Goldman’s recession odds are just 15% … the CMBS delinquency rate is back to 2021 levels … the fallout for small banks … why progress on inflation won’t help this dynamic

 

Goldman Sachs just updated its odds of a U.S. recession, lowering the likelihood to only 15%.

Behind this rosy forecast are a handful of bullish projections including reaccelerating disposable income in 2024… disagreement that Fed rate hikes have “long and variable lags” … and strong conviction that the Fed is done hiking rates.

Perhaps Goldman’s forecast will be accurate. But what I didn’t see addressed and explained away as benign is the toxic stew that’s been bubbling in the commercial real estate and small bank sectors for months now.

Goldman’s position is that the impact of the most aggressive rate-hiking campaign ever is largely baked into the cake. Its chief economist Jan Hatzius wrote: “We still strongly disagree with the notion that a growing drag from the ‘long and variable lags’ of monetary policy will push the economy toward recession.”

Respectfully, we strongly disagree with Hatzius’ strong disagreement.

Let’s take a tour through the commercial real estate/banking sector to better understand why.

The daisy chain between commercial real estate, small banks, the U.S. consumer, and your portfolio

Regular Digest readers know that for months, we’ve been running a “commercial real estate watch” segment to monitor this critically important sector of the U.S. economy.

The same factors that resulted in a handful of banking failures this spring have created cracks in the foundation of the $20-trillion commercial real estate sector. If defaults snowball, it will have an enormous impact on the U.S. economy.

If you’re new to what’s happening, the core problem reduces to elevated refinancing costs (based on the Fed’s rate hikes) that are inflicting serious pain on the commercial real estate sector.

Trillions of dollars’ worth of commercial mortgages are beginning to roll over. This will continue over the next several years. Many of these loans are “interest only.”

With this type of loan, the borrower pays only interest throughout the entire life of the loan. There’s no build-up of equity, so the entire principal payment comes due at the end.

In normal times, this is fine. After all, low vacancy rates and healthy rent levels enable the borrower to cover the interest-only payments easily enough. And over time, the value of the underlying real estate appreciates, so the borrower can pay the entire principal back and, hopefully, enjoy some profits left over.

But thanks to the Fed’s soaring interest rates, a surge in office vacancies after Covid, and crumbling rental rates/property values, these are not normal times. Worse, the number of real estate investment groups using interest-only loans has exploded in recent years which makes everything riskier.

According to Trepp, a leading commercial real estate analytics firm, in 2013, interest-only loans as a share of new commercial mortgage-backed securities issuance clocked in at just 51%. By 2021, that percentage had exploded to 88%.

This is a recipe for major fallout – and it’s already beginning to happen.

From Trepp:

The Trepp commercial mortgage-backed securities (CMBS) delinquency rate jumped again in July 2023 with four of the five major property segments posting sizable increases.

Overall, the delinquency rate rose 51 basis points to 4.41%. That is the highest level since December 2021.

What happens in commercial real estate has ripple effects

If commercial real estate suffers, so too do small/regional banks.

Banks smaller than the top 25 largest account for a whopping 67% of all commercial real estate lending (they also comprise about 38% of all outstanding loans, regardless of sector).

So, if/when commercial real estate companies can’t pay their debts, that toxicity transfers directly to banks.

With this context, let’s jump to The Wall Street Journal from yesterday:

Regional banks across the country [have gorged] on commercial real-estate loans and related investments in big cities over the past decade.

With the commercial real-estate market now in meltdown, those trillions of dollars in loans and investments are a looming threat for the banking industry—and potentially the broader economy.

Banks’ exposure is even bigger than commonly reported. The banks are in danger of setting off a doom-loop scenario where losses on the loans trigger banks to cut lending, which leads to further drops in property prices and yet more losses.

The WSJ explains that banks doubled their lending to landlords to $2.2 trillion between 2015 to 2022. But banks also increased their exposure to commercial real estate in ways that aren’t included in direct measurements.

For example, rather than lending to landlords, many banks lent to financial companies that then turned around and lent to landlords. So, that loan doesn’t show up on the bank books as a direct loan in commercial real estate, but that’s what it is.

The WSJ puts banks’ total exposure to commercial real estate, including this shadow lending, at $3.6 trillion.

Back to the WSJ for what’s now happening because of this exposure:

The doom-loop scenario is starting to play out in big cities where office vacancies have soared. Real-estate investors that are unable to refinance their debt, or can only do it at high rates, are defaulting.

The lenders, no longer getting the debt payments, often have to write down the value of those mortgages. Sometimes the bank ends up owning the property.

“The plumbing is clogged right now,” said Scott Rechler, chief executive of real-estate investor RXR Realty. “And that is going to create a backup that will eventually overflow on the commercial real-estate markets and on the banking system.” 

When this “overflow” happens, small banks will circle the wagons and pull back on their lending. Fewer loans mean less economic growth and spending. This eventually trickles down and means reduced bottom-line earnings growth for American businesses.

Too much of this cycle leads to an economic slowdown – and potentially, the recession that Goldman has now shrugged off.

Why recent progress on inflation is irrelevant

Goldman believes a recession isn’t likely in large part because it sees inflation as vanquished, which means the Fed is done raising rates.

First, this week’s economic data show that it’s presumptuous to claim that inflation is over and the Fed is done hiking rates.

But let’s assume this is accurate – well, so what?

As we’ve pointed out in the Digest repeatedly, rates don’t have to be climbing for there to be brutal economic fallout. As long as they remain elevated when commercial real estate companies refinance their loans, there will be pain.

Here’s the WSJ making this point:

Roughly $900 billion worth of real-estate loans and securities, most with rates far lower than today’s, need to be paid off or refinanced by the end of 2024…

Tyler Wiggers, a lecturer at Miami University in Ohio and former adviser to the Federal Reserve Board on commercial real estate, [says] “All of a sudden, banks have borrowers who are saying, holy crap, I was paying at 3.5% and now I’m paying 7.5%,” he said. “If borrowers aren’t able to service their debt then banks have to recognize this as a bad loan.”

So, what’s the likelihood that over the next 12-18 months the Fed saves the day with rate cuts, dovetailing into a lower-rate-refinancing environment?

Goldman is penciling in four separate quarter-point rate cuts in 2024. That relatively rosy scenario would mean we end next year with the fed funds target rate at 4.25% – 4.50%.

Even if this is plays out – which is hardly a certainty – consider the implications…

Let’s be simplistic and assume there’s a rough 1-to-1 relationship between the Fed’s reduced fed funds rate and reduced commercial real estate loan rates.

Based on Wiggers’ comment from a moment ago, that would mean today’s approximate 7.5% interest rate on loans falls to 6.5% by the end of 2024.

That still an 86% increase in financing costs for a company that was enjoying a 3.5% rate a handful of years ago.

For our economy to dodge the worst of this refinancing storm, the Fed would have to slash interest rates to somewhere in the 2.5% to 3.5% range

That target rate would still hurt real estate companies refinancing their loans, but the damage would be far less severe than for companies refinancing over the next 12ish months if rates don’t drop at all.

Unfortunately, the odds that the Fed gets aggressive with rate cuts is zero – unless it’s forced to slash rates as a form of emergency resuscitation for a flatlining economy. Unless the economy is in the gutter, aggressive rate cuts kick the door open to a resurgence of inflation, and the Fed is determined to avoid that.

Coming full circle, maybe Goldman is right. Maybe we’ll avoid a recession. But just 15%?

If these were real odds from a Vegas bookie, I’d take that bet against Goldman all day long.

Have a good evening,

Jeff Remsburg