The commercial real estate (CRE) implosion that has exposed endemic risk to regional banks and foreign financial institutions since the pandemic lockdowns manifested the first collapse of a CRE-related derivative product last week. I suggest reading Part 4 noted below if you are unfamiliar with derivatives and did not know they were the underlying cause of the Great Financial Crisis (GFC) that was blamed on a housing bubble. Feel free to peruse “The Implosion of Commercial Office Space Has Begun” Part 1 (Twitter thread) published in May 2022, 2 (thread) in May 2023, 3’s “Fire Sale” (thread) in Jul. 2023, and here is an excerpt from 4’s “Derivatives” in-depth analysis (thread) published in Feb. 2024:

“An issue most plebes are oblivious to is the smoldering CRE debt heap obfuscated by the synthetic securitization of commercial mortgage-backed securities (CMBS) within an overleveraged derivatives market. It is eerily similar to credit default swap (CDS) and collateralized debt obligation (CDO) tranches of mortgage backed securities (MBS) that were the catalysts behind the infamous 2007-2009 Great Financial Crisis (GFC). There are no regulatory rules that standardize CMBS structures, and they are comprised of ‘commercial mortgages of varying terms, values, and property types’ across the sector that include multi-family residential buildings. CMBS valuations are difficult to determine from a risk management perspective, which heightens the risk pool in the global derivatives market.” – TraderStef

A phrase that has circulated among financial rags since late May is “Bulletproof to Bust.” It describes the loan default for a Blackstone-financed property in New York City. That loan was gift-wrapped with AAA-rated bonds within a CMBS derivative product and is the first time since the GFC that investors in top-rated bonds backed by CRE took a major loss. Buyers of the AAA portion of a $308 million note backed by a mortgage on the 1740 Broadway building, a 26-story office building near Manhattan’s Columbus Circle, got less than three-quarters of their original investment back after the loan was sold at a massive discount. The fact that huge losses have affected top-ranked holders in CMBS tranches despite safeguards to ensure full repayment highlights how deeply distressed portions of the U.S. CRE market are. The loss was so precipitous that it wiped out multiple layers of bonds within the top $157 million AAA class amounting to a loss of $40 million.

One New York Office Building Shows the Stress in the $20 Trillion Commercial Real Estate Market – Bloomberg, May 8

Losses Pile Up in Top-Rated Bonds Backed by Commercial Real Estate Debt… “The 1740 Broadway building, formerly the Mutual of New York or MONY building, sits just south of Columbus Circle… It was bought for $605 million by Blackstone Inc. in 2014. To help finance the deal the firm took out a $308 million mortgage, which was packaged into a CMBS and scooped up by the likes of Travelers Cos., Endurance American Insurance Co. and others. In 2021 L Brands, the former parent of Victoria’s Secret and Bath & Body Works that occupied 77% of the property’s leased space, said it would exit the tower. While Blackstone spent tens of millions of dollars to modernize the building, tepid demand for office space made finding new tenants difficult. With no one paying rent, Blackstone stepped away from the property in 2022, defaulting on the loan. A few weeks ago, the mortgage’s special servicer and Blackstone agreed to sell the building to Yellowstone Real Estate for roughly $186 million. The deal resulted in the repayment of the CMBS. But with additional losses from fees and advances, only $117 million was left for bondholders. Investors in $151 million of lower-rated debt were wiped out, while those holding $158 million of debt originally rated AAA suffered a 26% loss.” – Yahoo Finance, May 23

Bulletproof to bust: Top AAA bonds tarnished by a Blackstone office deal’s blow up… “AAA rated commercial mortgage bonds have long been considered safe investments typically favored by insurance companies and pension funds. That’s because they offer a little bit of income, but limited credit risks, while also helping fund long-term client obligations. In the case of Blackstone’s 1740 Broadway, bankers spun the property’s roughly $300 million senior mortgage into six classes of bonds. The top AAA class was protected by five junior classes of bonds, designed to absorb losses first, if the borrower defaulted. In theory, there should have been enough cushion in the deal’s junior classes to prevent a AAA loss, even if the loan repaid at a big discount. That isn’t, however, how Blackstone’s bonds shook out… ‘There is going to be more distressed bonds, more assets coming to market,’ said David Auerbach, chief investment officer at Hoya Capital Real Estate.” – MarketWatch, May 30

Bonds backed by single mortgages and tied to older office buildings dominated by one anchor tenant are especially vulnerable, and 1740 Broadway is a perfect example. The current surge of brick-and-mortar retail closures is worsening an already delicate situation. There are more losses on the horizon as more loans are sold at a fraction of their former value that were bundled within numerous CMBS-derivative products.

