Largest US Banks Face $48 Billion Commercial Real Estate Loan Loss, Fed Says

Article originally posted on CoStar on July 2, 2020

The Federal Reserve Building in downtown Washington D.C. (iStock)

The nation’s largest banks are facing a possible $47.6 billion loan loss on commercial real estate over the next two years in the worst-case scenario for economic fallout from the coronavirus, according to the latest stress test results from the Federal Reserve Board.

The U.S. central bank’s regulatory body considered three progressively worse downside scenarios in determining banks’ abilities to withstand the current crisis. In each case, the results suggest that commercial real estate will take large losses.

The results are not designed to be forecasts but are a measure of the money banks need to have on hand to survive the pandemic. Banks could take a hit on loans beyond commercial real estate. In total, losses in the three scenarios ranged from $560 billion to $700 billion — or about 47% to 57% of banks’ retained earnings and additional paid-in capital.

Even though all 33 of the banking groups in the stress test exceeded the required minimum capital and leverage ratios, the Fed took several actions to ensure large banks don’t deplete their cash.

Among those measures, the Fed is forcing institutions to reevaluate their longer-term capital plans. All large banks will be required to resubmit and update their capital plans later this year to reflect current stresses. This is the first time in 10 years the Fed has requested a review of capital plans.

The Fed also is capping dividend payments to the amount paid in the second quarter and is further limiting them to an amount based on recent earnings. As a result, a bank cannot increase its dividend and can pay dividends only if it has earned sufficient income.

Lastly, for the third quarter, the Fed is requiring large banks to preserve capital by suspending share repurchases. In recent years, repurchases have represented about 70% of shareholder payouts from large banks.

“Actions by the board to preserve the high levels of capital in the U.S. banking system are an acknowledgment of both the strength of our largest banks as well as the high degree of uncertainty we face,” Randal Quarles, vice chair of supervision for the Fed’s board of governors, said in a statement.

In contrast to the 2007-2009 financial crisis, the nation’s largest banks entered the pandemic with high levels of capital and liquidity: $1.2 trillion in common equity and $3.3 trillion in high-quality liquid assets, Quarles noted.

Cornerstone of Current Stress

The Fed has to make a last-minute adjustment to its scenarios to take into account the possible impact of COVID-19. In preparing for the test in February, before the coronavirus forced stay-at-home orders and broad business closures, the Fed’s 2020 severely adverse scenario featured a severe global recession, a rise in the U.S. unemployment rate to 10%, a 50% decline in broad equity prices and heightened stresses in corporate debt markets and residential and commercial real estate.

By the time the Fed issued its stress test, that scenario no longer seemed so severe.

“By mid-March, it became clear that the COVID event was disrupting U.S. economic activity and that even more extreme downside outcomes than the 2020 severely adverse scenario were plausible, especially for near-term unemployment and gross domestic product,” the Fed said in releasing the results.

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