KBRA Financial Intelligence

3 Things in Credit: Copy of Bank CRE risk, Slowdown earnings, Private credit borrowers

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Welcome market participants to another 3 Things in Credit. I’m Van Hesser, Chief Strategist at KBRA. Each week we bring you 3 Things impacting credit markets that we think you should know about.

This was the week where risk taking sentiment hung on one company’s earnings report, the one Goldman referred to as “the most important stock on planet earth.” The good news, for all you that are long credit, is that NVIDIA, and its declaration that we are at AI’s tipping point in terms of demand for its systems, delivered what the market needed to hear. Stock markets in the U.S., pan-Europe, Germany, France, Japan, along with MSCI’s world index hit record highs. Oh, and credit spreads tightened.

This week, our 3 Things are:

1. Commercial real estate threat to banks. We’ll provide some much-needed facts.

2. Shifting to slowdown. Here’s how corporate earnings growth is impacted.

3. Private credit borrowers. Ares’ description is useful context.

Alright, let’s dig a bit deeper.

Commercial real estate threat to banks.

Couple a cyclical threat with a secular one and you’ve got our attention. And that of investors. And bankers. And regulators. And policymakers. Such is the case with the latest pall hanging over commercial real estate.

Cyclically, anytime you have interest rates engineered by central banks to be artificially low, the economics of long-term assets, like real estate, are going to be distorted. So, yes, having had years of ultra-low rates, we now have pockets of overbuilt property markets. No surprise there.

The secular change, of course, is changes to how we use certain types of commercial real estate. We’ve been thinking about that with regard to retail properties ever since the rise of online shopping became a thing. And now, of course, post pandemic, we wonder how to dimension the impact of work from anywhere on the office sector.

The question is, broadly speaking, could losses in commercial real estate—driven by refinancing risk stemming from higher interest rates and reduced secular demand for some property types-- become a systemic issue to the banking system? Or to the economy?

Let’s start with the banking system. There is lots of misinformation out there, driven by a rush to publish views by opinion makers, be it by journalists, sell-side shops or academic researchers. All are guilty. Here are some facts.

Banks are big lenders on CRE, but collectively they account for just 38% of the $4.6 trillion of loans to the sector, according to the Mortgage Bankers Association. Sources well-regarded by some have put this number at 70%. Simply not true.

Here are some guidelines to remember when dimensioning the risk.

Owning up to the problem--Press reports suggest banks have been under-reserving for known risks in their CRE loan portfolios, ostensibly to hit earnings targets or maybe just out of delusion. Here’s the reality:

• The IRS has a say as to how much banks reserve

  --Banks cannot simply sock away whatever it wants to its loan loss reserve in an effort to make this issue go away. Provisions to the loan loss reserves must be justified in real time, or else the IRS would view this as sheltering income from taxes.

• Banks are regulated

  —Though far from perfect, banker risk ratings and valuations are reviewed and adjusted by regulators. Its not easy to hide problems, not in this country.

Patience, please--CRE losses take a while to materialize and bleed out over time. The process typically includes a restructuring of terms, and, if warranted, a lengthy period of collateral liquidation. Post the GFC, CRE losses bled out over four years.

Useful context--Banks have three lines of defense against loan losses—earnings, loan loss reserves, and capital. A widely quoted working paper published by the National Bureau of Economic Research in December uses a default rate forecast (10-20%) for all commercial real estate in this cycle. We think that is high, as the NBER uses the 30+ delinquency rate peak on CRE of 9% in the GFC as its guide. The GFC, aka, The Great Recession, had much greater economic destruction for years than what anyone is contemplating in this go around.

In any event, let’s take the midpoint (15%) of the NBER’s probability of default range and use their recovery given default forecast of 70%. That gives what we estimate to be a 4.5% cumulative loss rate on CRE. Now, let’s spread that out over three years. That comes to a $26 billion per year pretax hit to banks’ first line of defense, earnings. How big is that? Banks figure to earn roughly $300 billion pretax in 2024. So, we’re talking about a 9% hit to earnings. That’s not something to get all that energized about. And that, by the way, squares up with the 0.86% return on assets forecast in 2024 by Keefe Bruyette & Woods for their regional bank index. That 0.86% return compares to 0.94% the industry earns on average. In other words, it’s not a big deal, when we’re talking about systemic risk to the economy.

