The Three Waves: Wave 2 — Can we avoid a new financial crisis?

Commerce Ventures
Published in
11 min readApr 3, 2020


In our first installment on the impact of COVID on financial services and FinTech, we outline three waves that will reshape the market and provide a detailed look at the First Wave (click here for Part 1). This post will cover the Second Wave. We focus our analysis on a set of core dynamics that could transform the consumption shock experienced during the First Wave into a broader financial crisis. These core dynamics are primarily centered around structural risk to the credit and lending markets. We think about these risks in three broad categories: (1) commercial real estate lending, (2) consumer lending, and (3) other commercial lending.

Let’s first look at commercial real estate. As illustrated in Figure 1, delinquency rates across commercial mortgage categories were trending at a three-month low at the end of February. This matched generally low retail vacancy rates of 10.2% in the fourth quarter of 2019.

Figure 1: Commercial real estate delinquency rates prior to the COVID-19 crisis

The first wave of impact from COVID-19 will lead to dramatic spikes in these delinquency rates and create exposure for the underlying capital markets. Analysis by Trepp on commercial real estate exposure highlights the scope of potential risk. Applying a generally conservative model based on the “Severely Adverse Scenario” used by bank regulators in stress testing, Trepp projects that cumulative default rates for commercial real estate could go as high 8.0% and cumulative loss rates could hit 2.5% by the end of 2021.

This risk is most acute in the hardest hit sectors: lodging and retail. As illustrated in Figure 2, it is possible that these sectors may reach loss levels last seen during the 2008 Financial Crisis — with lodging at a cumulative 35% default rate and retail at 16%. To some extent, we are already seeing hints of this in the public markets, with year-to-date performance across publicly traded REITs (NAREIT) down an average of 56% in these categories (versus an average 30% across other categories). It is important to note that peak defaults are projected to occur in the middle of 2021 — further underscoring that the greatest impact of commercial mortgage losses on financial services lies ahead of us (consistent with this Second Wave).

Figure 2: Projected defaults and losses across commercial real estate

While the trough lies ahead, we are already seeing large businesses — including Nike, TJ Maxx, Burger King and H&M — delaying rent payments for the coming period. The scope of default risk is driven by the rate of these delinquencies on commercial rents. The greater the number of tenants that cannot (or refuse) to pay, the higher the pressure on commercial landlords to fulfill debt obligations. The faster these losses accumulate, the greater the balance sheet risk for banks and other lenders that have underwritten properties at valuations based on pre-crisis operating income.

The potential scale of this risk is massive. As illustrated in Figure 3, overall commercial real estate lending increased by 21% over the last 11 years, hitting $3 trillion in January 2019.

Figure 3: Commercial real estate mortgages ($M)

A relatively small percentage (14%) of these loans are held by the largest five U.S. banks. The remainder are held by a variety of other lenders. Exposure to retail mortgages is particularly concerning, with the Conference of State Bank Supervisors (CSBS) estimating that outstanding retail-related real estate loans make up approximately 27% of all outstanding commercial mortgage-backed securities (CMBS). This exposure may be especially severe for community and regional banks, which are estimated to hold nearly 25% of their total commercial real estate exposure in retail.

Overall, our projections indicate that cumulative commercial real estate defaults could top $340 billion and total losses could exceed $116 billion over the next 18–24 months. These losses would cascade throughout the financial ecosystem — impacting not just banks but asset managers, including insurance, private equity, pension funds and endowments. For some entities, these losses will represent a meaningful percentage of assets and may inhibit allocation of new capital. This will create further contagion risk to other parts of the economy that are dependent on these sources of capital.

Similar to commercial real estate, the market for consumer lending is likely to undergo a major shift as millions of Americans face sudden unemployment. Already, over 10 million Americans have filed for unemployment benefits — representing roughly 6% of the U.S. labor force and the largest month-to-month increase since 1975. Figure 4 shows that the current rate of unemployment is projected to rival or exceed the heights of the 2008 Recession by May. However, this is not just a question of scale but also speed, with unemployment potentially doubling what we saw during the last Financial Crisis but occurring more than 6 times faster — in a period of less than 4 months rather than 25 months during the last crisis.

Figure 4: Unemployment rate (%)

This will dramatically impact consumer lending. As illustrated in Figure 5, key areas of consumer lending have increased substantially since 2009 — with the total value of auto loans up 74%, credit card loans up 10%, and student loans up 128%. The aggregate value of consumer debt is at all-time high, placing significant potential stress on entities holding credit risk associated with these loans.

Figure 5: Increase in consumer lending across auto, credit card and student loans ($T)

Exacerbating the potential risk is a historically limited ability of consumers to withstand liquidity shocks. According to the 2019 Federal Reserve Study on the Economic Well-being of U.S. Households, roughly 40% of adults would have difficulty covering an unexpected $400 expense. This will likely lead to three consequences: (1) A near-term increase in the demand for new credit — including to cover income gaps resulting from unemployment; a (2) Decrease in credit spending across affected categories, and a (3) Longer-term increase in consumer default rates.

