385 Banks Projected to Fail / 1,000’s of Loans Projected to Default / Guarantors Wiped Out
By Stephen Speiser, Esq.
May 2024
The Coming Storm
Approximately $1 trillion of commercial real estate debt is coming due this year, and that number will increase dramatically in 2025. The Mortgage Bankers Association confirms that real growth in CRE debt together with major declines in real estate values raise the risk of widespread loan defaults. See Figure 1.
The Wall Street Journal recently reported that loan defaults in the office market are reaching historic levels not seen since the 2008-2009 financial crisis, and Bloomberg is now warning that the coming wave of defaults could “topple” hundreds of U.S. banks.
How Did We Get Here?
First, the Federal Reserve’s long-term, historic low interest rates helped pump-up CRE supply and inflate asset values. Then, beginning in 2020, COVID lockdowns caused businesses and workers to flee their downtown offices and caused vacancy rates to skyrocket. The CRE market has yet to recover.
The coup de grâce, however, was the Fed’s recent series of interest rate hikes in response to rising inflation. These rate hikes spiked the cost of CRE debt financing and effectively wiped-out hundreds of billions of dollars of asset value. Add to that the growing public fear of a dystopian urban America gripped by sanctuary cities, downtown homeless encampments, and rising crime, and you have the ingredients for a financial disaster of epic proportions.
What To Expect
The National Bureau of Economic Research recently released a study in which they estimate that up to 385 American banks may fail due to bad commercial real estate loans. These “at-risk” institutions are mostly local and regional banks currently holding more than one-third of their deposits in commercial real estate loans. See Figure 2.
By contrast, national banks are better positioned to weather the storm because they are holding a smaller portion of their portfolios in commercial real estate and have been increasing capital reserves to offset the coming wave of defaults. Nevertheless, even if national banks are well positioned to weather the storm, an important question remains: will there be any appetite to provide desperately needed refinancing for the thousands of CRE loans coming due over the next 2 years? If history is any guide, not much.
The simple truth is that borrowers across the spectrum will be hard pressed to find financing, and guarantors on the hook for trillions of dollars in loan guarantees will stand helpless as bankruptcy courts, hedge funds, and deep pocket investors gorge on the CRE carcass.
Guarantors Face an Abyss
There is, perhaps, nothing more destructive of personal wealth then a personal guarantee. Of all the parties involved in this nightmare scenario, guarantors are the most vulnerable. Lenders can proceed against guarantors without first foreclosing on the collateral, and there are few, if any, legal defenses to a valid loan guarantee. Even a bankruptcy filing by a defaulting borrower will not stop legal proceedings to collect on a valid guarantee. Yet, despite all these risks, personal guarantees are often freely given without any thought or planning.
Guarantors on Performing Loans Could Get Wiped Out
The stark reality is that many guarantors are about to get wiped out and don’t even know it. Bank regulators are currently taking steps in advance of the coming CRE meltdown that will make it more difficult to refinance performing commercial real estate loans. For example, proposed “Basel III” regulations would require banks to hold more capital to protect against potential losses on commercial real estate loans, which will reduce financing available to credit worthy borrowers. According to Bob Broeksmit, CEO of the Mortgage Bankers Association, the Basel III proposals would “cripple commercial property financing” and “end bank real-estate finance as we know it”. Broeksmit also warned that Basel III policy regarding CRE loan defaults will also impact performing loans. Under Basel III, if a single loan defaults, a 150% risk weight would be assigned to all loans linked to the same borrower – not just the loan in default. This would effectively drag all those performing loans into a default category.
In other moves, regulators have already begun tightening commercial real estate lending standards, with two-thirds of banks reporting tighter underwriting for non-residential and multifamily loans in Q4 2023. This will make it much more difficult for credit worthy borrowers to refinance their maturing commercial real estate loans leaving guarantors exposed to catastrophic loss.
Another important takeaway is that most CRE loans are callable at the bank’s discretion if financial conditions materially change. As with 2008-2009 financial collapse, we are likely to see many banks calling performing CRE loans this year and next to shore-up their portfolios which could wipe out thousands of guarantors in the process.
Is It Too Late to Shield Assets From Lenders?
While asset protection planning is most effective when implemented before guarantees are given and before loan defaults on the horizon, there are still legal options and strategies available that may allow your clients to preserve and protect some or all their wealth. Click here for a discussion of these domestic and foreign asset protection planning tools.
So, with a meltdown in the commercial real estate market just around the corner, what should CPAs be doing to protect their firms and their valued clients?
The CPA’s Role
The CRE meltdown threatens to not only wipe out borrowers and their guarantors, it also threatens to wipe out valued clients and the business they bring in to your firm. With clients laser-focused on chasing refinancing options, it is entirely possible that little, if any, attention will be given to a worst-case scenario and preparing for “the day after.” That is where a CPA can play an invaluable role. As a trusted advisor, CPAs can and should play a pivotal role in the preservation of their clients’ wealth – by advising them to engage in proactive planning, which can still be done even at this late date.
CPAs often have a greater understanding than clients themselves on how their businesses are structured or how personal assets are held. This intimate knowledge puts CPAs in a unique position to provide timely guidance before clients even become aware of the perils they face.
The very first thing every CPA should to do is reach out to clients who have executed a personal guarantee. It is vital that they be made to understand that a wave of bank failures and loan defaults is coming, and that performing loans across the spectrum may be as likely to get called as non-performing loans. Federal regulators are already mandating that banks shore-up their loan portfolios which will adversely affect even credit worthy borrowers. Also, guarantors need to be made to understand the realities of forced bank sales which often become “fire sales” where the collateral package only generates a fraction of its true market value — leaving guarantors on the hook for any deficiency.
Next, it is important to determine if the client has engaged any asset protection planning. For those who have, encourage them to dust off their plans and have them reviewed and updated. For those who don’t have an asset protection plan in place, let them know that they are at severe risk of catastrophic loss. Encourage them to take immediate action before there is a loan default or they are called on their guarantee. Once there is a loan default, asset protection planning becomes much more difficult to implement and there will be fewer and less desirable options available.
Do not let clients be lulled into a false sense of security. The CRE meltdown is coming. It’s no longer a matter of if but when, and it threatens all loans – not just CRE loans. With 100s of lenders exiting the market and national lenders under regulatory scrutiny and pulling back, commercial lending across the spectrum – not just CRE lending – will become much more challenging. It is vital that any client who has given a personal guarantee understand that they are entering a period of elevated risk and may be called on the loan guarantees given.
Conclusion
Proactive planning, even at this late date, is still possible but the window to act is rapidly closing. Time is of the essence, and CPAs may be the only thing standing between their clients and financial ruin.
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