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.