Bank Extend and Pretend Common in Commercial Real Estate Loans

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The Wall Street Journal today has solid piece of reporting on how banks are avoiding writing down commercial real estate loans. And the article even invoked “extend and pretend” near the top of the piece. The Journal also provides a critical factoid: regulators unwittingly enabled this practice.

I had been wondering why we hadn’t seen more reports of CRE related losses. Banking experts like Chris Whalen and Josh Rosner have been talking for some time about the time bombs sitting on the books of medium sized and smaller banks (well big banks too, but CRE is is usually a bigger % of equity at smaller banks).

Most of it is construction lending, and construction lending is close to Ponzi finance: interest on the loan is simply paid out of proceeds. Cash is going out the door all through the building process, and builders usually can sign up tenants only when the project is fairly far along.

Even worse, CRE projects that go bad often deliver loss severities in excess of 100%. Not only does the lender lose his principal, but he usually has to pay to demolish the project in order to sell the land.

From the Wall Street Journal:

A big push by banks in recent months to modify such [commercial real estate] loans—by stretching out maturities or allowing below-market interest rates—has slowed a spike in defaults. It also has helped preserve banks’ capital, by keeping some dicey loans classified as “performing” and thus minimizing the amount of cash banks must set aside in reserves for future losses.

Restructurings of nonresidential loans stood at $23.9 billion at the end of the first quarter, more than three times the level a year earlier and seven times the level two years earlier. While not all were for commercial real estate, the total makes clear that large numbers of commercial-property borrowers got some leeway….

Regulators helped spur banks’ recent approach to commercial real estate by crafting new guidelines last October. They gave banks a variety of ways to restructure loans. And they allowed banks to record loans still operating under the original terms as “performing” even if the value of the underlying property had fallen below the loan amount—which is an ominous sign for ultimate repayment. Although regulators say banks shouldn’t take the guidelines as a signal to cut borrowers more slack, it appears some did.

Banks hold some $176 billion of souring commercial-real-estate loans, according to an estimate by research firm Foresight Analytics. About two-thirds of bank commercial real-estate loans maturing between now and 2014 are underwater, meaning the property is worth less than the loan on it, Foresight data show. U.S. commercial-real-estate values remain 42% below their October 2007 peak and only slightly above the low they hit in October 2009, according to Moody’s Investors Service.

In the first quarter, 9.1% of commercial-property loans held by banks were delinquent, compared with 7% a year earlier and just 1.5% in the first quarter of 2007, according to Foresight.

Yves again. And who could the Journal find to praise this dubious practice? Of course, the official banking industry mouthpiece, the ABA:
Holding off on foreclosing is often good business, says Mark Tenhundfeld, senior vice president at the American Bankers Association. “It can be better for a bank to extend a loan and increase the chance that the bank will be repaid in full rather than call the loan due now and dump more property on an already-depressed market,” he says.
Yves again. This more, um, generous treatment of CRE borrowers has led to some regulatory pushback (but I wonder whether this message is being conveyed consistently):

In a May conference call with 1,400 bank executives, regulators sought to clear up confusion. “We don’t want banks to pretend and extend,” Sabeth Siddique, Federal Reserve assistant director of credit risk, said on the call. “We did hear from investors and some bankers interpreting this guidance as a form of forbearance, and let me assure you it’s not.”

I suggest you read it in its entirety. More here.

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  1. But What Do I Know?

    Kind of funny how it was much easier to lecture the Japanese on what needed to be done–get rid of the dud loans, Mr. Watanabe, and all will be well–than it is to do it oneself.

    At the risk of sounding crude, the resolution of this debt constipation will be worse and worse the longer the purge is delayed. . .

  2. Siggy

    The deals noted in the article are relatively small. There are much larger deals that are being restructured by extending the loan term. The banks made bad loans, a loan to value at more than 75% that is based on a 6% or lower cap rate is in trouble from day one. Those are the basic terms of most loans that were made during the period 2002 thru 2005.

    It’s lovely during the expansion phase of an economic cycle. The choice for the bank is simple, if they have the reserves, foreclose and take the loss, Foreclose and operate the property until it can be sold at a profit, that might be in 7 to 10 years. What ever the choice, knock 40% off the original value basis.

    This problem is hitting the banks quite silently, nonetheless, is operating to severly constrain the develpment of s solid basis for a recovery. My guess, the amount of troubled loans is probably on the order of a trillion dollars, give or take 300 billion.

  3. ep3

    “Most of it is construction lending, and construction lending is close to Ponzi finance: interest on the loan is simply paid out of proceeds. Cash is going out the door all through the building process, and builders usually can sign up tenants only when the project is fairly far along. ”

    could you elaborate on this sometime?

    1. matt

      It basically means that the lender makes a loan and holds back some of the loan to pay for interest (interest reserve). It’s essentially paying itself and booking it as income.

