Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / The Fed's New Worry About Commercial Real Estate and Banks
Transcript
- Lucas: So the Federal Reserve released its latest Financial Stability Report last month, and buried in there was a line that caught my eye — they said commercial real estate valuations remain 'elevated relative to fundamentals,' but that the risk of a sharp correction has increased. Luna: I've been seeing headlines about office vacancy rates hitting records in some cities. But how worried is the Fed, really? Lucas: That's the question — and it's not just about vacancy, it's about the banks holding those loans. The May Senior Loan Officer Opinion Survey — SLOOS — showed that banks tightened lending standards for commercial real estate loans across all property types. And demand for those loans is collapsing. Luna: Right, so banks are pulling back, but is that a response to actual losses, or just precautionary? Lucas: A bit of both. If you look at the data, delinquency rates on commercial real estate loans at banks are still low — around 0.5 percent overall. But they're rising in the office segment, and the Fed's own stress tests this year modeled a scenario where commercial real estate prices fall 40 percent. That's not a base case, but it tells you they're gaming out the worst. Luna: Forty percent — that's huge. What does that do to a bank's balance sheet? Lucas: It eats capital. When property values fall, the loan to value ratio goes up. If it breaches a certain threshold, the bank has to set aside more loss reserves or call in the loan. For a regional bank with a concentrated portfolio of office loans in a downtown that's half empty, that can wipe out a quarter's earnings — or more. Luna: And we saw last year with a few banks that deposit runs can happen fast if people get spooked. Is the Fed worried that this time it's not just a few outliers? Lucas: That's the concern. The Fed's latest Financial Stability Report flagged that some banks have 'relatively high' commercial real estate exposure relative to their capital. It's not systemic in the way subprime mortgages were in 2008 — the securitization market for commercial real estate is much smaller, and banks hold more capital now — but the risk is more concentrated in smaller regional banks. Luna: So if those banks tighten lending, that could spill over into the broader economy — small businesses that rely on them for lines of credit. Lucas: Exactly. And that's the link to monetary policy. The Fed has held rates steady at the last two meetings — the effective fed funds rate is at 3.63 percent — but the tightening in bank lending is doing some of their work for them. It's effectively a credit crunch for commercial real estate. Luna: Is that why we've seen the 10-year breakeven inflation rate drop to 2.26 percent? The market pricing in slower growth? Lucas: I think so. The breakeven rate — the difference between nominal Treasury yields and TIPS yields — is a market-based measure of expected inflation over the next decade. It's fallen from about 2.29 percent a couple weeks ago to 2.26 percent now. That's not a huge move, but it's directionally consistent with the idea that tight credit conditions are weighing on economic activity and inflation expectations. Luna: So the Fed is watching this as a signal that their tightening — plus this bank-led credit tightening — might be slowing things more than expected. Lucas: Right. And Chairman Warsh, in his first meeting last week, emphasized that the Fed is 'data dependent.' He specifically mentioned that they're monitoring 'financial conditions beyond the fed funds rate,' which I think is a direct nod to this commercial real estate dynamic. Luna: Let's get concrete — what's the actual exposure? How much commercial real estate debt is held by banks? Lucas: According to the latest data from the Federal Reserve, banks hold about $2.7 trillion in commercial real estate loans. That's about 15 percent of total bank assets. But for the smallest banks — those with less than $100 billion in assets — it's closer to 25 percent. And within that, office loans are maybe 15 to 20 percent of the commercial real estate portfolio. Luna: So a 40 percent decline in office values — worst case scenario — would be a hit. But not a system-wide killer. Lucas: No, not a killer. But for a bank that's thinly capitalized and highly concentrated, it could be existential. And the worry is that if one or two of those banks fail, it could spook the market for all regional banks, leading to a broad tightening of credit that the Fed didn't intend. Luna: That's why the Fed's discount window and bank term funding program were so important last year. Are those still in place? Lucas: The Bank Term Funding Program expired in March, but the discount window is still open. And the Fed has said it's ready to lend against collateral, including commercial real estate loans. So they're trying to backstop the system without encouraging reckless lending. Luna: So what's the base case? Do you think the Fed sees this as a manageable adjustment, or something that could force a rate cut? Lucas: Right now, I think they see it as manageable. Inflation is still above target — core PCE is at 2.8 percent, core CPI at 3.6 percent — so they're not ready to ease. But if commercial real estate stress leads to a sharp slowdown in lending and economic activity, that could change the calculus. They'll be watching the next SLOOS reading in July very closely. Luna: You know, it's interesting — this kind of analysis is exactly why I appreciate this show. It connects dots that most headlines miss. Lucas: I'm glad it connects. And honestly, a couple of dollars a month from listeners is what keeps these things going — if you've gotten something out of our conversations, buy me a coffee dot com slash fexingo makes a real difference. Luna: Yeah, seriously. It's how we stay independent and ad-free. So if you're able, that's where you can chip in. Lucas: And back to the data — I think the key number to remember is that the Fed's own stress test this year assumed a 40 percent drop in commercial real estate prices. That doesn't mean they expect it, but it means they're prepared for it. And for investors, watching the regional bank ETF — the KRE — can give you a real-time sense of how the market is pricing that risk. Luna: So the takeaway: commercial real estate is a risk, not a crisis — but it's the kind of risk that could amplify the Fed's tightening in ways they didn't fully anticipate a year ago. Lucas: Exactly. And that's why, even though the fed funds rate hasn't moved, financial conditions have tightened further. The Fed is aware of it, and they're watching. But for now, they're holding steady.