Next Financial Collapse Won’t Be From Subprime. It Will Come From CRE.

One of the cliches of military planning is that generals are always fighting the last war. Prior to World War II, the French built the Maginot Line of forts to prevent a frontal assault of the kind the Germans had launched in World War I. Instead, the Germans just went around it and marched into Paris without much opposition.

During the Suez Crisis of 1956, the UK and France acted like they were the imperial powers of the 19^th century, only to find the U.S. was now the global hegemon and quickly ordered the UK and France to desist from their half-baked plan to take over the Suez Canal.

The list goes on. The latest example is identifying the cause of the next global financial crisis (coming soon). We all remember the Global Financial Crisis of 2007-2008, which was allegedly caused by subprime mortgages. (Subprime loans played a role, but more as a symptom than a cause. The real cause was excessive monetary tightening by Ben Bernanke in 2006-2007).

With that as background, pundits are again looking at residential mortgages and inflated home values as a potential source of crisis. They’re looking in the wrong place.

Since 2009, conditions for mortgage loans have tightened considerably. A down payment of 20% or more is routinely required. Full documentation (tax returns, W-2s, employment verifications, title insurance, etc.) is necessary and co-signers are often required. This does not guarantee loans don’t default, but there will certainly be far fewer defaults and larger owner equity cushions to absorb any losses.

For warning signs this time, investors might do well to look at commercial real estate, (CRE). As reported here, CRE is crashing on several levels.

In the first place, valuations are falling and vacancies are rising, partly in response to the post-pandemic work-from-home movement and the general urban flight due to high crime and vagrancy. At some point, owners are underwater on rents and just drop off the keys with the lender and walk away.

The other problem is that new building construction is not financed with long-term mortgage, but with short-term construction loans. These usually have two or three year maturities. When the building is finished, the developer gets a long-term mortgage and pays off the construction loan in full. The difficulty arises when credit conditions charge materially between the time the project is started and when it is completed.

That’s exactly what happened between 2021 during the post-pandemic boom, and 2024 when a lot of the construction loans become due. If developers can’t get the long-term financing on favorable terms, that becomes another reason to walk away.

Investors don’t need to worry about subprime home loans this time around. But they would do well to pay attention to the CRE space. That’s one canary in the coal mine of the next global financial crisis.

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