      I’m a little confused though. Wouldn’t the loans described above be classified as construction loans, not CRE?

  4. Jackrabbit

    Extend and Pretend is a sort of collective madness (destructive group-think) that the bankers themselves can’t break free of. And we all pay the price.

    Banks that mark down assets would show poor results vs. their peers. Bank management fears that that might a loss of “confidence” that could start an irreversible slide: a falling stock price, client concerns, etc. But another important factor is that our crony capitalist system means that the banks have a big incentive to take care of their clients. Plugging the plug – unless forced by regulators or market circumstances – sends a message that you don’t care about your clients.

    So the banks (and those who would be hurt by banks getting tough) collectively complain to regulators, lobby politicians, and implore the Fed to keep up the sham.

    Banks will continue to extend and pretend as long as regulators make it easy for them to carry the assets with Mark to fantasy and Fed liquidity.

    Note: Its interesting how banks and their CRE clients get this favorable treatment while the unemployed are label as lazy freeloaders.

    1. Jackrabbit

      Um… to further the point: the large overhand of bad loans that banks hold via “extend and pretend” reduces their appetite for making new loans, which is a drag on the economy that causes unemployment to be higher and longer lasting than it would otherwise be.

      PS: We know were this “business-as-usual”, “muddle-thru” approach leads: to a Japanese-style lost decade(s).

    2. monday1929

      Peter Atwater, A useful tool of JPM, spreads the myth on Minyanville that the main cause of the Financial System collapse are efforts to apply “mark-to-market”. He is also big on blaming “deadbeat homeowners” (probably not to include the wealthy deadbeats) and “populisms” antipathy toward banks as a reason for dried up liquididity.

  5. charcad

    This article didn’t exhaust the list of tricks that have been used to maneuver the ball around the cups. Another tactic often used here in Florida starting in 2006 was to foreclose.

    After foreclosure the partly complete CREO project (or residential project) was resold to a favored developer client on E-Z terms with -0- cash down E-Z credit. An appearance of developer equity was easily created by a variety of devices.

    The Zombie banks have been animating a series of Zombie construction projects. We can see one example of the results in the Venice – North Port- Port Charlotte US 41 corridor. Strip mall construction has continued unabated in North Port. Among other effects this has led to 20 vacant inline stores in the Port Charlotte Town Center Mall (Simon’s) just 5 miles further south.

    Banks are on the lender end. On the equity side we have entities like Simon’s as managing general partner. Plus CALPERS and its many peers as passive investors. Dig a bit and we’ll find plenty of examples of these institutions funding “investments” that are destroying the value of their adjacent investments.

    Now this ought to give anyone a long pause. What little construction activity the official statistics are reporting is really endeavors of that nature.

  6. Gary Anderson

    Is’t it peachy that the homeowner doesn’t get the same sweet deals? But then they must be made to feel guilty, whereas commercial borrowers are just doing business.

  7. Anonymous Jones

    As you suggest in the article, some CRE loans are much worse than others.

    Construction lending is, by far, in the worst shape, for the obvious reasons you cite above. C&D loans are true catastrophes, with many lender recoveries below 50%, sometimes significantly below 50%, even in multi-hundred-million dollar developments. It’s a disaster.

    That said, I’m not sure that “most of” the CRE lending is construction lending. Most CRE is already built real estate. And in that area, I have to say the market is simply holding up much better than I anticipated (at least in LA…I do some deals and SF, Miami and NY as well…same story). I’ve recently seen quite aggressive bidding when banks look for the best and final on note sales for existing hotels and apartment buildings, even when the underlying properties are not meeting debt service. Even though the equity is of course wiped out in a foreclosure after the note sale, many of these note sales are close to 100 cents on the dollar recovery for the lender. There is still a vestigial pot of money (seemingly invisible but much larger than anyone apparently thinks) out there in REITs and CRE funds that needs to find some kind of real estate investment. I’ve seen some really outsized bids in the hotel market recently by a REIT that shall remain anonymous here…

    1. Yves Smith Post author

      Most larger CRE loans, class A buildings and bigger malls, are securitized, so they would not be counted as “loans” if a bank held some CMBS. And many smaller de facto CRE loans, to small businesses secured by real estate, are classified as small business loans, not CRE. So what you find on bank balance sheets as loans is much smaller than the # of loans originated or conceptually equivalent to CRE.

      1. renholder

        I don’t think this is correct. Small business loans 50% secured by CRE will be classified as CRE loans for almost all aggregate statistics because those are the instructions for the Call Report which all banks file. BHCs and Banks almost always file financials consistent with call report instructions.

        The other thing to consider is that when a bank grants a concession to a troubled CRE borrower they have to recognize impairment equal to the present value of future cash flows and or the present value of the concession granted. Extend and Pretend is still a major problem, I just think not as big as people think it is. However it is a mistake to think that regulatory forbearance is “new.” The new CRE guidance is almost identical to the 1991 CRE guidance, just with more explicit examples.

