If you asked a few months ago where the next financial crisis might emanate from, most people probably wouldn’t have said regional banking. Rather, they might have guessed at the shadow banking sector, which has grown dramatically since the global financial crisis of 2008. It remains far less regulated than the traditional banking sector.
When the pandemic hit, non-banks such as hedge funds and open-ended money market funds pulled out of key credit markets, forcing governments to intervene to stabilise things. As Treasury secretary Janet Yellen said in a speech last week, “Put simply, the Covid shock reaffirmed the significance of structural vulnerabilities in non-banks.” Yellen pointed out a number of ways in which US regulators are trying to better monitor hedge fund leverage and address liquidity mismatches in open-ended funds and money markets. These can, when under pressure, “break the buck”, leaving small investors with big losses.
It’s good that policymakers are focusing on shadow banks, because I’d still bet that this is where the real nexus of risk in 2023 and beyond will lie.
Consider, for example, the trouble brewing in commercial property loans, and private equity real estate funds. This is where the shadow bank and small bank stories meet. Small banks hold 70 per cent of all commercial real estate loans, the growth of which has more than tripled since 2021. Following the easing of Dodd-Frank rules for community banks, smaller financial institutions have also invested more in riskier assets owned by private equity and hedge funds (as have other institutions looking for better returns, including pension funds).
Small bank funding to commercial real estate is now tightening. This, along with interest rate rises, is putting downward pressure on commercial property values, which are now below pre-pandemic levels. That will curtail capital flows, derail investments and put pressure in turn on private equity funds with loans that are maturing, or which need equity injections.
As a recent TS Lombard note laid out, the level of real estate debt maturities in 2023 is expected to be high. This means asset managers may be forced to go to investors for more capital (which will be a tough negotiation at the moment) or sell property out of their portfolio to cover loans.
This has the feel of a doom loop to me. Big real estate indices had already turned negative in 2022. Last month, the Canadian property group Brookfield stopped making payments on $734mn of LA office building debt, and there is elevated short interest in real estate investment trusts such as Hudson Pacific Properties and Vornado Realty. It is possible that concerns about commercial real estate will start to expose other vulnerabilities — or at the very least asymmetries — in the financial system and shadow banks in particular.
Consider, for example, how rich non-bank asset managers such as Blackstone, Apollo, Carlyle and others became on both residential and commercial real estate in the wake of 2008. This was partly because they were able to make deals that more regulated banks couldn’t. Private equity players have also made new investments in utilities, farmland, transportation and energy (renewables in particular, driven by the government push for a clean energy transition).
I’m not saying that these institutions are about to go broke. Quite the opposite — the major private equity firms are flush with cash. According to data provider Preqin, real estate funds in general have the equivalent of 18 months of equity held in reserve, though as TS Lombard points out, that could dry up as returns fall. But it’s safe to say that the combination of falling values, higher rates and a credit crunch is going to mean we’ll probably see some high-profile defaults. Perhaps more importantly, I think we are about to see a curtain pulled up on what private equity and the global asset management business in general has been up to over the past few years.
This month, political economist Brett Christophers will publish a book titled Our Lives in Their Portfolios: Why Asset Managers Own the World. He believes we’ve moved from financialised capitalism to something more insidious — an asset manager society in which the titans of finance own “essential physical systems and frameworks” — the homes in which we live, the buildings where we work, the power systems that light our cities and the hospices in which we die.
It is a process that has been sped up by post-Covid fiscal stimulus plans in the US and elsewhere, which have encouraged more public-private infrastructure partnerships. The Infrastructure Investment and Jobs Act in America, for example, had less public investment than initially proposed, but introduced a host of new concessions for private investment.
The opening quote in Christophers’ book is from Bruce Flatt, chief executive of Brookfield Asset Management, who says, “What we do is behind the scenes. Nobody knows we’re there.” Well, not anymore. The problem of private equity in residential real estate has been well explored. With the looming crisis in commercial real estate, we are likely to get a much closer look at the highly leveraged bricks and mortar empires built by shadow banks, and what risks are posed by the privatisation of such assets.