in places such as Times Square or SoHo used to be considered almost a sure thing. But that was before the contagion emptied New York City’s skyscrapers, hotels, apartment buildings and stores, leading the president of the United States to call it “a ghost town” and forcing some borrowers to stop making loan payments.
Now Signature, which has nearly 60% of its portfolio tied up in commercial real estate, is bracing for the fallout. The bank’s bad-loan write-offs, though still modest, are creeping higher. Despite years of steady profits, investors are punishing the stock, which has lost 43% of its value this year even as the broader market has gained.
If U.S. banks absorb big losses on their $2 trillion in commercial real estate loans, the entire economy will suffer. Just the fear of looming bankruptcies and defaults has prompted banks in recent months to restrict new lending, at a time when the virus-ravaged economy needs all the help it can get.
Tighter credit standards make it harder for commercial borrowers to roll over old loans as they come due and could starve other businesses of capital needed to expand and hire more workers. If the economic downturn proves lengthy, mounting losses could even undermine financial stability, according to some Federal Reserve officials, economists and credit analysts.
“This is something that could make a bad situation worse,” said Adam Slater, lead economist for Oxford Economics in London. “What we don’t want is to get really nasty stresses and strains in the financial system from something like this.”
Today’s worries are grounded in history. Banks have repeatedly failed after stumbling into big losses on commercial real estate loans, from the savings-and-loan crisis of the 1980s to the Great Recession in 2008. U.S. banks lost $110 billion on commercial real estate in the last financial crisis, at least one-quarter of their total losses, according to Oxford Economics.
This time, the losses could be even worse, with the pandemic forcing a fundamental reconsideration of how Americans work, shop and live. With a highly contagious disease circulating in the country, tens of millions of people have been working for months from home, shopping online and only occasionally visiting shops and eateries.
If a coronavirus vaccine becomes widely available in the first half of 2021, people may revert to their old habits. But some societal changes may endure, especially if a vaccine takes longer to develop or offers only limited protection.
Such shifts would make downtown office buildings, hotels and stores less valuable, sending losses ripping through banks and bond investors that hold $3.4 trillion in commercial real estate debt.
Office space, the largest single slice of the commercial real estate sector, already is seeing rents fall as vacancies rise. Property values eventually could plummet 20% to 35%, according to a recent Barclays report. Hotels and retail properties have been hit even harder.
Regulatory changes enacted in the aftermath of the 2008 crisis mean banks now are better armored against losses. But more than a decade of ultra-low interest rates has allowed financial risks to accumulate, which the pandemic is now laying bare.
The Federal Deposit Insurance Corp. (FDIC) regards 356 banks as “concentrated” in commercial real estate, based upon criteria such as the ratio of their CRE loans to their capital base and the pace of loan growth over the past three years.
Valley National Bancorp in Wayne, N.J., is the largest bank to exceed the regulatory guidance. Its CRE loan portfolio has grown by 81% in the past three years, according to S&P Global.
“We remain confident in our underwriting and believe we are well positioned to navigate the current environment from a credit perspective,” Michael Hagedorn, the bank’s chief financial officer, told investors last month.
Community banks are particularly dependent on lending for commercial properties. These smaller banks get into trouble with these loans by growing too fast and expanding into geographic areas where they lack expertise, according to Bert Ely, a banking consultant.
Banks that exceed the FDIC criteria were “three to four times” as likely to fail than other institutions during previous downturns, according to a 2019 study by the Federal Reserve Bank of Philadelphia.
“In the event of another such crisis, most banks would be affected, and many might fail,” wrote economist Pablo D’Erasmo, the author. “The CRE sector remains a potential source of instability for the banking sector.”
In the second quarter, banks reported the largest percentage increase in charge-offs for bad loans since early 2010, according to the FDIC. They also nearly quadrupled the reserves they set aside to absorb loan losses.
“I don’t see any way of avoiding a great deal of pain in the commercial real estate market in 2021. It’s almost inevitable,” said Cam Fine, the former president of the Independent Community Bankers of America. “My friends at the Federal Reserve and the FDIC are becoming increasingly uncomfortable with what’s going on in the commercial real estate world.”
