Amid the looming threat of an economic downturn, one of the primary concerns for many is the impact on the real estate market. Not only does an economic downturn significantly affect the labor market, but it also makes it challenging for individuals to purchase their first home or relocate.

Indeed, a downturn in real estate prices has a domino effect on the entire economy. But what impact does a fall in real estate prices have on banks? Here, we explore what could happen to major banks if real estate prices were to plummet by 25%.

Real Estate Market Dilemma

Although the economy seems somewhat turbulent at present, the real estate market actually shows some positive signs. According to the National Association of Realtors, the inventory of homes in the market is low compared to historical standards but has seen a slight increase from last year. This means there are multiple offers for the same property, making it a seller’s market.

However, the shortage in inventory could stem from economic uncertainty. With rising interest rates and high inflation rates, many homeowners might be hesitant to consider upgrading, leading to a decrease in real estate market transactions.

Why Banks Should Worry

While you might be aware of the impact a drop in real estate prices could have, there are several reasons why banks should be concerned too. These include:

• Decrease in Business: The primary reason banks should worry about a decrease in real estate prices is the potential for reduced business. There would be fewer customers seeking mortgages, and those who do might be looking for lower amounts.
• Higher Risk of Defaults: In tough economic conditions with falling real estate prices, homeowners might find themselves underwater – unable to sell their homes to pay off debts. If homeowners are financially struggling but cannot sell their homes, the risk of defaults increases.
• Greater Losses: Banks balance attracting depositors and utilizing those funds to provide mortgage loans and financing. Unfortunately, when real estate prices drop and market uncertainty arises, not only are the potential losses for mortgage clients greater, but depositors might consider putting their funds into more inflation-resistant investments. This could pose a risk of financial instability for banks.
• Exposure to Commercial Real Estate Risk: Unfortunately, the issues in the real estate market aren’t limited to the residential sector. The pandemic in 2020 and rising costs have put many businesses under increasing financial pressure. In fact, the recent collapses of Silicon Valley Bank and Signature Bank were partly attributed to their exposure to the commercial real estate market.

How Do I Know If My Bank Is Exposed to Real Estate Risks?

Even if you’re not directly affected by the real estate market, you might indirectly face real estate risks through your bank. When you deposit money into a bank, you might not fully know how the bank is utilizing those funds. So, is your bank investing in high-risk real estate deals?

To find out if your bank is exposed to real estate risks, some research is needed. All banks publish financial reports that offer deep insights into how they use assets. However, platforms like MightyDeposits can help you discover where your bank is making investments.

For instance, Pacific Western Bank has a strong interest in commercial real estate. As of the end of 2022, commercial real estate loans constituted over 375% of the bank’s capital. Worse yet, the highest-risk sectors – construction and land real estate loans – constituted about 140% of PacWest’s capital.

However, many banks are now aware of this potential risk and have taken steps to mitigate it. For example, according to S&P Global Market Intelligence, office loans saw the second-largest quarter-over-quarter decline since 2022. The company’s office loans decreased by 15.1% from the previous year.

Will Banks Collapse?

Unfortunately, yes. As we have recently seen with Silicon Valley Bank and others in the past years, banks can collapse under extreme circumstances. Therefore, checking your FDIC protection and ensuring you are covered is crucial.

FDIC insurance is federal insurance that provides protection in the event of a bank or financial institution’s bankruptcy. The coverage limit is fixed, but the limit is set per depositor and per financial institution. If the likelihood of a bank’s collapse is minimal, FDIC insurance kicks in so you can recover the funds in your account.

Historical Impact on Banks from Real Estate Downturns

In recent history, the 2007 real estate crash had a devastating impact on banks. During the crash, hundreds of thousands of homes were foreclosed, leading to the bankruptcy of numerous subprime lenders. At the time, the U.S. government had to devise a bailout plan worth $236 billion, involving around 700 banks.

The slowdown in the market and stagnation in home sales prices led to a widespread collapse in the mortgage industry, including some of the largest lenders in the U.S., like New Century Financial.

While this served as a stern warning about the potential vulnerabilities of banks, it also highlighted the significant impact real estate prices can have on banks of all sizes.

Summary

The economy is an ecosystem where each aspect affects the others. While it might be easy to overlook, real estate prices can be a significant factor for banks, increasing risks and causing a ripple effect on homebuyers, savers, and mortgage holders.

Therefore, whether you’re considering investing in real estate, buying a home, or just want to ensure you’re not at risk, it’s worth doing some research to see what your bank is up to.