We are already starting to see the first play out. Both traditional financial institutions as well as FinTech firms operating in consumer lending have seen a significant increase in demand for refinancing. In student lending, industry heavyweight Social Finance (SoFi) saw a 75% increase in refinancing applications from March 8 to March 15. Auto refinancing start-up MotoRefi saw a 46% month-over-month increase in applications. And national mortgage refinancing applications were up 479% from the same period in 2019.

However, while mortgage refinancing increased substantially, weekly applications for new mortgages declined by 29%. This reflects a broader trend — with certain credit segments seeing a substantial reduction in volume. In the payments industry, the numbers are telling: At American Express, travel and entertainment account for close to 30% of card volume; Citi’s U.S. Consumer Business had 33% of 2019 revenue driven by its private label retail business; and Synchrony’s retail card program accounted for 77% of total purchase volume in 2019.

We do not yet have data to fully assess the potential extent of consumer defaults but it is not hard to imagine a scenario where increasing unemployment leads to an inability to pay down existing loans and forces lenders to write-down their portfolios. Part of the challenge is the inability to predict the extent of potential delinquency. The 2008 Crisis provides some guidance. As illustrated in Figure 6, total delinquency rates rose substantially at the heart of the crisis, with nearly 8% of balances more than 120 days late.

Figure 6: Delinquency rates as % of total portfolio

Importantly, as illustrated in Figure 7, delinquency rose across all major consumer lending products and the overall rate of new delinquencies increased by 126% during the last recession. Applying the same delinquency rates to the 2019 lending balances highlighted in Figure 5, this would yield $459 billion in new delinquencies — $144 billion in auto, $127 in credit card, and $187 in student loans.

These numbers could be significantly higher if unemployment reaches the high-end projection from the Federal Reserve (32% unemployment due to COVID-19 versus 10% at the heart of the 2008 Recession). It is obviously too early to determine the full extent of credit defaults but it is likely that financial services and FinTech providers with exposure to consumer lending will see material headwinds in the coming months.

Figure 7: Delinquency rates by loan type between 2004 and 2019 (30 days or more delinquent)

Unlike consumer lending, the implications for commercial lending will differ substantially between large enterprises and small businesses. Many small businesses are seeing immediate liquidity needs driven by a sudden loss of income. The availability of $350 billion in grants under the newly passed CARES Act will provide a measure of temporary relief. However, it is unlikely to be sufficient. A significant number of these businesses will be unable to survive the time period for new SBA grants to get processed — with half of small businesses having enough cash to last only 27 days without revenue, according to the JPMorgan Chase Institute.

Projections based on data from the U.S. Small Business Administration (SBA) indicates that there are 26 million individual small business loans ($1 million or less), worth an estimated $340 billion (not including commercial real estate). The potential exposure to underlying defaults is particularly significant for community banks, which held 43% of all small business loans based on the FDIC’s 2017 community bank performance report. Assuming a 25% default rate on small business loans, these would generate over $36 billion in losses or roughly 2% of total assets held by all community banks.

However, this is not just a bank problem. Instability in the SMB lending market has already impacted FinTech lenders, with Kabbage having furloughed the majority of its employees and other lenders seeing stress on both access to capital as well as inability to price the insolvency risk across underlying businesses.

For large businesses, the implications on commercial lending will fall into two categories. The first are institutions issuing new, investment-grade corporate bonds to generate cash. As illustrated in Figure 8, issuance of new bonds in the U.S. hit $73 billion last week. This is up 93% since the beginning of the year and 21% higher than the previous high that was set in 2013.

Figure 8: Issuance of new investment-grade corporate bonds (January — March, 2020)

The second category are companies that are drawing down on existing credit facilities in order to bolster their near-term balance sheets. So far, the combination of well-capitalized mega-banks and an aggressive monetary response focused on injecting liquidity into the markets has prevented shortage of funds. However, we are still in stages of this crisis. It is possible — if not likely — that more large businesses will be tested over the coming weeks and require access to credit lines in order to fund basic operations. With many large retailers experiencing a total collapse of in-store revenue and travel companies seeing >80% decrease in volume, it is not hard to imagine a scenario where the Federal Reserve will need to pump substantially more liquidity into the market in order to prevent a credit tightening similar to what we saw in the 2008 recession.

Total exposure across the three lending categories discussed in this post could exceed $1 trillion, representing roughly 1% of total assets in the U.S. financial sector (including bank assets and third party asset managers such as insurance and pension funds). This number is simply a projection and could get much worse before it gets better — with the Federal Reserve estimating that the unemployment rate could ultimately hit 32% and impact 47 million Americans. This highlights that there are many unknowns, not just around unemployment, but around the full scope of exposure to other areas of the real estate and commercial lending market such as residential mortgages, industrials and manufacturing.

However, there is still opportunity to stave off some of these dangers and ride the wave to calmer waters. Our next post will examine the Third Wave and longer term implications for financial services. This wave is centered around recovery and industry transformation — driven by M&A, an acceleration of digital capabilities and experiences, and a new class of FinTech companies that will redefine the market.


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Commerce Ventures

Early-stage venture capital firm investing in technology innovators in the retail and financial services eco-systems.