Alright, on to our second Thing, Shifting to slowdown

I know, I know, you’re tired of hearing about the threat of the long and variable lagged effects of monetary tightening. After all, it’s been just about two years since the fastest hiking cycle in 40 years commenced, and we have been growing at twice the rate of the Fed’s longer term estimate for the US. So…what am I worried about?

Well, the lagged effects clearly have taken longer to bite than what has been typical in past cycles for a variety of reasons. But we remain firmly in the camp that monetary tightening does slow growth. You can’t tell me 7% mortgages, 11% middle market loans, and 24% credit card rates won’t eventually leave a mark. We’re not here to debate that, at least not this week.

We’d rather talk about corporate earnings growth, that which underpins every asset class in credit. Unlike consumers, where some meaningful percentage are delusional about their ability to spend when the cycle turns, businesses tend to be more grounded, more pragmatic, maybe because they are reliant on the vagaries of capital markets and banks in order to finance their growth.

So, we’ve been through the earnings recession, mild as it was, caused largely by inflated costs that exceeded inflated income. Now, we’re coming out of it. The question really is, coming out of it into what exactly?

Well, into the growth trough that figures to lean on top line. That should put pressure on margins, which, in turn, pushes managements to be cautious on costs. So how are these colliding forces faring?

Consensus top line for the equal-weighted S&P 500 is expected to be up 3% in 2024, with earnings growth coming in at 5%. To get there, we picked up these tidbits. Firms are talking on earnings calls about cost control and resource reallocation more than ever, according to Morgan Stanley. We’ve talked in the past about how this slowdown has been as well telegraphed as any, and that has allowed managements to implement cost control strategies. And that should dampen the effects of slowdown. And sure enough, EBIT margins are expected to expand in 2024 from 10% in 2023 to 13%. That gives us comfort that positive earnings growth is possible.

The resource reallocation story is about redirecting spend into technology in order to further enhance productivity (there, I worked NVIDIA into this bit). I’d say “further” because surging productivity is happening and it has helped keep growth elevated and unemployment low in the face of monetary tightening.

At the end of the day, proactive measures by managements—thoughtfully cutting costs and achieving greater productivity through enhancing technology are important elements in keeping this soft landing soft.

Alright, on to our third Thing, Private Credit Borrowers.

We read through the transcript of a fireside chat between Craig Siegenthaler of Bank of America and Mike Arougheti, Co-Founder and CEO of alternative asset giant Ares Management.

Mr. Arougheti made a credible case in laying out the type of companies that Ares lends to, this, coming at a time when many are wondering just how risky this latest iteration of private credit is.

He starts with the logical opportunity set, 30 million small to mid-sized businesses in the US., 18,000 of which have revenue in excess of $100 million. The average EBITDA margin in Ares book is 20-25%, so think of the opportunity set for private credit to be those 18,000 companies producing EBITDA of, call it $25 million.

In Ares US portfolio, the average EBITDA is $150 million, the median $50-$60 million. By Mr. Arougheti’s estimation, Ares is doing business with the top 1% or maybe half of 1% of middle market companies in terms of size and sophistication. Not surprisingly, he takes issue with those that suggest private credit lenders like Ares are taking what he calls “profligate” risk. He goes on to point out that loan to value in his portfolio is 43%, and that private credit’s model of long-duration, unlevered, match funded pools of capital is a prudent way to fund the middle market.

Not every lender in private credit will be as advantaged as Ares. But the points Mr. Arougheti makes are valid, and should make investors and policymakers comfortable that this model is sensible and represents positive evolution in the capital markets.

So, there you have it, 3 Things in Credit:

1. Commercial real estate threat to banks. There will be losses, over time. The likelihood that this poses a systemic threat is unlikely.

2. Shifting to slowdown. Managements’ efforts to control costs and invest in productivity enhancing technology will cushion the blow.

3. Private credit borrowers. Risk and reward at the advantaged lenders are aligned.

As always, thanks for joining. See you next week.