I'm getting excited about bank stocks and preferreds for contrarian reasons. I think they could fall, and within a few months represent a buying opportunity. My enthusiasm arises from fresh information about where we are in the business cycle.
The following recession indicators are all flashing red.
Yes, some of these have been giving warning for over a year, but the Sahm indicator, zero/negative CPI, and durable goods orders are recent additions that might seal the deal. The only commonly cited recession indicator that is not yet warning is the National Financial Conditions Index, though this may be mathematically explained by its reliance on spreads - which are inverted.
So I'm shifting my baseline expectation from soft landing to a recession starting in Q4 or Q1. About 6-10 months from there we're likely to see a "bottom" in cyclically sensitive bank stocks. So which banks should be on my watchlist?
I'm obviously a bit dumb in my understanding of banks, but I'm thinking CRE and residential loans will become problematic in a recession if rates do not fall significantly before unemployment rises beyond a critical level. We can bet on that happening due to the Fed's delays in cutting rates.
CRE has been getting a break lately, but office could still be a time bomb in a recession due to already-record vacancy rates increasing even further. So maybe the most RE-dependent banks are the riskiest, and could be hit the hardest. Banks with a portfolio more tilted toward government bonds might be more stable, as rate cuts enable them to take gains.
Thus the biggest gains might come from those RE-dependent banks that survive if one can buy them at the bottom, and the safest bets might be government bond dependent banks that get thrown out with the bathwater. However, I don't know how to distinguish the two. Does anyone know of a resource that shows a breakdown of various regional and/or small banks' holdings of bonds vs. consumer vs. RE loans?
While there still may be some risk to banks for office loans it is likely been taken at this point - most banks drastically reduced their office exposure by selling the notes or writing down the loans. The greater risk is actually in multifamily as most of the loans originated in 2020-2023 were underwritten at extremely low rates and besides not being able to cover at current rates at original underwriting the concessions that are were only supposed to be in place during initial lease up are still rampant and increasing. Also, if there is a recession it will impact the potential tenants ability to afford and pay rent at this high end properties. Long term it will be fine and could present buying opportunities.
As for banks, other than preferred they make no sense to me because they have essentially become utilities but with all the volatility of broader markets.
IDK.
Somebody has to be holding the loans that finance almost almost every office building in the world, and if not banks then who? I have not heard any news about a massive transfer of risk from the publicly traded banks to the shadow banking sector (e.g. BDCs) or mREIT sector, but I am hearing news about the
office vacancy rate rising to 19.8% as of early 2024 - a new record.
Office rents have increased 0.0% in the past 12 mos. Moody's recently estimated that banks have still not set aside sufficient loss provisions to cover their likely office CRE losses.
These properties at the price they were originally financed were only feasible at certain level of leverage, below a certain interest rate, and below a certain level of vacancy. A cut in revenue of maybe 10-15% (accounting for 5-10% baseline assumptions about vacancy) probably has the typical property at breakeven, and some large percentage of properties making unsustainable losses for their owners. A wave of office foreclosures could be on the way, and the holders of debt will be left holding the bags.
This is how bad things are in the best of economic times, with unemployment around 4% and GDP growth in the high 2% range. So how many office loans stay afloat when a recession strikes? What happens at 7-8% unemployment, or when the vacancy rate hits 30-40%?
Maybe it doesn't matter during a recession whether the landlord was able to refinance to a lower rate in 2024, just like the rate cuts of 2007-2008 didn't help the overextended homeowners and speculators in Vegas. Work from home is here to stay, and it will take a generation to right-size the supply of office space to fit the modern economy. Meanwhile, billions of square feet of new
construction is still occurring, at a magnitude of 1.1% of existing stock. This new construction is typically being financed by banks.
Seems like multifamily would be better off because rents have risen dramatically since the last refinancing timeframe and because no technology has come along to make apartments unnecessary for many of their users, as occurred with offices. Higher rents should support higher refinancing rates, IMO. In the event of recession or uptick in foreclosures, demand for apartments seems likely to rise, even if evictions rise too. There are worries about overbuilding - an entire city was put up in my neighborhood recently - but with
vacancies lower than we've seen since the 1980s and
rents increasing at twice the rate of inflation (5.1% most recently, vs. 2.5% for
PCE) it seems justified.
As always I am open to evidence to the contrary. In the meantime MAA-PRI with its 7.86% yield seems more appealing to me than VLYPO at 9.39% or HBANP at 6.24%, because I foresee disaster for office but am optimistic about multifamily.
