Do recent bank failures reflect a liquidity problem in the capital markets?
by KEN PATEL
As one watches the news reports of the past few months, it seems the sky is falling in the banking industry. Not surprisingly, the largest borrower of capital – the commercial real estate sector – continues to exude anxiety as the fear that capital won’t be available as the almost $29 billion in CMBS loans mature in 2023.
After all, inflation, construction, and capital costs are all on the rise. And, many people have the dubious honor in 2023 of refinancing their debt at a time that represents a 15-year high watermark in interest rates.
Many in the hospitality industry remember far too well the issues surrounding the great recession of 2008. Similar to today’s reports, that slide started with a meltdown of the financial sector, and soon led to the inability to advance capital as the banking industry was lacking liquidity and capital to fund some of the most basic loans.
However, the difference between 2008 and 2023 is that, following 2008, Congress improved the regulations in the banking industry to learn from the inadequacies of the former checks and balances.
So, what happened to Silicon Valley Bank and the others that followed? Here is a hint: Their loans weren’t what caused the banks to collapse.
SORT IT OUT
For 40 years Silicon Valley Bank has supported tech companies, making loans that fuel innovation. More than 95% of the bank’s employees are lenders and credit analysts and, through the years, Silicon Valley Bank was the “go-to” bank for any early stage technology company. Because venture capital always involves a great deal of risk, the lenders have become very proficient in securing the bank’s collateral position, and supporting sponsors that have a proven track record of success. As these customers, borrowers, and depositors had success, the size of their cash deposits grew at a commensurate rate.
A few years ago the venture-capital market got very frothy. As a result, the bank’s clients deposited huge amounts of newly acquired cash equity – so much that the bank’s deposit base quadrupled within a few years. Silicon Valley Bank couldn’t lend out that much money, and since unused deposits are a drain on its financial returns, the bank had to deploy them somehow. Rather than put all the excess cash into low-yielding, short-term investments, the bank decided to place a significant chunk of them into higher-yielding, longer-term securities.
In other words, they borrowed short and invested long.
As the venture market became less frothy, many of the venture capitalists’ portfolio companies needed some of their deposits back for working capital. Unfortunately, that money was locked up in these longer term securities, but the Federal Reserve had raised interest rates, thereby reducing the market value of these long-term investments. Selling them to meet the liquidity needs of the bank meant taking a hit of about $1.8 billion.
To reduce the financial burden, the bank attempted to issue additional stock. When the bank announced the stock offering – as well as the reported losses – many venture capitalists panicked. Within 24-hours, several venture capitalists and investment funds were encouraging their portfolio companies to withdraw their deposits from the bank. This, of course, triggered a full-fledged bank run.
In the blink of an eye, a 40-year track record of success was snuffed out, not because of bad loans, but because of bad decisions about what to do with excess deposits, which should never have been plowed into long-term securities.
ASSESSING IMACT
Ultimately, borrowers can breathe a sigh of relief: there is no liquidity crunch coming in 2023. Lenders actively are lending, and there’s plenty of capital available to fund deals. That’s the good news. The bad news? Interest rates have increased at an historically quick pace and are predicted to continue to increase for at least the next couple of months.
There isn’t a liquidity problem. There is a cost-of-capital problem,” says capital markets expert Ronald Davis, first vice president at Matthews Real Estate Investment Services. Multifamily mortgages are above 6%, and commercial mortgage coupons are at levels not seen in a decade-plus. Despite this, Davis says money for lending on commercial real estate is still available, but with an important caveat: “We have to adjust to the fact that it is more expensive.”
It will take some time, but investors have to transact, whether because a loan term is coming due, or because they have investment capital to place, or because they have a 1031 exchange. In the first half of the year, the market will work through these changes and an adjustment in cap rates. “Once we get comfortable with the new cost of capital,” Davis assures, “there will be a return to normalcy.”
Ken Patel is the owner and CEO of A&R Group. After immigrating to the U.S. in 1996, he began his career in the hospitality industry by managing a family-owned hotel. In the years since, Patel has accumulated a portfolio of globally recognized brands such as Hilton, Intercontinental Hotel Group, and Wyndham.
