Warren Buffett: A "Storm is Brewing" in the Banking Industry

Banks can take a lot of loan losses, but they can't take something that wipes out their capital and expect the world to ignore that fact. If those rates change, let the person who bet that they wouldn't change lose money. I mean, that's if you make mistakes in business; there are plenty of people who make mistakes, you pay for them.

Legendary investor Warren Buffett is warning about a 2.2 trillion dollar storm that is about to strike the banking industry, the consequences of which will likely be felt for years to come. As you're about to see, a problem of this magnitude did not form overnight. The origins of this crisis date back more than 40 years, and now it's finally too big to ignore.

With each passing day, we're getting closer to impact. Listen to Buffett explain, "We have had lots of investors in commercial real estate who have come in and said that this is going to be a crisis point that the government is going to have to step in, that something should be done because there are so many commercial real estate loans that are coming due between now and 2025 and that they won't be able to get credit from the banks in the same way to renew or to refinance."

Well, let's say they lose a hundred billion in the banking system. Most of the banks can take that loss, their share of that loss, and a few of them, because they did other things, you know, their shareholders will end up losing the money. But the depositors won't lose money. But if you lend money to somebody and it comes due and they can't pay—you know the old story about the banker: "I never made a bad loan; of course, some of them turned bad after I made them." I mean, that’s exactly what happens, whether it's in commercial real estate.

If people, if money rates are 2% or we were lending money out at four basis points at Berer to the federal government—not much more than a year ago, a year and a half ago or so, something like that—and if those rates change, let the person who bet that they wouldn't change lose money. I mean, that’s if you make mistakes in businesses. People—plenty of people make mistakes; you pay for them.

If you've got a big, profitable business on top of it, you know, which a good many banks do, you take your losses and you keep going on. I mean, banks can take a lot of loan losses, but they can't take something that wipes out their capital and expect the world to ignore that fact.

Meaning that you don't think anything needs to be done on the commercial real estate front? "I think that the people that lend too much money should take the loss, and they're getting properties handed back to them now. I mean, you know, within the last month or six weeks, I mean, yeah, I mean they got some office buildings in Los Angeles and, you know, Blackstone walked away from something. I mean, and if you get a non-recourse, you know, everybody goes in the real estate business is told the first rule, the second rule, the third rule is never sign your name to anything. And so you have non-recourse mortgages, and they're going to walk away, and the bank's going to get stuck with losses."

"And maybe they'll hold the property a long time, and it'll come back, and I mean, there's all kinds of ways that if you've got capital strength, you may decide, well, I'll just hold it. But that money is sterile for quite a while, and that's part of banking. I mean, you expect to lose some money in banking; it's not a sure thing on every loan, and you build that into your calculations. Then you have capital that protects your depositors from it eating into their money, and if it does eat into their money, then the FDIC, which is in effect really a mutual insurance company of a very peculiar sort, essentially spreads the losses among the continuing banks by higher FDIC assessments in the future."

To truly understand what Buffett is saying, you first need to understand the business model of a bank. At their core, banks are in the business of lending money, which on the surface seems like a pretty simple business; banks have money, and they lend that money out to people and businesses that need it. The borrower pays the bank back the money with interest over time until the loan is paid off in full.

The borrower is happy because they got to purchase something they otherwise wouldn't have been able to afford, and the bank is happy because it was able to make money on the loan in the form of interest paid by the borrower. If you have ever interacted with a bank, you probably understand this part of the banking model firsthand.

However, the actual loaning of the money is only part of the story. What really matters in understanding Buffett's warning is how banks even get the money that they loan out in the first place. This is an often hidden aspect of the banking business model that has the potential to make things extremely risky.

What I'm about to say may come as a surprise to some people, but when banks give out a loan, they actually aren't lending out their own money. Here, let me explain what I mean by using a loan between friends as an example. To demonstrate, here we have John and Michael. Michael just got incredibly lucky and got the girl of his dreams to agree to go out with him on a date tonight.

There's just one tiny problem: Michael doesn't have enough money to pay for the date. It's Saturday night, and Michael doesn't get paid again until Monday. Since this is a huge opportunity for Michael, he decides to go to his friend John and ask to borrow some money. Michael pleads his case and offers John a proposition: if John loans Michael $100 for his Saturday night date, Michael will pay John $120 when Michael gets his paycheck for work on Monday. That's the original $100 Michael borrowed plus $20 in interest.

Wanting to be a good friend and never wanting to turn down a quick buck, John agrees. But John also has a problem; he himself doesn't even have $100. John only has $20 and needs to come up with another $80 to be able to make the $100 loan to Michael. This is where a third character named Tim enters the story.

John knows that Tim is a very diligent saver and that he probably has some extra money laying around. John gets Tim to loan him $80 with a promise to pay him back his original $80 plus $10 of interest on Monday. Combining this $80 from Tim with the $20 John already had, John now has the full $100 he needs to make the loan to Michael.

