Distressed Real Estate Debt Could Spark Another Regional Banking Crisis

Merely two years ago, over seven weeks during the spring of 2023, the entire financial system nearly came crashing down when the United States experienced the second-, third- and fourth-largest commercial bank failures in its history. 

Between March 8, 2023, and May 1, 2023, Silicon Valley Bank (SIVBQ) ($209 billion in assets), Signature Bank (SBNY) ($110 billion) and First Republic Bank (FRCB) ($213 billion) all went down — one by one — as panicked tweets from investors and online deposit withdrawals outran the coordinated efforts among the federal government and the largest players in private sector finance to stave off the crisis. The great fear was that these regional banks could spread the contagion to the bigger financial institutions.

SEE ALSO: Multifamily CMBS Loan Distress Rate Doubles in NYC

Eventually, after the Federal Deposit Insurance Corporation (FDIC) defied nearly a century of precedent by guaranteeing all commercial banking deposits — even those above the standard $250,000 threshold — the bleeding stopped.

But the big question from a regional banking landscape is: Can it happen again?

Part of the crisis was due to a run on deposits. Another part had to do with rising interest rates. And the fallout meant a lot of loans on the books were for assets that were worth considerably less than when the debt was issued. This includes billions of dollars in distressed commercial real estate assets. 

The government actions back in 2023 certainly left the industry breathing a sigh of relief. “One thing the FDIC and the Federal Reserve showed was they’re willing to come in and be a backstop, if things came down to that, and it feels to me that we’re safer than we were two years ago before that was definitely determined,” said Robert Hockett, professor of corporate law and financial regulation at Cornell Law School. “On the other hand, there’s things going on today that weren’t going on in 2023, so there’s more additional risks.” 

These risks are manifold both for the Too Big To Fail giants carrying between $500 billion and $4 trillion in assets and the more numerous regionals that hold between $50 billion and $250 billion in assets. 

For one, the stock market — which affects the fortunes of every public bank — is down 6 percent over the last month. Then there’s the Trump administration’s affinity for tariffs, which threaten to impact nearly every industry in America, and have already shaken equities. On March 19, shortly after announcing he’d keep the benchmark borrowing rate at 4.25 percent, Federal Reserve Chairman Jerome Powell admitted that “further progress may be delayed” when it comes to fighting inflation, due to “uncertainty around the changes” concerning the Trump administration’s new tariff and immigration policies. 

Some are sounding alarm bells. Former Treasury Secretary Lawrence Summers said there is now a one in two chance of a recession this year. Others are even more pessimistic. 

“There’s no doubt we’re going into a hard-landing recession,” said Chad Carpenter, CEO of Reven Capital. Carpenter faulted the departed Biden administration’s handling of the economy and emphasized that some of the largest commercial banks are losing their shirts on deals cut on distressed CRE debt, especially in the commercial mortgage-backed securities (CMBS) space. 

Trepp announced this month that the rate of all CMBS loans in special servicing rose from 7.14 percent in February 2024 to 10.32 percent in February 2025. The pain is mainly in office: At 16.19 percent, the office special servicing rate is at a 25-year high, and 600 basis points higher than February 2024. 

“The banks can’t hide anymore from this. They’ll all have to face the music,” said Carpenter. “All those regional banks with overexposure in office, they’re going to be in big trouble.”

Or are they? Just like the stock market, the capital markets system has both bulls and bears, and more than a few in the know argue that the banking system is not only far from risk, but that it’s relatively stable, if not healthy. 

“The state of banking is strong at both the regional level and the broader U.S. level,” said Matthew Bisanz, a financial services and bank regulatory attorney at Mayer Brown in Washington, D.C. “The banks are well situated for many different events that can occur,”

Bisanz emphasized that the Trump administration’s anti-regulatory ethos will allow regional banks to have an easier time merging with one another, and likely kill off the Basil III Endgame proposal to revise large bank capital requirements. “Certain issues that were important before are no longer issues,” he added. “All that has gone away.”

Megan Fox, senior credit officer at Moody’s Ratings, noted that her agency changed its outlook on the U.S. banking system from negative to “stable,” mainly due to the solid credit fundamentals, steady asset base, and potentially higher profits at many banks.  

