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Elizabeth Warren On The Impending Commercial Real Estate Crisis

 March 07, 2010 08:49 PM

In my recent T3Live Strategy Research report, I dedicated a section to the Congressional Oversight Panel's warning on the impending commercial real estate crisis. In that section, I outlined that over $1.4 trillion of CRE loans are reaching their end of terms over the next 4 years. As 50% of commercial real estate loans are underwater, estimates are for $200-$300 billion in potential losses with the greatest concentration of risk in banks with less than $10 billion in assets. As small banks are at the heart of small business lending, this could cast headwinds on any sustainable economic recovery.

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Recently on the Charlie Rose show, Ms. Warren, who chairs the COP, continued to wave the red flag that bank balance sheets have not been cleaned up and that toxic assets are still sitting on the books. In addition, as the banking industry continues to consolidate, the concentration of risk is greater than it was before the crisis, creating distortions throughout the economy. In her words - "We're seeing banks that don't want to lend because they see every dollar that comes in the door and say I've got to hold on to it to try to fill my commercial real estate hole or else I will be gone."

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In the chart above, you can clearly see just how much capital banks are hoarding in excess reserves. To me, this presents two major risks going forward. First, if Ms. Warren's thesis is correct that banks are indeed buttressing their balance sheets against unrealized losses from toxic debt, then there is a significant chance the we are still in store for another leg down in this secular bear market . Under this scenario, credit conditions will remain tight and small businesses will continue to find it difficult to finance ongoing operations, much less plan for expansion. Unemployment will continue to remain elevated as small businesses created over 33% of the jobs in previous expansions and consumers will not have enough spending power to carry the economy after the inventory cycle completes. I believe this to be the most probable scenario.

On the other hand, some are arguing that this $1 trillion poses an substantial inflation risk if banks decide to begin to lend again. Known as the multiplier effect, bank lending can quickly set off a chain reaction that ignites the monetary base. For instance, suppose the Federal Reserve sets the reserve requirement at 15%:

Bank A has deposits of $100. They are required to keep $15 on their balance sheet, but can lend out the remaining $85 to customers. These customers then take their $85 in loans and place them in depository accounts at another bank which in turn will keep $12.75 on their balance sheet and lend out $72.25. That cycle proceeds until Bank A's original $100 has now generated over $660 in additional deposits (100/.15).

The Fed is fully aware of this risk and has began to prep the market that they will be taking steps to drain some of this excess liquidity out of the system before inflationary pressures build up. As we touched on in the paper, the Fed is going to begin paying interest on excess reserves for the first time in history, to provide an incentive for banks not to lend and keep inflation under control. While a valid first step, this excess reserve conundrum poses an entirely different set of risks to the economic recovery - unleashing a resurgent inflation if banks begin to lend, or if economic growth does not rebound meaningfully, banks will sell excess reserves on the open market and weigh on the fed funds rate, a deflationary effect. The inflation/deflation argument is a very interesting topic that will have to be saved for another post!

For now, I continue to admire Ms. Warren's diligent effort in the quest for truth and transparency in the financial system. Like her, I am inclined to believe that there is still another wave of debt destruction on the horizon, constraining any robust economic recovery, and pushing the last leg down in this secular bear market.



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