In this version of the story, everything works out great. John lends the $100 to Michael. Michael has a successful date on Saturday night. Michael gets his paycheck Monday morning and, as promised, pays John $120. John then turns around and pays Tim back the money he borrowed to be able to make the loan to Michael. Tim gets $90 in the form of his original $80 plus an additional $10 in interest. John now has $30 and thinks to himself how brilliant he is; he was able to turn his $20 into $30 simply by combining his money with borrowed money from Tim and loaning it out to Michael.

Now, as crazy as this may sound, this story just explained in simplistic terms how banks work at a fundamental level. You see, the majority of money that banks lend out isn't even actually theirs; it actually belongs to the bank's customers. Customers make deposits at the bank in the form of checking and savings accounts. Then the bank essentially borrows that money and turns around and lends it out to borrowers, the goal being to make a profit on the difference, also known as the spread, between what the bank pays its depositors and what the bank can earn lending it out to borrowers.

Banks essentially play the role of John in our story from earlier. As that story showed, this business model can be incredibly lucrative if— and this is a very big if—everything goes to plan. However, as history has frequently shown, things don't always go to plan.

Let's revisit our story of Michael, John, and Tim, this time with a less cheery outcome. Okay, let's rewind. In this version, John borrows the money from Tim to be able to give Michael the loan he needs to take his dream girl on the date. Unfortunately, this time around, things didn't go as well. Michael's date goes terrible. The girl leaves halfway through the date, sticking Michael with the bill.

Michael is sad and decides not to go to work on Monday because of this. He doesn't get his paycheck, the same paycheck that was going to be used to pay back the money he owed John. It's now Monday, and John isn't able to get a hold of Michael; call after call goes unanswered. John is now in a bad spot; he was relying on getting that money from Michael for John himself to be able to pay back the money he borrowed from Tim.

Instead of feeling like a genius, John is now feeling like a complete idiot. This story is an analogy for the quote unquote crisis banks are facing that Warren Buffett was referring to. But instead of $100 being lost, there is an estimated $2.2 trillion worth of potentially troubled loans the banking industry could be stuck with. The source of all this trouble is concentrated in just three words: commercial real estate.

You're going to see what the impacts of this ticking time bomb are going to be in a second, but first, here's how banks got into this problem in the first place. This chart is the US fed funds rate, a proxy for interest rates in the economy. As we can see here, the fed funds rate peaked at nearly 20% in the early 1980s. Over the next roughly years, the fed funds rate kept getting lower and lower until it literally had no further left to fall.

The fed funds rate finally hit near 0% in December 2008 and remained at essentially zero for the better part of more than a decade. This four-decade period of declining interest rates was a massive tailwind for the value of assets. One of the single biggest beneficiaries during this time period was real estate.

When it comes to real estate, the vast majority of purchases are made using debt, whether it is the massive building downtown or a small suburban house—debt props up nearly the entire real estate market. As interest rates decreased, it became less expensive for people and companies to borrow money to purchase real estate. Buyers could afford to take on more debt to fund the purchase. This acted like jet fuel for the real estate market, sending prices to the stratosphere. Buyers of real estate loaded up on trillions of dollars of cheap debt, encouraged by low rates and consistently higher property values.

For more than 40 years, this hadn't been a problem, but things have now changed. A radical shift has occurred that threatens to tear down this house of cards that has taken generations to build. We will get to that radical shift shortly, but first, some important background. In the United States, when an individual or family purchases a house, the vast majority of the time that purchase is funded with what is known as a 30-year fixed-rate mortgage.

With the so-called fixed rate, the interest rate remains the same for the entire life of the loan. This significantly reduces the risk to the buyer, as they don't have to worry about the interest rate on their loan increasing and causing their monthly payment to skyrocket. Buyers of commercial properties are not as lucky. Interest rates on commercial loans are not fixed for the duration of the loan; instead, the loan essentially comes due every 3 to 5 years, and the rate resets to whatever the current interest rate is for that type of loan.

Well, this may not sound like much at first, the results of these interest rate resets can be devastating for commercial property owners. This is where the radical shift I mentioned from earlier comes into play. Between 2009 and the first quarter of 2022, interest rates in the economy were essentially zero. During this nearly 15-year period, real estate owners loaded up on as much cheap debt as they could get their hands on, much of which was borrowed from banks.

But oh boy, have things changed! In an attempt to get inflation under control, the US Federal Reserve started to dramatically increase interest rates. This increase was not gradual; it was swift and severe. Rates were raised at the fastest pace in generations. Now, interest rates are currently at their highest levels in 20 years.

This has created the ticking time bomb sitting in the banking industry. The $2.2 trillion of commercial loans currently held by banks were made at much lower interest rates than what exists today. With each passing day, these loans are getting closer and closer to finally reset, and the consequences of which could be devastating not just for banks and property owners but for the entire economy.