“Banks have built capital pretty significantly over the past two years,” Fox said. “And they did this by conserving capital, retained earnings, and we saw a material pullback in share repurchasing, while loan growth was fairly tepid over this period.” 

But, even as the system itself appears to show signs of improvement, the restructuring of that dreaded wall of commercial real estate debt maturities — $957 billion are expected to mature in 2025 alone, according to the Mortgage Bankers Association — can go only so far. 

“Things are slowly turning positive in commercial real estate. There’s an increased return to office, and high-quality office space is impossible to find in some cities,” said Tomasz Piskorski, professor of real estate finance at Columbia Business School. “Having said that, we’re not completely out of the woods.”

Piskorski pointed to elevated CRE delinquencies, which banks are still extending and pretending won’t hurt their books (just so long as the maturity is pushed a little bit down the road), and the persistently high interest rate regime, which poses an ongoing risk to many bank securities, notably long-term Treasury bonds, just as it did in 2023. 

“The banks were rallying after the election because the idea was deregulation will improve bank profitability sufficiently, that banks would deal with losses on books by becoming more profitable,” Piskorski added. “But there’s a very significant risk of recession, and if we have a recession the banks could be in trouble.” 

The problem with banking

One of the reasons so many finance and real estate professionals are on edge about the health of the U.S. banking system is because the 2023 regional banking crisis showed that, unlike in the past, a run on a bank can now happen in a matter of hours, if not minutes. 

On March 9, 2023, over the course of one business day, Silicon Valley received a request for $42 billion in withdrawals — roughly 25 percent of its assets. The bank told regulators it expected $100 billion in withdrawals within 24 hours and was promptly closed by morning. The next day, Signature lost $18.6 billion (20 percent of its assets), while First Republic watched $25 billion (14 percent of its assets) disappear that afternoon, as well. 

The speed and severity of these runs haven’t been lost on the market.

“Silicon Valley Bank was a liquidity crisis — you can’t survive a liquidity crisis, whereas with a capital crisis you can hope to fight another day,” said Pat Jackson, chief investment officer at Sabal Investment Holdings. “Regulators will say, ‘We gave you the benefit of the doubt, but you’re starting to take losses, your capital is going down, so you either need to do a capital raise, merge with another bank, or we will close you.’ ” 

Lawrence White, an economics professor at the New York University Stern School of Business, said that the high level of uninsured deposits — those beyond the $250,000 limit — represent a threat to the whole banking system, and that uninsured deposits make up 40 percent of all commercial deposits today. That share was only 20 percent in 1990. 

“When you have uninsured deposits, they are flighty and they are a source of instability,” said White. “And it remains a source of instability because if depositors do get nervous, they can always leave the bank.” 

Mayer Brown’s Bisanz said that “a big lesson” learned from the 2023 crisis is that “there’s a lot about customer behavior that banks and regulators still don’t understand very well.” He cited Silicon Valley Bank serving as the payroll account for large California tech firms, thereby automatically surging their average deposit base far beyond the $250,000 insured limit.  

He also mentioned that regional banks now face “a too small to succeed problem,” which is forcing, and will force, many regionals to merge and consolidate in the years ahead. 

“If you’re a regional bank, holding $50 billion in assets, covering three or four states, you have a difficult battle when competing with a super-regional or a Too Big To Fail bank,” Bisanz said. “You can’t get the economies of scale, the branding, and the profitable product lines. You’re relegated to being a small business lender and a commercial real estate lender.” 

Toby Cobb, co-founder and managing partner of lender 3650 Capital, said that while the banking system “has always been unstable,” the real question is why the FDIC has decided to treat all deposit insurance equally, when some banks fund their books with only their short-term deposits, while others have a more tiered asset base, with long-dated liabilities and long-term bonds balanced against short-term loans and cash reserves.  

“To say that the banking system today, writ large, is unhealthy is not right. I think the banking system is pretty healthy because the top 50 banks, which represent 90 percent of our banking, are healthy,” said Cobb. “I think some regional banks are real problems and they will have terrible outcomes, but it’s certainly not systemic.”

The real estate conundrum 

As trillions of dollars of distressed real estate debt has weighed down the U.S. economy, borrowers and lenders alike have engaged in a game of extend and pretend, a mutually assured strategy secured by the assumption that once the market stabilizes, and interest rates finally fall, underwater loans can be paid off at par — and everyone can go home happy. 

