A Warning and a Lesson from the Bursting Real Estate Bubble

Two events in the first weeks of 2024 reminded the world that the 2007-2008 financial crisis has never ended, and that we are sitting on a volcano waiting to erupt in a pyroclastic flow: the resurgence of the crisis of community banks in the United States and the bankruptcy of Chinese conglomerate Evergrande. Both events have a common underlying feature: they are tied to a real estate bubble. But they are handled in fundamentally different ways.

The New York Community Bancorp (NYCB) was one of the largest banks in the United States and one of the largest lenders in the New York City metro area. At the end of fiscal year 2023, its total assets amounted to $116.322 billion and its equities to $10.820 billion. In the past days, its shares have plunged more than 50%.

The NYCB surprised investors with bad news on Jan. 31, reporting losses, and cutting dividends. The bank’s problem underscored a crisis among regional lenders, whose exposure to commercial real estate cannot survive the Federal Reserve’s high interest rate policy. Some 18% of commercial real-estate loans in the U.S. are held by banks in the $50 to $250 billion asset range, according to Morgan Stanley, and about 24% by bigger banks, but the remaining 58% are held by small banks under $50 billion in size.

The NYCB crisis affected all bank equity values on Wall Street, because the system is so full of toxic assets that even the default risk of a small to medium size bank could bring down the entire house of cards.

Analysts at the German financial daily Handelsblatt pointed to a new wave of commercial real estate risks, affecting a whole series of banks worldwide, including Deutsche Bank. The latter has quadrupled its provisions for U.S. real estate loans at risk of default, compared to the previous year. The Japanese Aozora Bank has also had to significantly increase its risk provisions for U.S. commercial real estate, which resulted in the bank’s first annual loss since the financial crisis. The company’s shares fell sharply on Feb. 1-2, dropping 33% in value.

Turning to China, Evergrande may be the largest real estate investor in China, but it is based in the Cayman Islands. With a debt of over $300 billion, it is nominally considered the largest bankruptcy so far, and the liquidator will have to decide who will be refunded and how much. The Chinese government has decided that priority will be given to customers who have already purchased homes not yet delivered. It won’t allow a liquidation which would entail blocking completion of the projects, thus onshore units will be kept operational.

Offshore creditors will meet a different fate. Some 26% of Evergrande debt is offshore, amounting to circa $80 billion. It will most likely be refunded at not more than 2.8%, according to an S&P assessment.

While the Chinese stock market is declining as a consequence of the Evergrande bankruptcy, that market represents only about 60% China’s GDP. Compare that to the ratio of Wall Street to U.S. GDP that is about 150%.

The most evident reflection on the two cases described here is that while the global financial system is dominated by the “Too Big To Fail” rule and speculators are protected, in China, companies can be liquidated and the speculators pay the bill. That has a limited impact on the national economy because the banking system is regulated by a separation between commercial banks and investment banks. The abolition of that rule in the United States and eventually in the Global West is the single main cause of the bankruptcy of Wall Street and the Western banking system overall. Thus, it is high time to reintroduce such a separation, the famous Glass-Steagall Act, before the volcano erupts.

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