Imagine the owner of a small apartment building. Each year, his property makes $100,000 after paying all expenses. Let's say this owner has a loan on his property of $2 million. To keep things simple, let's say this loan is what is called interest-only, meaning the owner is only responsible for paying the interest on the loan each year at a 3% interest rate. Our owner has to pay $60,000 of interest on his $2 million loan, calculated by taking the loan balance and multiplying it by the interest rate.

This $60,000 in loan payments can be comfortably covered by the $100,000 the property generates in income each year. However, let's see what happens as we increase the interest rate. Let's bump up the interest rate to 4%. The annual interest payment jumps up to $80,000. The income the property generates still covers the debt payments, but things are getting tight. Now, let's take that interest rate up to 6%. The annual interest payment skyrockets all the way to $120,000.

There's no way around it; this owner is in trouble. The $100,000 the property generates isn't even enough to cover the interest on the loan each year. In this situation, unless the owner can come up with the money to cover the difference, the bank will probably be forced to take over the property. The bank would likely take a pretty significant loss during the process.

This is where things start to get troubling for the banks, as it doesn't take too much in the way of losses to put a bank out of business. Let's say a bank has $100 million worth of loans outstanding to borrowers. The bank doesn't use its money to fund those loans; instead, they use the customer deposits that we talked about earlier. The bank is, in effect, borrowing that money and is using it to make loans. By law, banks are required to keep some of their own money in what is called the capital reserve to cover any losses that may happen from the loans.

So if a bank has $100 million worth of loans, it may have $10 million of its own money set aside. This money is meant to act as a buffer in the event some of the loans go south and help cover customer withdrawal requests. During good times, this $10 million may be more than enough of a cushion. However, as you are about to see, when it comes to banking, things can go downhill quickly.

Let's say only 20% of the bank's loans go bad. In this example, that works out to $20 million. The bank takes over those properties and is able to recover 70% of the loan value by selling off the properties. This works out to recovering 14 million on those $20 million worth of loans. This leaves the bank with a loss of $6 million, which is simply the difference between the original loan amount of $20 million and the $14 million the bank was able to recover.

That $6 million loss comes out of the bank's $10 million capital reserve. Now the bank only has $4 million left as a cushion against any further blows. However, the news of the bank taking this big loss gets out to the bank's customers. The customers start to get nervous and want to withdraw their money from the bank. Customers flock to the bank and demand to take out their money.

This is where things start to get really messy. The bank doesn't have the majority of customer deposits just sitting in its vaults; most of the deposits have already been used to give out loans. This is why things can snowball downhill so quickly for a bank. Banks do what is referred to as "lend long and borrow short," meaning they give loans that don't have to be paid back for a long time, often years if not decades, but at the same time, they're borrowing money from customer deposits that have to be paid back literally at a moment's notice.

The bank is legally required to honor customer withdrawal requests, and that money comes out of the bank's capital reserves. The $4 million starts to decrease as customers demand their money back, decreasing faster and faster as more and more customers find out the bank is on shaky footing. Eventually, the bank's capital reserve hits zero, and it's out of business.

Thankfully, the United States has deposit insurance. This means that the first $250,000 in a bank account is guaranteed by the government in the event of bank collapses. However, that doesn't mean there won't be impacts that ripple throughout the entire economy. As we can see from this graphic here, roughly two-thirds of all real estate loans are held by banks outside the top 25 largest in the country.

What this means is that it's not going to be the massive Wall Street banks getting crushed from what's happening in the commercial real estate market; instead, it's going to be the local community banks that are so important for economic growth in cities and towns throughout the United States.

When banks take loan losses, it decreases their ability to provide future loans, that is, assuming the bank is able to absorb the loss without going out of business. This decreased ability by banks to provide loans has significant impacts throughout the economy. Imagine a local restaurant owner in your hometown; everyone in the area loves the food and the atmosphere. There is always a line out the door.

Given the success this location is experiencing, the owner naturally wants to expand. However, this obviously requires significant amounts of money. To get that money, the owner will likely have to go to a small local community bank or credit union. If the restaurant owner gets approved for the loan, many people and businesses are going to benefit.

There's the contractors that will be making renovations to get ready for opening—plumbers, electricians, painters, handymen. This location opening will give all of these people more income. Then there are the real estate brokers, lawyers, and accountants that will get more business as a result of this location being opened. The list goes on and on, but you get the point; this restaurant opening is going to be a huge positive for the economy.

But what if the local bank denies the loan? The bank would love to give out the loan but doesn't have the ability to because it recently incurred significant loan losses. All of the people and businesses that were poised to benefit from the restaurant opening are out of luck. This example is obviously hypothetical; however, there are hundreds and thousands of real-life situations like this happening at any time in the United States.

This shows how trouble in the banking sector can send shockwaves throughout the broader economy. Only time will tell how things will play out. According to Warren Buffett, there will be banks that get completely wiped out. The real question is just how far things will spread.

So there we have it. Make sure to subscribe to the channel because it's my goal to make you a better investor by studying the world's greatest investors. Talk to you again soon.