Market panics are a favorite of financial journalists. The relative stability between panics and rises in living standards is, for them, dull and boring.
It is with a frisson in my stomach that I notice the return to relative calm after all the chaos of the past few weeks. That would be a great relief. It would be a disappointment for those who like chaos to tell a story.
It looked like the credit Suisse-UBS shotgun marriage didn’t stop the inferno for a brief moment on Friday. The once-mighty Deutsche Bank was widely believed to be the next in line.
It was a touch and go situation. By bailing out junior bondholders in the Credit Suisse bust, incompetent Swiss authorities tried to create a larger banking crisis. They were not able to succeed. Supervisors from other jurisdictions rushed to assure them that they would not make the same mistake. The firestorm is over for now.
Media are often accused of encouraging financial panics by recklessly reporting on them. This may not be true. Alarmist commentary and reporting only gain traction when there is real cause for concern. It’s like chicken and eggs. There is still much to worry about.
There is no way to fix the problem without a monetary tightening immediately, which seems unlikely with inflation still high. Many financial institutions have been misled by the pace and extent of tightening. It is surprising that this has not yet led to more destruction.
Be that as it might, the current focus is shifting away from specific worries about solvency to how the latest ructions may be affecting the supply of credit.
Any outflow of bank deposits into higher interest money markets funds will only increase an already severe credit crunch.
It is difficult to quantify the economic effects of this phenomenon. However, some analysts believe that it is equivalent to a one percent increase in interest rates.
If this is true, then tightening at the US Federal Reserve, European Central Bank, and Bank of England should be continued. Inflation will be controlled by the markets.
There are still many opportunities for mishaps. The US and UK have a very vulnerable commercial property market.
A commercial property crash is the reason behind almost every post-war bust. We are now perilously close to one.
MSCI’s monthly UK property Index shows that the value of British commercial property – office, factory and retail – declined 18% in the second half last year compared to June’s peak. According to CBRE, an American-based commercial realty services company, values for 2022 fell by 13.3 percent on average.
The situation is worse in the United States. Commercial real estate prices in the US have dropped by 5pc from their peak in mid-2013. Capital Economics predicts a further decline in US real estate prices of 18pc-20pc, which would result in a peak-to-trough drop of 22pc.
We tend to think of house prices as the most important factor in the economic cycle’s ups and downs. But it is actually commercial property that almost always causes the majority of the problems.
The household leverage is low compared to other downturns. Therefore, house prices are expected to decline and foreclosures will not cause major system-wide problems in banks this time.
Commercial real estate may be the bigger wrecking ball. This type of lending was not domestic mortgages that brought down Lehman Brothers (USA) and HBOS (UK) during the 2008-10 banking crisis.
These near-death experiences have made banks doubly cautious. Today, exposure to commercial properties is less than 6pc of all UK bank lending, compared with double the amount at the time the Global Financial Crisis.
The situation is even more dire in the USA, where the lending sector for commercial real estate is dominated and dominated by the already vulnerable banks of the small and middle tier.
According to Paul Ashworth, Capital Economics’ chief US economist and chief economist, commercial property lending accounts for around 40pc of all loans made by smaller US banks. These banks account for approximately 70pc in outstanding loans to commercial real estate.
These banks are also experiencing large outflows of funds to higher yielding money markets funds. The US commercial real estate financing market is expected to tighten.
The cry goes up, “But this time it is different.” It is true at the least in the UK , where banks have sufficient capital to withstand high levels of debt forbearance if loan covenants are broken by falling property values. It remains to be determined if the same holds true for the US.
It doesn’t matter what the answer is, it won’t be good for credit expansion in the US or Europe. Banks will not lend if there aren’t recognized losses on the balance sheets.
There is a real risk of a negative feedback loop in the US. If not in the UK, it could be in the UK. This occurs when worries about commercial property exposure among smaller bank leads to more deposit withdrawals and a contraction in the balance sheet, which further weakens real estate prices. Let’s not panic.