The collapse of three large (but not “too big to fail”) banks has exposed risks in the regional banking sector. After years of extremely low interest rates, the banks were blindsided by the rapid raises in the fed funds rate. They had not adequately hedged this risk.
Investors expect Fed officials to stop raising the fed funds rate after raising it 0.25% on May 5, hold rates steady for a few months and then begin to lower them — perhaps substantially, to a range of 4.5 to 4.75 percent by the end of the year.
Fed policymakers, however, have been adamant that they do not expect to lower rates imminently. And some have hinted that more increases might be warranted if inflation and economic strength show staying power… [end quote]
Even if the Fed does not continue to raise the fed funds rate but only holds it stable for a protracted time – which they have declared repeatedly is their intention – regional banks and their customers will be harmed. A large part of regional banks’ business is commercial and industrial (C & I) real estate lending. About 80% of C & I lending is by regional banks.
Property Owners May Soon Get a New Reason to Sell
The cost of interest-rate hedges, which are mandatory for most floating-rate commercial real-estate loans, is soaring
By Carol Ryan, The Wall Street Journal, May 2, 2023
…
Lenders in the U.S. commercial mortgage-backed securities (CMBS) market and banks usually require borrowers to hedge their interest-rate risk when they take out a variable-rate loan.
If a landlord buys an interest-rate cap with a 3% strike rate, they receive a payment whenever benchmark rates—often the secured overnight financing rate, or SOFR—rise above that level. This reassures lenders that the borrower will be able to meet its debt payments even if interest rates rise.
Protection bought by real-estate investors can last for up to five years, but typically runs for three. Many of the interest-rate caps bought during the pandemic are still shielding landlords from higher debt costs but are due to roll off this year and next. Buying new hedges will be expensive. According to data from risk-management firm Chatham Financial, a three-year cap at 3% for a $100 million loan cost $98,000 in April 2019. Today, the same cap costs $3.48 million. …
To make matters worse, property buyers loaded up on unusually large amounts of variable debt during the pandemic. In 2021 and 2022, the share of floating-rate loans in total CMBS issuance was around 60%… [end quote]
During 2020 to 2022, the Federal Reserve suppressed interest rates as an emergency measure during Covid. Borrowers should have locked in these rates with long-term loans instead of getting floating-rate loans.
The unexpectedly high cost of interest rate hedges may force property owners to sell (even at a loss) or even default. While defaults are still low, there may be a wave of fire sales and defaults later this year and in 2024 if interest rates stay high. (This is separate from the similar problem with zombie companies loaded with corporate debt.)
This looming risk will strike at the heart of the regional banks that earn income by financing C & I loans. The Fed is working on tightening oversight and rules for regional banks. They will be less likely to easily finance troubled C & I borrowers. This will reduce earnings for the banks as well as the borrowers.
The market is well aware of the looming risks for regional banks. The SPDR S&P Regional Banking ETF (KRE) has been dropped 28% this year and lost over 7% so far today.
Unfortunately, small towns and cities throughout the U.S. will be hurt by this problem. Local businesses borrow local, not from the big money-center banks. Unless the Fed pivots quickly and strongly (which they probably won’t since they are all too aware that pivoting extended the 1970s inflation) the local economies and regional banks could have a deeper recession than the coasts.
Wendy