Two questions about commercial real estate lending
By Scott Sumner
The S&L crisis of the 1980s was centered around loans to real estate developers. The banking crisis of 2007-09 was centered around loans to real estate developers (not mortgage loans). Dodd-Frank was supposed to fix this problem. How’s it working so far?
This Financial Times story suggests the answer is “not well”:
Fears that smaller US banks are taking excessive risks in commercial real estate deepened on Friday as shares plunged in an Arkansas lender that has ploughed billions of dollars into developments in states as far away as New York.
Bank OZK — which this year changed its name from Bank of the Ozarks — revealed that it was taking a $45m writedown on two commercial real estate (CRE) loans, sending its shares down by more than a quarter in afternoon trading.
Bank OZK has $22bn in assets, half of which are CRE and multi-family real estate loans, making it a leading example of a nationwide trend: As big banks have pulled back from CRE and regulators have warned about high valuations, small banks have turned to the asset class as opportunities to expand in other areas have declined.
While many pundits on both the left and the right have focused on the issue of big banks and mortgage loans, I’ve consistently argued the real problem is smaller banks and commercial real estate loans. Consider these two questions:
1. What’s causing excessive bank lending on commercial real estate?
2. Why is it a public policy issue?
It turns out that the answer to both questions is identical: the Federal Deposit Insurance Corporation.
It’s literally indefensible to let banks lend taxpayer-insured funds to property developers. Full stop.
Large banks are more diversified than small banks, which helps to explain why they are less likely to take excessive risks. The fragmented nature of the US banking system also explains why Canada (with its large diversified banks) has not experienced the sort of financial crises that we frequently experience in America. If a few big property loans made by a big bank fail, the shareholders of the big bank usually absorb the loss. If a few major property loans made by a small bank end up in default, it’s very possible that the US taxpayers will bear a part of the losses.
If that Arkansas bank sounds vaguely familiar, it’s because I did a post discussing OZK Bank in June 2017. As long as we keep creating moral hazard with FDIC, these problems won’t go away. Dodd-Frank didn’t solve the problem for the exact reason that the “re-regulation” after the S&L crisis didn’t solve the problem. Policymakers refuse to do anything about moral hazard, because it’s so politically popular. Not just in banking, but also in federal flood insurance, health care, and many other areas.
People seem to want the government to create a giant featherbed for them, so they don’t have to worry about anything at all. But that merely shifts risks up to the macro level.
PS. Of course I’m not saying people should not have access to safe investments for their life savings. I have no objections to banks that invest FDIC-insured funds in safe investments.