Eric Rosengren, the president of the Federal Reserve Bank of Boston, has sounded the alarm for years about banks and businesses bingeing on low-interest borrowing. In recent speeches, he has warned that commercial property values were artificially inflated by more than a decade of ultra-easy money.
As the pandemic shock makes existing commercial properties less valuable—because workers and customers are afraid to return to them—their owners will struggle to roll over their mortgages. Some will default, leaving lenders to absorb the loss and hobbling the economic recovery.
“I am especially worried about a second shoe dropping that will particularly affect small and medium-sized banks, which provide a large share of commercial real estate loans and small-business loans,” Rosengren said in a September speech. “A curtailment of credit resulting from such problems has caused serious head winds to recoveries in the past and may be a serious problem going forward.”
In the third quarter, Signature reported making $1 billion in new loans, a 75% drop from the previous quarter, though the bank says it has plenty of pending deals in the pipeline.
Fed Chair Jerome Powell told a House committee in September that regulators would try to help banks and their commercial customers ride out the pandemic.
“With smaller banks the issue is there has been a 30-year trend of consolidation and banks going out of business, and that’s not a trend we want to do anything to exacerbate,” he testified. “Smaller banks are going to probably bear too much of the burden here. They have more exposure to real estate and to smaller businesses, which are probably more vulnerable and have less resources to deal with this sort of stress.”
Bank balance sheets remain healthy. But in past crises, losses were slow to materialize, not appearing until lengthy commercial leases came up for renewal. In the last cycle, losses did not peak until three years after the recession ended in June 2009.
But the market for commercial mortgage-backed securities already is providing an indication of what lies ahead. Wall Street banks such as Deutsche Bank, Goldman Sachs and JPMorgan Chase have bundled about $550 billion worth of commercial mortgages into securities and sold them as investments to pension funds, life insurance companies and mutual funds.
As the pandemic plunged the economy into a deep freeze this spring, the share of commercial real estate loans that were delinquent rose to 10.3% in June from 2.3% in April, according to Trepp, a provider of financial data.
Lenders have allowed some borrowers to delay payments or use loan reserves as a stopgap. That has brought down the share of delinquent loans to a still-high 8.3%, meaning borrowers are behind in their payments on commercial real estate loans worth about $45 billion, Trepp said.
“The disasters are retail and hotels,” said Manus Clancy, Trepp’s senior managing director.
Borrowers have missed payments on nearly 20% of hotel loans, according to Trepp.
An aging shopping mall south of Minneapolis shows how the pandemic is hurting lenders and investors.
In July, CBL & Associates, a real estate investment trust, was due to pay off its $63 million mortgage on the Burnsville Center, anchored by tenants such as J.C. Penney and Macy’s. Instead, after pandemic-related “store closures and rent reductions” cut into mall income, CBL surrendered to its lender half of the mall, which it had pledged as collateral.
That 525,000-square-foot parcel was worth $137 million in 2010. But last month when the unpaid note was auctioned off, it sold for less than $20 million, according to Trepp. That 85% decline will mean losses for investors holding the riskiest slices of a securitized loan pool packaged by Goldman Sachs’s structured finance unit.
At Signature Bank, meanwhile, executives have extended forbearance to some borrowers, hoping they can resume making loan payments once the pandemic passes. Chief executive Joseph DePaolo is betting that the bank’s deep-pocketed borrowers and base in neighborhood retail outlets will help it weather the storm.
Signature is attracting billions of dollars in new deposits and has been reliably profitable for 51 consecutive quarters. Earlier this month, it tapped the bond market for $375 million, paying a lower interest rate to raise fresh funds than JPMorgan paid on its last debt offering.
But when skittish investors look at the bank, they see only a potential victim of the next lending implosion.
Signature did not respond to a request for comment.
“We believe it’s a timing issue. . . . If we can keep some of these clients in their businesses, New York will come back,” DePaolo said on an Oct. 20 earnings call. “I don’t think it’s a death sentence, what’s going on.”