The financial sector was rocked a month ago when Silicon Valley Bank collapsed, sparking concerns throughout the industry. However, the situation has now stabilized to a certain extent. While there is still some anxiety, people are now taking deep breaths and feeling assured that their money is safe, and that banks have the tools needed to handle the crisis, thanks to the government.
Wells Fargo’s senior bank analyst, Mike Mayo, believes the situation has gone from flashing red lights to flashing yellow lights, meaning that there should be a heightened awareness and vigilance towards anything that might further undermine confidence. Regulators and investors are both on high alert and are searching for potential red flags.
There are three areas where analysts are particularly concerned about potential risks: commercial real estate, underwater bond portfolios, and shadow banks. Silicon Valley Bank’s issues, such as rapid growth, weak risk management, and over-reliance on uninsured deposits, among other factors, were things that should have been detected before the bank’s collapse. Now, everyone is trying to spot the next potential disaster before it happens.
The toll of the WFH era
According to a report, commercial real estate – including offices, apartment complexes, warehouses, and malls – is facing significant pressure, with valuations potentially falling by 20% to 25% this year. Experts warn that the decline could be even steeper for offices, which have an average occupancy rate in the United States of less than half their March 2020 levels. In 2023, approximately $270 billion in commercial real estate loans held by banks will come due, with $80 billion of that on office properties.
Signs of strain are already visible, with the proportion of commercial office mortgages where borrowers are behind on payments increasing. Recently, a landlord owned by asset manager PIMCO defaulted on nearly $2 billion in debt for seven office buildings, and the sector is a potential problem for banks, given their extensive lending. According to Goldman Sachs, 55% of US office loans sit on bank balance sheets, and regional and community banks account for 23% of the total. Experts are becoming increasingly concerned about the situation.
During a time when interest rates were low, US banks invested in long-dated Treasuries and mortgage-backed securities, but as interest rates have risen, the value of those bonds has decreased. As a result, US banks are now estimated to hold $620 billion in unrealized losses, meaning their assets are worth less than what they paid for them. This poses a problem if a bank is forced to sell those assets in a crisis. It is still uncertain where these unrealized losses are located, whether they are spread throughout the sector or concentrated in specific types of lenders. Experts suggest that the $620 billion is a conservative estimate. Silicon Valley Bank did not hedge against the risk of losing value of those assets, which compounded its problems.
As previously discussed, the term “shadow banking” refers to non-depository financial institutions that engage in lending activities. These institutions include hedge funds, investment banks, private equity firms, and insurance companies. Unlike traditional banks, these institutions are not regulated as strictly, which means that they can assume more risk. They are also not backed by the government, which means that they cannot rely on a government safety net in case of a crisis.
Despite these differences, traditional banks and shadow banks are often interconnected, and problems with one can lead to problems with the other. This is particularly true when it comes to confidence in the financial system. If investors lose confidence in a shadow bank, this can quickly spread to traditional banks, potentially triggering a financial crisis.
However, it is important to note that shadow banks also play an important role in the financial system. For example, they provide funding to start-ups and other businesses that may not be able to obtain financing from traditional banks. While they may be riskier than traditional banks, they also offer opportunities for growth and innovation in the financial sector.