Don’t expect any free toasters from your bank

Stocks closed lower yesterday in the wake of last Friday's Goldilocks employment figure as traders repositioned for the markets’ next move. A services PMI came in surprisingly lower than expected and just above the waterline which is Fed-friendly but economy-scary.

What do you think it’s worth? There was some important banking news swirling around the markets yesterday. The Wall Street Journal reported that banking regulators were considering raising capital requirements for US banks. The requirement would, in theory, provide banks extra cushion for things like extreme withdrawal episodes (colloquially referred to as BANK RUNS) as well as for things like failed loans. In the wake of March’s bank tizzy, the move seems reasonable, if not expected. But there will be some big consequences.

You may be wondering where those banks will get that “extra” money. Assuming that they can’t send a cookie basket to that rich, eccentric uncle asking for help, banks will have to, I dare say, borrow money by issuing some sort of subordinated debt. That will put banks’ books in a tighter space. Meaning, they will not only be less profitable, but also, they will be that much more stringent when issuing loans. Ok, so we were kind of expecting lending to tighten up after March’s banking madness. In past notes, I covered the potential for that credit tightness to have an additive effect on the Fed’s credit tightening policies… to the equivalent of around +50 additional basis points, according to experts’ estimates. When I wrote about it, the credit tightening effect was indirect, but this additional regulation would have a direct impact on credit flow. To be clear, there has not yet been any new regulations yet, nor is it clear exactly what that regulation will look like. There is speculation that the amount of additional capital required will be commensurate with a bank’s loan book, so banks with more outstanding loans may be required to up their capital more than banks with smaller books. In other words, incentivizing banks to be less… um, loany, if that is even a word (it isn’t, but I will do anything to get you to smile). The bottom line is that credit is going to get tighter as banks pull back on lending. End of story? Not yet, bear with me.

What about the effect on real estate? Commercial real estate borrowers are watching these events unfold quite closely. They are heavily reliant on bank loans to conduct their business. Typical commercial real estate loans have 5-year maturities and when they mature, owners/developers will either refinance the loans or possibly even seek to sell a property. If the value of the property is climbing, as they had leading up to and even through the pandemic, a refinance or sale would be a locked-in win for the investors. I just read the other day that Brookfield, one of the largest REIT operators, handed over control of a second LA property this year. Sadly, I wasn’t surprised.

Most of the pain has been in office commercial real estate where vacancy rates remain high, with occupancy rates a fraction of what they were prior to the pandemic. The big shift to WFH and hybrid is a thing, and it is sticking. Half-filled offices would, as one would expect, cause companies to rethink the amount of space required per employee, and as leases expire, we can expect real estate owners to take the brunt of that pain. When those owners go to the bank to refinance, those properties will be underwritten at lower valuations, which will only make a nervous underwriter that much more… um, nervous to offer a beneficial refinance package. That will leave many owners with a dilemma. If a property cannot be operated profitably, they must consider selling. But sellers face the same challenge as borrowers/refinancers… lower valuations resulting from diminishing rent rolls. Many may choose to cut their losses, similar to Brookfield, who surely determined that turning in the keys was cheaper than riding out a fire sale and potentially, an even bigger loss. Folks, this rodeo is not over yet, and for office-based real estate, it may just be the beginning.

YESTERDAY’S MARKETS

Stocks could not hold on to early gains yesterday as investors pondered the Fed’s next move and whether AI had enough strength to drag the broader S&P back into a bull market. The S&P500 fell by -0.20%, the Dow Jones Industrial Average declined by -0.59%, the Nasdaq Composite Index slipped by -0.09%, and the Russell 2000 Index dropped by -1.32%. Bonds gained and 10-year Treasury Note yields slipped by -1 basis point to 3.68%. Cryptos fell by -5.95% as Binance was collared by the SEC and Bitcoin dropped by -5.9%. The S&P500 ESG Index slipped by -0.17%.

NEXT UP

• No economic releases today.
• Crude oil has slipped overnight, and index futures are marginally lower before the open.