This week, the ongoing saga of regional bank failures continues.
Chances are, you’ve heard all about JP Morgan buying First Republic Bank after going into receivership with the FDIC.
But here’s the story you haven’t heard…
In the last two banking crises, we had a lot of small banks fail, with a few larger ones.
However, in the current crisis, the only failures so far have been three $100b+ institutions.
Where are all the small bank failures?
Answer: Thanks to short sellers and the pending commercial real estate crisis, bank stocks are getting crushed, and it appears the worst is still to come.
Today, we’re going to unpack what’s been going on in banking and capital markets this week…
And how the current bank crisis is both different, but also the same as the previous two.
Let’s dive in,
-Equifund Publishing
A Brief History of Regional Bank Failures and Real Estate
Since the creation of the FDIC during the Great Depression, the United States has gone through two major banking crises.
First, the Savings and Loan Crisis (S&L). Between 1980 and 1995, more than 2,900 banks and thrifts, with collective assets of more than $2.2 trillion, failed.
Second, the Great Financial Crisis (GFC). Between 2007 and 2014, more than 500 banks with total assets of nearly $959 billion failed; The 2008 collapse of Washington Mutual was (and still is, for now) the largest bank failure in U.S. history.
But why do banks fail in the first place? Generally speaking, there are three reasons.
- Bank Run: a run on deposits (which leaves the bank without the cash to pay everyone who wants to withdraw their money);
- Loan Failure: too many bad loans or assets that fall precipitously in value (both of which erode the bank’s capital reserves);
- Interest Rate Risk: a mismatch between what the bank can earn on its assets (primarily loans) and what it has to pay on its liabilities (primarily deposits).
What does this have to do with Real Estate?
A lot it turns out; Real estate lending is the “bread and butter” of small and regional banks.
When businesses fail, they can’t pay rent to their landlords.
When landlords fail, they can’t service their debt, and thus default.
And when loans start to default, banks start to fail, and the contagion spreads to the rest of the economy.
Here’s how it went down in the previous two bank crises (and the several similarities between them):
- Rooted in real estate: Both crises had their origins in the real estate market. The S&L crisis was driven by the collapse of the savings and loan industry, which was heavily involved in mortgage lending. The GFC was fueled by a housing market bubble, and subsequent collapse, leading to a wave of mortgage defaults and losses for financial institutions.
- Deregulation and inadequate oversight: In both cases, deregulation and inadequate regulatory oversight played significant roles in creating an environment conducive to excessive risk-taking. In the S&L crisis, deregulation allowed savings and loan associations to engage in riskier investments, while the GFC saw weak regulation and oversight of complex financial instruments and the mortgage lending industry.
- Risky lending practices: Both crises involved risky lending practices that contributed to the problems in the housing market. In the S&L crisis, many institutions pursued aggressive growth strategies without adequate risk management, leading to high levels of bad loans. In the GFC, the proliferation of subprime mortgage lending, and adjustable-rate mortgages with unfavorable terms, set the stage for widespread defaults and foreclosures.
- Financial innovation and complexity: The S&L crisis and the GFC both involved the use of innovative and complex financial instruments that contributed to the instability of the financial system. In the S&L crisis, this took the form of investments in commercial real estate and junk bonds, while the GFC saw the widespread use of mortgage-backed securities, collateralized debt obligations, and other complex derivatives.
- Contagion and systemic risk: Both crises demonstrated the potential for financial problems to spread rapidly throughout the financial system, due to the interconnectedness of institutions and markets. In the S&L crisis, the failure of numerous savings and loan associations led to a broader crisis in the industry, while the GFC saw the collapse of major financial institutions, and the freezing of credit markets, which had global implications.
- Government intervention and bailouts: In both cases, government intervention was required to stabilize the financial system and mitigate the economic fallout. The S&L crisis led to a massive government bailout to resolve the failed institutions, while the GFC saw unprecedented monetary and fiscal policy measures, as well as direct bailouts of financial institutions, to stabilize markets and stimulate economic recovery.
If you’re thinking “man, that sure sounds a lot like what’s happening today,” you’d be right. Except for one thing.
Unlike the S&L crisis and the GFC, the current wave of bank failures was not rooted in real estate.
However, the contagion will likely spread into the real estate sector if small and mid-sized banks continue getting hammered.
Here’s why…
Capital costs had already increased substantially since the Fed began increasing short-term rates in March of 2022, which has resulted in value declines in both private and public markets.
Today, the fear of over-exposure to commercial real estate, particularly the office sector, has effectively placed smaller banks on the sidelines.
More specifically, the credit markets are tightening, liquidity is drying, and the “refinancing timebomb” looms near.
