The impact of the banking crisis is still unfolding despite assurances from the Federal Reserve and the Big Banks that the banking system remains strong and resilient. With over 100 banks in similar situations as SVB the mismanagement of "duration" risk is clearly widespread among many regional banks. In addition to the current "risks" that have the headlights focused on them are the significant commercial paper "risk" that regional banks hold and will need to be refinanced in the coming years. These are valued in the trillions of dollars. A significant portion of this debt was financed when interest rates were around zero. As this debt rolls over and needs to be refinanced there is a high probability this will occur in a market with higher than zero interest rates, lower property values and less liquidity in the short term, due to the banking failures and call for tighter regulation of regional banks.
COVID accelerated a comprehensive change in employee remote work arrangements. While the trend has generally moved towards a hybrid approach of remote and in-office work arrangements, companies are down-sizing their office space requirements as they consolidate use with shared employee spaces. This trend will impact demand for commercial office space. The commercial real estate market is struggling as a result. Before the pandemic, office space occupancy was close to 95% whereas last December it was at 47%.. Lower rental income equates to declining values. An office building in San Francisco for example that sold for $397 million in 2019 was on the market in December 2022 for $155 million.
Regional banks carry significant risk exposure to commercial paper and commercial real estate companies that are in a market downturn and this will be or should be a forward looking concern to investors and depositors. Columbia Property Trust’s default on a $1.7 billion floating-rate loan, and Brookfield Asset Management’s default on $750+ million in debt in Los Angeles are early warning signs. Commercial real estate leases can span several years so it will take approximately a couple of years for this to unfold during which millions of leases will expire. Companies renegotiating their leases will have the upper hand. They may lease less space or no space attall. Either way, this trend will impact the value of commercial real-estate if rental occupancy and rates decline. This in turn will impact the value of commercial loans on regional banks books and impact their capital ratios.
Goldman Sachs expects approximately 21% of commercial mortgage-backed securities outstanding office loans to default. This in turn will impact municipalities which drive over 70% of their tax revenues from property taxes. The shift to a hybrid work from home and in-office pattern will likely make investors more selective and risk averse to holding commercial paper and they will demand more compenstation for carrying such debt.
The chart below from March 22 through March 23 shows the S&P 500 and the U.S. Investment Grade Credit Spread. The credit spread represents the difference in yield that an investment-grade bond is paying above a government bond of the same maturity. Wherever the spreads rise it not only reflects that investors are demanding more compensation for assuming risk, it has been corresponding to a drop in the S&P 500 since March of 2022.
The inverse correlation tracks fairly closely and while the past is not a predictor of the future it represents a pattern and probability that needs to be noted. If the same pattern persists the S&P 500 would decline.
As credit contracts in the short term due to the banking crisis and the Federal Reserve continues its battle to tame inflation the margin of the spread will be dependent on "inflation data" and expectations about rate hikes.
As we have mentioned, the perceived risk of owning debt by investors is increasing and they are demanding higher rates of compensation to hold this debt. Borrowing costs for both businesses and consumers are likely to increase if tightening credit conditions continue to be priced in by the markets. Conversely if the trend in disinflationary economic data becomes more consistent this will likewise influence investor perceived risk as this will temper rate hike expectations.
According to some analysts the current credit crisis could represent the equivalent of a 1 to 1.5% increase in rates. While these numbers are guesses, what is clear, is that the banking crisis will add further disinflationary force to the economy.
Both inflation data and the impact of the banking crisis will continue to shape the narrative. expectations and the resulting credit spread and (if the patterns of the charts continue to track inversely), the S&P 500.
