Echoes of the 2008 financial crisis

EVENTUALLY, the world is starting to feel the ripple effects of the US commercial real estate turmoil. The real estate market distress goes back to issues — such as reduced office demand and apartments that were overbought at their peak values — stemming from the Covid pandemic.

The crisis is exacerbated by rising borrowing costs resulting from monetary tightening by the Fed to tame decades-high inflation.

A Bloomberg report last week argued that “the shakeout in the $20 trillion market had long been delayed for a simple reason: No one could figure out just how much properties were worth. And, more crucially, few wanted to.”

Many US lenders, especially the country’s regional banks ‘loaded up on loans for properties now worth a fraction of their initial price’, are finally beginning to feel the pain. However, the pain is no longer confined to the US banks; it is also spreading like a contagion outside the US to Japan, Germany and elsewhere as “the lenders take steps to brace for bad loans after property deals started to pick up, revealing just how far real estate prices have fallen.” The slump spurs concerns about losses that can ripple across the global financial system.

Economies like Pakistan could be indirectly impacted by US property woes if the contagion spreads like the one about 16 years ago

According to Bloomberg, The plunging US values are being felt worldwide because properties in top-tier American cities were once magnets for global investment. “Offices were seen as super safe bets backed by high-quality assets with long-term leases and rising rents. That’s now coming back to bite. It’s why pockets of distress have cropped up in areas far away from the US. As more loans near their maturity dates and investors write down properties or walk away, lenders across the world will have to stockpile more reserves to deal with possible losses.”

Starting with New York Community Bancorp, Japan’s Aozora Bank and Germany’s Deutsche Bank AG are making provisions for and bracing for significant losses tied to their investments in US commercial property, heightening concerns over global banks’ exposure to the souring real estate bets.

Beyond that, Switzerland’s Julius Baer reported a more than 50 per cent drop in profits after it wrote off $700 million from its exposure to Signa, the crisis-hit Austrian property group. Germany’s Deutsche PBB and Aareal Bank have seen their unsecured borrowing costs climb as investors scrutinise their books for bad US loans.

South Korean banks and asset managers, among the largest investors in European and US commercial buildings in recent years, are also bracing for a wave of problematic debt. The issues have also hit Canada as Sun Life Financial saw the value of its US office investments plunge.

The magnitude of the crisis is still up for debate. So is its potential impact on the global financial system and developing economies like Pakistan as the US commercial property market troubles hit banks in New York and move to Japan and Europe, elevating fears about broader contagion.

Nevertheless, Gary Shilling, an economist best known for correctly forecasting the 2008 housing crash, is reported to have said: “This isn’t of the magnitude of the subprime-mortgage bonanza.”

He was referring to the cascade of defaults that crashed multiple Wall Street banks and brought on the global financial crisis. “But I think it is a bubble which is beginning to crack,” he had predicted in November.

US Treasury Secretary Janet Yellen is of the view that losses in commercial real estate are a worry, but that the situation is “manageable,” a similar sentiment expressed by Fed Chair Jerome Powell on February 4.

Others have more dire outlooks, with real estate investor Barry Sternlicht predicting $1tr in office losses. For lenders, that means the prospect of more defaults as some landlords struggle to pay loans or simply walk away from buildings.

“This year will be when the distress brewing in commercial real estate finally reaches its breaking point,” the Business Insider quoted research firm Capital Economics in a report in January. The firm pointed to pessimism that has clouded the commercial real estate sector.

Commentators have been warning of a crash, thanks to tightening credit conditions as a wave of debt from property owners comes due. Around $541 billion of commercial real estate debt officially matured in 2023, though fallout was muted as many loans were granted extensions, the firm said.

“That’s a sign many building owners are looking to ‘extend and pretend’, but that strategy can’t last forever as there’s still a $2.2tr mountain of commercial real estate debt that will mature by 2027,” Capital Economics says.

Defaults and late payments on commercial real estate debts are already on the rise, and property values have begun to fall. The sector is now in the midst of the greatest price slump in the last half-century, according to the International Monetary Fund (IMF), with values diving around 11pc last year.

In late January, the IMF expressed deep concern over the impact of two specific threats to commercial real estate: rapidly rising and maturing debt paired with declining property values. Another problem for the industry is that about a third of the $4.5tr in commercial real estate debt comes due before the end of 2025, according to Morgan Stanley analysts.

Many think if the commercial real estate losses spread to Europe through smaller German banks, it would echo the 2008 global financial crisis. Back then, the Landesbanks got into trouble when their exposure to subprime mortgages in the US led to billions of Euros of writedowns. “You have to be mindful as you don’t know exactly where the bottom is,” according to Tikehau Capital.

Federal Reserve Chair Jerome Powell is reported to have said: “It feels like a problem we’ll be working on for years. It’s a sizable problem, albeit a manageable one, that is more likely to affect smaller or regional banks. It doesn’t appear to have the makings of the kind of crisis things that we’ve seen sometimes in the past, for example, with the Global Financial Crisis.”

So far, economies like Pakistan’s, which are largely disconnected from the global financial system, remain insulated from these developments. Yet these economies could be indirectly impacted by the crisis’s consequences if the contagion spreads like the one did nearly 16 years ago.