It is no secret that the Fed is quite, quite concerned about the ongoing shakeout in the US commercial real estate market in the US, but just in case anyone missed the memos, Dennis Lockhart of the Atlanta Fed has devoted a whole speech to the subject.
Here are some of the key elements of Lockhart’s address, which he was scheduled to deliver at a real estate conference on Tuesday (any emphasis FT Alphaville’s):
Outline -
I will try to give you a sense-as a policymaker concerned with the broad economy-of how I am sizing up the commercial real estate challenge. One of my themes this morning will be the links, or connectivity, between sectors and the potential for troublesome, self-reinforcing interactions.
Disclaimer -
I must emphasize that the views I’ll express are my personal thoughts and are not necessarily shared by my colleagues in the Federal Reserve and on the Federal Open Market Committee (FOMC).
On contagion -
it’s instructive to consider the connectivity among sectors and the potential of a self-reinforcing negative feedback loop involving multiple sectors.
Today, I’m particularly concerned about the interaction among bank lending, small business employment, and CRE values.
To elaborate, there is a tight linkage between CRE values and jobs. In a mid-September conference at the Atlanta Fed, CRE practitioners, investors, and academics agreed that the evolution of the CRE picture will depend greatly on the path of employment.
Small business impact -
Let me go on to show the link between jobs and small business credit. During the last two economic expansions, small firms (those with fewer than 50 employees) contributed about one-third of net job growth. But the depth and duration of this recession have taken a substantial toll on small businesses. In the 2001 recession, small firms held up reasonably well and accounted for only 9 percent of net job loss. In this recession, however, small firms have accounted for about 45 percent of net job losses per our most recent data through the end of 2008.
Small businesses tend to depend greatly on the banking sector-especially community and regional banks-for financing. A Federal Reserve survey earlier in the decade showed that more than half of smaller firms had a credit line or loan with a bank. In addition, about half of these businesses used a personal or business credit card to finance working capital. In this recession, credit standards have tightened for all businesses, including small businesses.
At this juncture, it’s hard to be encouraged about a fast rebound in job growth. As you know, last week’s employment report pushed the official unemployment rate to 10.2 percent, the highest since May 1983. Net job losses continue on a monthly basis but at a declining pace. Because employment growth tends to lag recovery from a recession and because of factors such as small business credit constraints, my current outlook for employment is one of very slow net job gains once the trend reverses, in all likelihood sometime next year. If this view is correct, this job growth outlook doesn’t help the commercial real estate situation.
Likely impact of the CRE problem on the financial system and the broad economy –
While the CRE problem is serious for parts of the banking industry, I don’t believe it poses a broad risk to the financial system. Compared with residential real estate, the size of the CRE debt market is smaller, and the exposure is more concentrated in smaller banks.
However, I am concerned about the potential impact of CRE on the broader economy. Unlike residential real estate, there is not the same direct linkage from CRE to household wealth-and therefore consumption-caused by erosion of home equity. However, there could be an impact resulting from small banks’ impaired ability to support the small business sector-a sector I expect will be critically important to job creation.
To add some detail: At the end of June 2009 there was approximately $3.5 trillion of outstanding debt associated with CRE. This figure compares with about $11 trillion of residential debt outstanding.
About 40 percent of the CRE debt is held on commercial bank balance sheets in the form of whole loans. A lot of the CRE exposure is concentrated at smaller institutions (banks with total assets under $10 billion). These smaller banks account for only 20 percent of total commercial banking assets in the United States but carry almost half of total CRE loans (based on Bank Call Report data).
Many small businesses rely on these smaller banks for credit. Small banks account for almost half of all small business loans (loans under $1 million). Moreover, small firms’ reliance on banks with heavy CRE exposure is substantial. Banks with the highest CRE exposure (CRE loan books that are more than three times their tier 1 capital) account for almost 40 percent of all small business loans.
To repeat my current assessment, while the CRE problem is very worrisome for parts of the banking industry, I don’t see it posing a broad risk to the financial system. Nonetheless, CRE could be a factor that suppresses the pace of recovery. As the recovery develops, the CRE problem will be a headwind, but not a show stopper, in my view.
It’s appropriate to be a bit tentative in the assessment of CRE risk to the financial system, however. In 2007, many underestimated the scale and contagion potential of the subprime residential mortgage-backed securities problem. With this experience in mind, my assessment should continue to be refined.
Overall, Lockhart didn’t paint a doomsday scenario, but his comments about the smaller banks — linchpins of the economy, essential to job creation, failing at an alarming rate, insufficiently regulated — do not reassure.
As BNP Paribas put it in a note on Monday:
There seems to be, only in the US, an unwillingness from a political perspective to further restructure / nationalise banks, which is the crux of the rising unemployment problem. It is the lack of bank lending, that is squeezing businesses, causing them to lay off employees and the politicians need to get a grip on this dynamic rather than wasting one stimulus package after another while increasing the budget deficit.
Related links:
US bank regulators warn on commercial real estate – Reuters
For America’s small banks, the problems are just beginning – FT Alphaville
Banks not worried enough about commercial real estate, Fed says – FT Alphaville
US commercial real estate datapoint du jour, Hawaiian hotels edition – FT Alphaville