And, to an extent, that has happened, is happening, and will continue to happen, according to Jay Neveloff, partner and chair of Karmer Levin’s real estate practice.  

“We’re seeing a lot of that activity, we’re seeing a lot of recapitalizations and refinances,” said Neveloff, who singled out J.P. Morgan Chase as a bank that has re-entered CRE. “But I don’t know if it’s enough to stem the tide, though.” 

This doubt exists because of the incredibly complex relationship between commercial real estate and interest rates. The Federal Reserve can control the short-term interest rate, known as the federal funds rate, which is important for refinancing loans and improving debt service coverage ratios (DSCR). But the long end of the curve, the 10-Year Treasury, is a true bond market, and is where cap rates and valuations are most impacted, and problematic. 

“The short end is really where a lot of lenders and borrowers were looking for relief,” said Stephen Lynch, senior credit officer at Moody’s Ratings. “So when you come in for refinancing, you might have relief on DSCR. But, if your cap rate has widened and your loan-to-value [ratio] has weakened, then banks and lenders are asking sponsors to kick in more equity to bring [loan-to-value ratios] down.”

If only it were so simple, and a little bit more equity could solve the bevy of CRE problems.

The key element underlying extend and pretend is the belief that all it takes is time until the asset’s cash flows exceed its debt service requirements, or that in just the next month interest rates will go down a bit more and allow a sensible refinancing to take place to create a positive margin between cash flows and the risk-free interest rate. 

Unfortunately, as interest rates remain elevated above their pre-2022 levels, the debt of many CRE assets continues to swallow diminishing cash flows, as rapidly truncated values devour any equity almost from the moment it dares enter the capital stack. 

“You extend for a chance, for the opportunity, that the asset can be resuscitated with the cash flow of the asset,” said Cobb. “It’s not happening — in fact, it’s not even close to happening. The interest rate on the loan, in most cases and certainly in the case of all floaters, is 7 percent or 8 percent, and that’s 100 percent or more than the cash flow of the asset.”

Cobb added that he believes instead of helping themselves with extend-and-pretend, many CRE assets “have been eating themselves alive” and “are deteriorating” as equity and restructured debt — ordinarily used for tenant improvement packages and physical building investments — is going straight to the banks.  

“They’re worse off than they think because no new money has gone into the assets, there is no excess cash flow, and whatever cash flow is available, the banks are siphoning off as interest,” said Cobb. “I believe the problem is getting worse and is exacerbated because the maturity wall that everyone is afraid of always gets kicked. The can keeps getting kicked.”

Dan Berman, a partner at Kramer Levin, said an entire industry has developed around the relationships of working behind the scenes so banks can get these loans off their books, paving the way for “closed lip” loan sales to take place across the country, and especially in New York. 

“It’s behind the scenes. It’s with an eye toward getting to the assets,” Berman said. “But since 2008 the capital stacks have gotten more complex, so you’re buying into a stack that has multiple senior lenders, has a mezzanine lender, and it’s not for the faint of heart.”

Berman added that a lot of debt and equity are entering into assets and capital stacks they don’t quite understand, and that there’s not enough volume of fresh rescue capital to cover the distress that’s out there. 

“Each building has a story, and unless you know the story, it’s easy to get hurt if you’re buying into some complex capital stack that has distress,” he said. 

Rather than provide more CRE loans during a time of persistent uncertainty, banks
hunkered down, collected whatever they could get to alleviate their distress, continued to raise capital, and pretended along with their borrowers that time will heal all debt-induced wounds. 

But the capital markets demand activity, reinvestment and growth, which has opened the door for an entirely new industry of finance to take a boatload of business that formerly had been reserved for the once-
immutable fiefdom of commercial banking. 

“What I’m hearing, and feeling, is that none of the commercial banks have been lending, and a void has been filled by private lenders,” said Neveloff. “But there’s not enough private lenders to fill that void, and it’s especially the case with regional banks … but a lot of the banks were held back in terms of putting out money, and that’s even more true with the regionals.”

Outside threat 

Along with the retrenchment of commercial banks, the story in CRE capital markets over the last five years of distress has been the rise of private credit, such as alternative lenders or debt funds.

