Small Banks’ Big Problem: Too Many Commercial Real Estate Loans

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I should be used to it by now, but I’ve lost track of how many times I’ve heard financial television anchors parrot the lead sentence of last week’s Up and Down Wall Street, which posited that the collapse of Silicon Valley Bank might help the Federal Reserve tighten credit and slow the economy.

Still, even after regulators put together a fire brigade of fixes to provide liquidity, some banks, especially smaller ones, remain strapped after having aggressively expanded their balance sheets in recent years, while boosting their share of lending, relative to their bigger brethren.

The Fed itself provided $300 billion of credit to banks in the week ended Wednesday, including almost $12 billion via a new facility that will let them borrow against their holdings of securities that have lost value, owing to the rise in bond yields. In addition, the megabanks provided $30 billion in deposits to

First Republic Bank

(ticker: FRC), extending a lifeline to that beleaguered California institution.

But those measures serve only to stanch the bleeding from an exodus of deposits. The banks are unlikely to be able to offer as much credit—the lifeblood of the economy—as they had previously. “This loss of confidence in regional banks means there has been a sudden and significant contraction in credit availability in the economy,” writes James Bianco, founder and eponym of Bianco Research, in a client note.

Steven Blitz, chief U.S. economist at TS Lombard, pointed out the problem in a prescient report entitled “Is a Small Bank Problem Brewing?” weeks before the SVB debacle broke. Not only were these institutions more aggressive lenders than their larger peers, he warned, they also have a larger concentration of loans in commercial real estate, which has big problems, especially in the office-building sector.

That is distinctly different from the woes that felled SVB, which stemmed from an egregious mismatch between its short-term deposit liabilities and its long-duration Treasury and mortgage-backed securities. Standard & Poor’s thought the macroeconomic fallout from SVB’s failure should be limited, at least initially. But the collapse of the technology-centric institution reflects tech’s retrenchment, Blitz tells Barron’s.

The shuttering of New York-based

Signature Bank

(SBNY) could have more impact, especially on the Big Apple’s commercial real estate market, according to a research note by Kiran Raichura and Sam Hall, property economists for Capital Economics. Signature has an estimated $25.5 billion in loans secured by NYC assets, equal to about 12% of all outstanding CRE debt in the city, they added. Those loans haven’t caused Signature’s difficulties and should be easy to sell, they write, after being marked to market, once the bank is wound up.

The indirect impact is likely to produce more stringent credit terms for commercial real estate borrowers, Raichura and Hall add. Even before benchmark Treasury yields plunged in the flight to quality precipitated by SVB, banks had become more cautious in extending loans. They’re apt to want larger spreads in the future.

Many small banks are being squeezed in a vise, according to Blitz. On the asset side, they’ve been depending on nonresidential lending. On the liability side, they’ve been relying on large time deposits they’ve purchased, plus borrowing from the Fed’s discount window.

Since the beginning of the Covid pandemic, small banks have ramped up their nonfarm, nonresidential loans to $1.2 trillion from $900 billion, while large banks have trimmed such loans to $495 billion from $515 billion, he writes. As of January, small banks had 28% of all their loans in nonfarm, nonresidential real estate, compared with just 8% for large ones. Add in agriculture loans, and the percentage rises to 35% for small banks, versus 11% for the biggies.

As it turned out, it was the run on the tech-heavy SVB that caused concern about the funding of an array of regional banks, rather than worries about commercial real estate. That was despite the widely noted vacancies in office buildings and retail properties.

Tech isn’t likely to be immune, having splurged on offices before the WFH—work from home—norm took hold. It is a slow-moving problem, with most structures still 90% rented, Blitz says. Even with hybrid work becoming more common, as bosses induce workers to come to the office perhaps three days a week, many companies are likely to downsize when their leases come up for renewal, seek concessions, or both. The surfeit of empty space is likely to grow.

Tech companies hired many more bodies than they had jobs for, Blitz observes. Now they’re reversing that binge, with Facebook parent

Meta Platforms

(META) announcing 10,000 layoffs this past week, following its 11,000 last November.

For now, steps by the Treasury, the Fed, and the megabanks to shore up smaller banks and stop the deposit hemorrhages have staved off a crisis. But that will still leave regional banks, on which many communities depend, less able and willing to lend, with negative repercussions for the national economy.

Write to Randall W. Forsyth at [email protected]