        1. Yves Smith Post author

          I think we are talking past each other, and I admittedly was not clear. Many small business loans are personally guaranteed by the principals. The bank looks to the net worth of the principals. Real estate is often their biggest asset. So the lender factors in the borrower’s assets even though he does not take a security interest.

      2. Anonymous Jones

        You are correct. I was talking mostly about securitized loans for office and hotels.

        The small and mid-sized banks have a lot of C&D. I have some large C&D with Citi that was meant for securitization but was not securitized before the crash. The smaller banks are the ones that are being killed by the C&D, and these are mostly not securitized. I should have been much more precise in my reading and my writing. Alas…

  8. Ishmael

    Extend and Pretend is also what the S&L industry. Most S&L’s were insolvent in RE and CRE. The govt did not require them to take their markets and gave them breathing space to recover. Along came the junk bond business and S&L’s doubled down to save themselves and the net result was the loss to taxpayers went from around nil to a $100 billion. Those loses will probably look like piker change compared to what is coming.

    I am only familiar with retail real estate. Most retailers over the last 10 years have paid far to much for space even when the consumer had credit. If there is another leg down for the consumer then almost all retail deals done in the last 10 years will look very bad.

    Two years ago I was advising a CEO after they had purchased a BK competitor. They thought they had done well but when I went through the RE and showed him that he was paying significant more for RE than comparable retailers he was a little upset.

  9. PQS

    I was hearing from small developers in the Pacific NW in the FALL OF ’08 that lending was so tight they couldn’t even fund any projects without SIGNED LEASES, which was much more stringent than any years previous. Typically they were only required to get Intents or some other kind of security in order to get a construction loan. (And this is for property that is owned, not under some kind of purchase agreement.)

    You figure out how in the world they are going to get Mr. So and So who wants to lease a little shop in a new building to sign a lease on a piece of property that isn’t even built yet, and on favorable terms to the developer.

    And so we have 27% unemployment in construction. (Yes, I know, there are lots of “shack-knockers” as we call them, in that number. (i.e., housing folks.))

  10. Siggy

    The banks, large and small, regional and global, all have exposure to bad CRE loans. The loans in question were largely originated during the period from 2002 thru 2007.

    Many of the loans, especially the large balance ones were securitized. Fitch is reporting with an alarming degree of frequency the movement of these loans to special servicers. Inevitably, when the distressed loan is examined it has those ready markers that are the precursor of default, a loan to value greater than 75% and a cap rate against trailing 12 income that is lower than 7%. Default for these loans was never in doubt, when was and remains the question. In many securitizations foreclosue and resale at a fair price is difficult but not impossible

    To the extent that there are restructurings in progress the typical format is for an infusion of capital that restores the LTV and an extended term of the loan at a slightly lower interest rate which is made possible by the incredibly and artificially low current yield curve.

    The lenders are extending and pretending because they have a simple choice. If the property is foreclosed its depreciated replacement value goes to 30 cents on the dollar in a heart beat. If the property is carried, it goes to 60 cents on the dollar. If the property has say 80% occupancy, it may be able to throw a net cash flow of say 6% of that 60% value.

    What does that mean, it means that the lender bot the property the day it made the loan. Unfortunately, the lender is rarely competent in the area of property management and operation. Hell they are clearly incompetent as to lending.

    Now that incompetnence affects us all because it limits the availability of credit to us all. The lenders were, and continue to be, undercapitalised and cannot absorb the writeoffs that would otherwise be necessary to restructure the financing.

    The quickest and least costly resolution is the bankruptcy of both borrower and lender. Out of that process we might get better management of risk and better allocation of loanable funds.

    This is easily a trillion dollar problem. Now who gets to take the hit? Is it rational to socialize the hit by placing it on the balance sheet of the Fed or the Treasury; or, would we be better served by liquidating culpabale lenders and real estate operators?

    The big threat of wholesale bankruptcies would be with respect to the banking industry in that we would soon have an even more consolidated banking industry. Note that there were once some 40 plus ‘primary dealer’ banks, today there are fewer than 20. This concentration of banking power and politcal influence is a symptom of a much more profound problem.

    Correcting our problem will be a lot like peeling an onion. in the end we will be left with a lot of onion peels whose best use is now the deep fat fryer. Ultimately it is all about our failed fiat currency. Pity it really can’t be deep fried. And then maybe it already has been fried.

  11. CRE Services Guy

    CRE still would seem to be a (relatively) small hit to the banks. At $176bill, its what, 10% of the hit to banks that residential real estate was? I’m not saying this won’t take down some banks, especially given the concentration of these loans found in smaller banks and the larger hole each individual loan will leave in a balance sheet, but in the grand scheme of things, this is about a 1/4 TARP problem.

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