Axos: Glaring Commercial Real Estate Loan Problems and Lax Underwriting… “The industry has begun to plummet: distressed U.S. commercial properties rose from $56.9 billion in 2022 to $85.8 billion in 2023. $2.2 trillion in commercial mortgages are set to mature before the end of 2027. Even AAA-rated bonds backed by CRE debt are now taking losses, and multifamily investments have plunged to four-year lows. ‘It’s a sh*t show,’ one Axos deal partner told us about the office market in New York. 37.5% of Axos’ commercial real estate loans were in New York, where a CRE ‘bloodbath’ has resulted in commercial realty foreclosures increasing 65% year over year.” – Hindenburg Research, Jun. 4

According to a Moody’s Ratings report released in mid-May, the number of delinquent office loans packaged into CMBS reached their highest percentage since 2018.

Office CMBS Delinquency Reaches Highest Rate Since 2018: Report… “Moody’s Ratings believes delinquencies will rise and refinancings will fall so long as interest rates remain high. A new report from Moody’s found that national CMBS office loan delinquencies hit 6.4% in April, the highest monthly average since 2018, when many 10-year loans negatively impacted by the 2008 Global Financial Crisis were still being worked out upon maturity. Moreover, the office conduit/fusion CMBS refinance rate collapsed to 24%, after spending much of the last two years in the 50% range. The lack of repayments comes as the 10-year treasury rate hovers around 5%, one of its highest levels over the last 17 years. Darrell Wheeler, head of CMBS research at Moody’s, noted that the increased loan delinquencies and lack of repayments are indicative of widespread distress across the office sector that his firm had baked into their forecasts entering the year. However, Wheeler emphasized that even he has been surprised to see the distress emerge this quickly in 2024… Wheeler believes the distress for office CMBS isn’t anywhere close to done, and that the 6.4% delinquency rate is threatened by interest rate uncertainty… Perhaps most alarming, of the $1.57 billion in newly delinquent CMBS loans, a whopping 82% of them were maturity defaults, according to Moody’s… Maturity defaults are when the borrower fails to repay or refinance their CMBS loan at maturity, largely due to the balloon payment they’ve put off until the end of their loan’s lifespan, whereas term defaults are when a borrower fails to make their monthly interest rate payments.” – Commercial Observer, May 14   

The trend in loan delinquencies and defaults is mirrored by a banking crisis with unrealized losses piling up on investment securities, particularly for regional and community banks where a majority of CRE loans are held and/or originate. The delinquency rate in multifamily housing is leading the race to oblivion as it tops the highest level since 2013.

 

 

Unrealized losses jumped to $516.5 billion in 1Q24 and were $39 billion higher than in 4Q23. The surge was driven by higher residential mortgage-backed securities (MBS) losses held by banks due to rising mortgage rates. 1Q24 marked the 10th consecutive quarter of unrealized losses, an even longer streak than during the 2008 GFC. If interest rates are kept “higher for longer,” unrealized losses will continue to rise.

Why hundreds of U.S. banks may be at risk of failure… “Hundreds of small and regional banks across the U.S. are feeling stressed. ‘You could see some banks either fail or at least, you know, dip below their minimum capital requirements,’ Christopher Wolfe, managing director and head of North American banks at Fitch Ratings, told CNBC. Consulting firm Klaros Group analyzed about 4,000 U.S. banks and found 282 banks face the dual threat of commercial real estate loans and potential losses tied to higher interest rates. The majority of those banks are smaller lenders with less than $10 billion in assets.” – CNBC, May 1

FDIC Quarterly Banking Profile First Quarter 2024… “The number of banks on the Problem Bank List, those with a CAMELS composite rating of ‘4’ or ‘5,’ increased from 52 in 4Q23 to 63 in 1Q24. Total assets held by problem banks increased $15.8 billion to $82.1 billion during 1Q24… The Deposit Insurance Fund (DIF) balance was $125 billion on March 31… The banking industry still faces significant downside risks from the continued effects of inflation, volatility in market interest rates, and geopolitical uncertainty. These issues could cause credit quality, earnings, and liquidity challenges for the industry. In addition, deterioration in certain loan portfolios, particularly office properties and credit card loans, continues to warrant monitoring” – FDIC, May 29

 

“British Banks are all on the brink of collapse” – Godfrey Bloom, May 22

 

The banking system began to disintegrate at a rapid pace in 2023, and the Federal Reserve has been plugging holes in the Titanic with liquidity accommodations that dwarf the pandemic panic and GFC.

 

 

Real Estate Crisis to Create a WORSE 2008 – ITM Trading, Jun. 4

 

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TraderStef on Twitter / Website: TraderStef.com

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