Led by mega firms such as Ares Management and Apollo Global Capital as well as smaller, independent firms like Northwind Group and 3650 Capital, debt funds have emerged in the post-GFC landscape to alter the world of debt. It’s not unlike the way private equity changed the face of Wall Street in the 1980s. 

In recent years, $1.8 trillion has been raised by private credit investment firms, and that market is expected to double to $4.5 trillion by 2030, according to The New York Times.

“We’re seeing some of our best years in the last two years, and this is the time alternative lenders can lend to top-quality sponsors and properties that would typically get a low-rate bank loan,” said Ran Eliasaf, founder and managing partner of Northwind Group. 

What fueled the rise of private credit has been post-GFC bank regulations around leveraged lending guidance and what is and isn’t bankable on a regulated balance sheet. These stricter capital requirements and onerous leverage limits have opened the door for private credit to take over the riskier CRE and corporate lending that banks no longer have an appetite for, according to Moody’s Fox. 

“There’s been new innovations in the world of finance and credit intermediation that traditional lending has to compete with,” she said. “Private credit is a new form of that … and it is a competitor for U.S. banks the more it wants to move into middle-market lending, which is the bread and butter of your traditional U.S. commercial banks. So that’s a challenge.” 

Because of their lower capital requirements, long-term lockup timelines, and ability to deploy capital without the burden of federal regulators, debt funds have more opportunities than banks when it comes to competition for business.  

But the lack of regulation and accountability of the debt funds has created what Cornell’s Hockett called “the latest version of shadow banking,” and one that mimics the opaque (and highly lucrative) qualities of derivatives markets, repurchase markets, and securitization markets. 

“It’s a particularly dangerous area, as these debt funds are the primary form shadow banking now takes. They’re not regulated like banks are regulated,” he said. “And, because of their association with commercial real estate, which is looking increasingly vulnerable, if I were a federal regulator I’d be sweating bullets. It’s a realm of extreme vulnerability.” 

However, despite debt funds’ growth, wealth and increased market share, some market players are skeptical that the funds will replace the broad and highly engrained world of commercial banking, especially when it comes to real estate lending. 

Neveloff admitted that although debt funds pose a threat to regional banks and smaller banks, the industry is “certainly not a threat to J.P. Morgan” and other large firms. 

“While debt funds have massively increased in terms of volume and capacity, they still can’t scratch the surface of commercial banks,” he added. “For the past two or three years, they wanted to be a lender with equity returns, but I don’t think the magnitude of the wealth will replace commercial banks.”

Joseph Fingerman, president of commercial real estate at Peapack Private Bank & Trust (and the head of commercial real estate lending at Signature Bank when it was seized by regulators), said it’s “unlikely” that debt funds would pose any meaningful threat to commercial bank lenders. That’s mainly because, without a deposit base to leverage, their return requirements tend to be higher. 

“Debt funds have been successful for larger transactions with more institutional ownership,” said Fingerman. “But they have had trouble working with smaller borrowers as they can only do what their back leverage allows them.”

However, we no longer live in a world that was created for commercial banking. Generative artificial intelligence is at hand, cryptocurrency is a new form of money, and the internet has combined with the securities markets to create a brave new world of high-frequency finance. 

Columbia’s Piskorski noted that loans are now originated by banks and nonbanks and packaged as asset-backed securities and mortgage-backed securities that are bought without the involvement of banks, and that traditional bank deposits now compete with retirement funds, exchange-traded funds and money market funds when it comes to interest rate returns. 

“Banks are becoming increasingly less relevant,” he said. “The only reason they are operating is they have a deposit advantage, a funding advantage, as it’s a cheaper source of funding through deposits.”  

Over the last 50 years, the share of private lending on bank balance sheets fell from 55 percent to 33 percent, while the deposit share of savings dropped from 21 percent to 13 percent, and loans as a percentage of bank assets have declined from 70 percent to 55 percent, according to a study by Piskorski and several university professors at Stanford and Northwestern. 

“To the extent they lose their deposit advantage — to digital currencies or even a central bank digital currency — that could further pressure banks,” said Piskorski. “Banks are a bit like retail stores, and, as alternative currencies combine with the debt securities market, the banks, like retail chains, might become obsolete.” 

Brian Pascus can be reached at bpascus@commercialobserver.com.