Current U.S. Treasury Secretary Janet Yellen has a tremendous amount of financial and economic experience. She first started working at the Federal Reserve in the 1970s, and also has held a number of esteemed roles in the world of academia. From 2014 to 2018, she served as chair of the Federal Reserve and also previously led the White House Council of Economic Advisers.
Needless to say, Yellen is an expert who has seen her fair share of recessions and various cycles. Recently, Yellen made a prediction about the future of the key commercial real estate and banking sectors. Let's take a look.
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1. Commercial real estate
After the banking crisis broke out, investors began to worry about commercial real estate (CRE) loans at banks and elsewhere, believing that it could be the next shoe to drop, particularly with office space, which has been disrupted by the pandemic and the big shift to remote work.
Yellen doesn't deny that there won't be issues, given the high-interest rate environment and shift to remote work, but she argues that the U.S. banking system has adequate levels of capital and that the Federal Reserve's annual stress testing has shown banks can withstand a significant amount of loan losses. Each year, the Fed puts the largest, most complex banks through a hypothetical, severe economic scenario that includes a severe recession and high unemployment. It also includes a significant decline in commercial real estate properties. I would agree with Yellen on this front.
Another thing investors should realize, if they haven't already, is that many CRE loans at banks have low loan-to-value (LTV) ratios, in the 50s and 60s percentile. The LTV looks at the size of the loan in relation to the appraised property value and helps identify how much equity a borrower has in a property. So a 60% LTV means a borrower has 40% equity down, a significant amount. This also means that a property can lose significant value before the bank begins to lose money on the loan.
That's why I think CRE will be a problem for banks, but it isn't a systemic risk. However, CRE loans made outside the banking system could be more problematic.
2. Banking
Broadly speaking, Yellen believes the banking system is on sound footing and can navigate the difficult near-term environment and CRE concerns.
"My overall read is that the level of capital and liquidity in the banking system is strong, and while there will be some pain associated with this, that banks should be able to handle the strain," she told CNBC.
Make no mistake: Banks do face challenges from higher funding costs that will likely be more pronounced in second-quarter earnings reports, the normalization of credit quality, and enhanced regulation. But most banks should be able to survive and ideally rebound long term after this most recent crisis earlier this year.
Fed data for May shows that deposits at U.S. banks have been growing in recent weeks. And not that it will solve everything all at once, but a Fed pause on interest rates, which could happen soon, would also help banks by starting to alleviate higher funding costs. This will allow banks to reprice loans higher, which will help grow one of their key sources of income: spread income.
While Yellen likes the diversity of community, regional, and large banks in the U.S., she said that "... certainly in this environment, some banks are experiencing pressure on earnings, and there is a motivation to see some consolidation. And it wouldn't surprise me to see some of that going forward." However, consolidation had been a prominent theme in the banking sector prior to the banking crisis.