According to data from the Mortgage Bankers Association and Citigroup, the size of the commercial real estate debt universe outstanding was nearly $5 trillion, as of the end of 2022. This represents roughly 28% of the entire investable commercial real estate universe.
Of that share, commercial banks and thrifts represent $1.7 trillion, or roughly 35% of all commercial real estate (CRE) debt in the market today—a sizable share of the overall lending universe.
Of that total, roughly $448 billion is maturing in 2023, with 60% of that total held by banks.
CRE has already been under pressure thanks to COVID, the “work from home” movement, and rising interest rates.
Layer in a banking crisis, and the next 12-18 months will likely be painful, as CRE struggles to refinance and cover debt servicing costs.
But that’s not to say CRE is a “bad investment,” or that there aren’t excellent setups for opportunistic investing.
“As I talk with people around the world, it is clear that many expect real estate to play a similar role in the next downturn as it did in 2008. But there is an important new pattern today – not all real estate is created equal.
In the past, sub-sectors moved more or less together. But if you look at the first quarter, the dispersion between sectors is very wide.
Take [a] traditional U.S. office – it is facing real challenges with high vacancy rates and rent pressure. On the other hand, look at warehouses – vacancies are miniscule, rent growth is strong and new supply is rapidly declining.
We see similar strength in other areas like hotels and data centers.
This dispersion has influenced how we’ve deployed capital in recent years.
Today, U.S. traditional offices make up less than 2% of our real estate equity business, down from over 60% in 2007. In that same timespan, we’ve increased logistics exposure from zero to 40% of the business.
You can’t paint commercial real estate with one brush.”
What are your thoughts on commercial real estate in today’s markets?
Let us know what you’d like us to cover if you’re interested in this asset class.
When Short Sellers Attack: Banks Fall and Ichan Loses
This week, regional banks had a series of terrible, horrible, no good, and very bad days.
Not only have small and regional banks had to deal with mini “bank runs” as deposits flow into larger banks…
Any bad news flow results in downward pressure on the stock, which only fuels the panic (although we saw a rebound on Friday).
To make things worse, we’re in a Bizzaro market environment where investors are actively shorting regional banks.
Not surprisingly, the practice of short selling has come under fire (again).
“The administration is going to closely monitor the market developments, including the short-selling pressures on healthy banks. I would have to refer you to the SEC on any possible actions”
The American Bankers Association, on Thursday, called on the SEC to investigate significant short sales of banking shares and social media engagement that it said appeared to be “disconnected from the underlying financial realities.”
But as of now, the SEC is “not currently contemplating” a temporary short selling ban.
Why? Because like it or not, short sellers do provide an important function in capital markets.
Exhibit A: Carl Ichan lost $10B in ONE DAY following a critical report from short seller Hindenburg Research
The report alleged that Icahn Enterprises (IEP.O) was overvalued, and was operating a “Ponzi-like economic structure” to pay dividends.
According to the report
Jefferies analyst Daniel T. Fannon initiated the firm’s research on IEP in April 2013 with a “buy” rating and has touted the company ever since. In Fannon’s February 28, 2023 research note, he placed a $70 price target on Icahn Enterprises, saying:
“IEP represents one of the few public vehicles for investors to access the activist investor style”.
As noted earlier, Jefferies’ research notes assume that Icahn’s dividends will be paid out in perpetuity even in a worst case scenario, despite free cash flow and investment losses that clearly evidence that the dividend is high risk.
To sustain its dividend, IEP has sold units over the last 4 years, totaling over $1.7 billion in at-the-market (ATM) offerings. The sole agent of all of IEP’s offerings has been Jefferies.
Once again, the very investment bank selling IEP units to investors is simultaneously drawing in additional retail investors with its “buy” rating and its unsupported assumption that IEP’s dividend is safe forever.
After a review of the largest 5 components of Icahn’s portfolio, comprising ~95% of its gross investment value, we found that reported values were either clearly overstated due to (i) pro forma losses not yet reflected in the most recent 2022 year-end NAV calculation or (ii) blatant overvaluation of less liquid valuation marks.
Carl Icahn has built an aura of invincibility around himself—a titan of Wall Street with a knack for coming out on top. But while the focus has always been on his grand public activist campaigns, quieter long-term investment losses, along with the substantial use of leverage, have whittled away his empire.
At this stage, Icahn’s net worth is reliant on selling overpriced IEP units to retail investors while convincing them that they will be rewarded with a consistent, safe dividend in perpetuity, despite extensive evidence to the contrary.
In an ironic twist of fate for activist investor Carl Ichan, this is the first time his firm has become a target of activist investing.
What are your thoughts on short selling?
