Were there any numbers that you wanted to get into beyond the couple that you already mentioned?

EJ: Yeah. What we did in our RECENT PAPER is try to assess the stress risk of commercial real estate. We used non-level data to compute two important measures of the stress risk.

One is called loan to value ratio, or LTV. And the other one is debt-service coverage ratio.

LTV tells us whether a loan is underwater. In other words, it’s whether the market value of the property is lower than the outstanding loan amount. You can imagine an underwater loan is going to be very difficult to refinance and also faces higher default risk.

What we find is about 15% of all CRE loans are underwater. And among all types of commercial real estate properties, the office loans face particularly high distress risk, about 45% of those office loans … So those loans are actually insolvent.

Another measure we looked at was the debt-service coverage ratio that tells us whether a property’s annual cash flow is sufficient to cover its debt obligation. We find that the average debt coverage ratio was about 2 to 3 when those loans originated. This is because many of those loans originated when interest rates were very low … also the demand for office buildings and demand for other commercial real estate properties was still high, and back then they were able to generate a lot of operating cash flow.

If this ratio falls below one, that means the property does not have sufficient cash flow to meet its annual debt payments. And we found more than 6% of those CRE properties have a debt-service coverage ratio below one by the third quarter of 2023. This was due to the decline in property cash flow.

Between high interest rates and low property rates, this seems to be a perfect storm for commercial real estate. Do you see any way out of it before interest rates decline?

EJ: In that paper, we did so-called “stress testing.” What we found is if we just have the CRE distress, the banking sector would have incentive to help those commercial real estate property owners through the distress. This is because, as a debt holder, if the bank is able to roll over the debt and help them through the current episode, when interest rates fall, eventually the bank will be able to recover some of the losses on the loan provided to CRE.

But what’s really problematic is that the banking sector is not doing well because of the interest rate. We have an earlier work where we showed the entire banking sector is having a huge exposure to the interest risk, and long term assets on banks balance sheets had a significant declining value.

As a result, many of the banks are actually insolvent because of the rising interest rate. This current banking sector really doesn’t have a lot of buffer to help the commercial real estate industry go through this. They don’t really have that much ability to withstand the credit risk.

Are we in danger of a banking crisis in terms of banks failing?

EJ: That goes back to [the failure of] SILICON VALLEY BANK (SVB) last year. Right after the closure of SVB, we had our FIRST PAPER out where we collected bank call reports. We were able to look at the balance sheet of each individual bank in the United States. We found the market value of all of those banks’ assets and then linked it to the deposit side and the liability side.

What we wanted to do in that paper was to see if 50% of depositors withdrew their money or 100% of uninsured depositors withdrew their money, how many banks were going to be at risk? We wanted to know how many banks will not be able to withstand such withdrawal.

We found about 186 banks will be at risk if half of their uninsured depositors withdrew their money. So that was the first piece. We also documented that a couple hundred banks will be at risk if 10% of their CRE loans actually default.

Some experts have said this is a 12 to 24 month process, and that this is something that the market just needs to work through its system. Do you think there’s any way to increase the value of these properties in the meantime?

EJ: If the interest rate stays high, it’s going to be a risk that everyone needs to pay attention to. But of course, if we can rebuild the confidence of the depositors in the system, then presumably the bank lenders would be able to help the commercial real estate property owners either roll over the debt or just let them keep running.

In other words, there are two risk factors. One is fundamental, the other is interest rates. For the fundamental factor, I just don’t think there is any way we can deal with it, right? You cannot force people to go to work, and people have the right to choose where to work.

There could be something to be done related to the second risk factor. If we cannot expect interest rates to drop in the short run, then the question is how we can make the banking sector healthier so that it can provide additional loans to help the healthy commercial real estate loan properties through this period.

How do you imagine the CRE market stabilizing after all of this? What do you think the market is going to look like once banks and borrowers figure out what to do?

EJ: On the CRE front, I think a lot of builders and property owners will adjust their business model.

On the banking side, there are a lot of discussions about how exactly we can increase or decrease banks’ risk taking by forcing them to hold more capital.

This is really a major proposal we are pushing for. We have another work that talks about what is the optimal capital structure or how much capital can banks hold that does not affect their lending ability. This is a major question in terms of how much risk banks actually take and given their equity position, given the capital they hold, whether we are able to force them to take less risk.

Can you imagine that, maybe in one to three years, there is going to be less risk on these bank loans?

EJ: If we are able to actually have a new capital requirement, which is much higher than currently, I think it would definitely lower the risk in the whole banking system.

Would that be a matter of policy?

EJ: Yeah, I think this is a matter of policy, right? Capital requirement is one of the major regulations imposed on banks. If you ask the banks to ultimately choose how much equity they want to hold, the banks would have incentive to hold almost 100% of deposits. They don't want to have any equity on their balance sheet.

What regulation is supposed to do is to set a capital requirement so that all of the risk taking incentive is removed from the banking sector or at least the banks can behave in a socially optimal way.

What’s problematic is the banking sector is already experiencing a lot of losses because of the rising interest rate. The market to market losses, plus this additional CRE distress are going to further push a lot of banks to insolvency. That is where the problem is.