Dive Overview:
Federal Reserve Chairman Jerome Powell predicted on Wednesday that losses in the commercial real estate market would hit mostly small and mid-sized banks, and warned that efforts to ensure stability would need to continue for years. “Some banks are going to suffer losses,” Powell said in testimony before the House Financial Services Committee. “The concentrations of problem loans are really small and mid-sized banks,” he said, adding, “I think this is going to be an issue that we're going to be working through for several years.” “This is manageable,” Powell said, noting that the central bank is working with other regulators to help banks absorb loan losses. “You need to have adequate capital, adequate liquidity, and a plan to absorb the losses that you're probably going to incur. That's what we're doing.”
Dive Insights:
The Federal Reserve, the Treasury, bankers and commercial real estate executives have been warning for months that markets could be in turmoil as property owners struggle to refinance their debt at high interest rates.
America's top regulator warned in December that commercial real estate was the biggest risk to financial stability this year, citing rising vacancy rates, falling office property values, a possible economic slowdown and high interest rates. The Fed, seeking to tame inflation, has kept interest rates on hold at a 23-year high since July.
“CRE is the largest loan category for nearly half of U.S. banks, and more than a quarter of U.S. banks have large CRE loan portfolios relative to their capital holdings,” the Financial Stability Oversight Council said in its annual report.
“The office sector faces the most severe challenges as demand for office space remains weak, particularly in the largest US markets,” the council said.
Over the next three years, $2.2 trillion in commercial real estate debt that was financed at near-zero interest rates before 2022 will come due, according to Scott Rechler, a New York Fed governor and CEO of real estate firm RXR.
“To address this, we first have to admit that our values are wrong,” Rechler said in an interview with CNBC on Wednesday.
“Some of the larger banks have built up significant reserves over the past year to ultimately position themselves to reduce lending and have sold those reserves at fair value,” he said. “But there hasn't been enough transaction activity to provide any real pricing clarity.”
The crux of the problem is the small banks, Mr. Rechler said, echoing comments by Mr. Powell and Treasury Secretary Janet Yellen: “It's the small community banks that are highly concentrated, that don't have reserves, that don't really build reserves, and that's what regulators are focusing on right now.”
In her testimony, Powell said she wants commercial property owners to refinance their debt at lower interest rates this year.
“If the economy develops broadly as expected, it will likely be appropriate to begin easing policy restraints later this year,” he said. “However, the economic outlook is uncertain and sustained progress toward the 2 percent inflation target is not assured.”
The central bank is trying to navigate a conundrum by gauging when to cut the federal funds rate from its current range of 5.25% to 5.5%.
“Reducing policy restraint too soon or for too long could reverse the progress made so far in inflation and ultimately require even more stringent policy to return inflation to 2 percent,” Powell said.
“At the same time, easing policy restraints too late or not enough could weaken economic activity and employment too much,” he said.