'Extend-And-Pretend Ideology Is Gone': Major Banks Prepare For More CRE Losses

Fresh off a stressful 2023, due in large part to turmoil in CRE, the nation’s biggest banks are bracing for more trouble, ratcheting up the amount of money they hold in reserve to protect against commercial loans going bad. 

Loan loss provisions by the four largest banks, JPMorgan Chase, Bank of America, Wells Fargo and Citigroup, were up 40.7% compared to a year ago, Trepp reports.

A year ago, these banks allotted 8% of their total loan loss allowances to CRE. Now they are reserving 12%, according to data compiled by Trepp. 

“The extend-and-pretend ideology is gone,” Anax Real Estate Partners principal Eric Brody said. “The banks are like, we're going to have to deal with it, whether that's foreclosure or taking the asset back.”

Banks are slowly taking losses as they annually adjust account values in accordance with the market, Brody said, and while much of that is going on behind the scenes, he said the momentum is becoming more palpable.

“If you're trying to come into a new transaction and either buy the loan or the asset, when it is a lender that's required to mark-to-market, that creates a better opportunity of actually making a deal,” Brody said.

“The game has been extend and pretend,” Morning Calm Management CEO Mukang Cho said, with banks generally willing to work with borrowers over the recent period of rising interest rates, as all parties viewed an asset going to the bank as an outcome that benefited no one.

“Still, there have been some noteworthy foreclosures involving marquee sponsors and well-known projects over the past several quarters,” Cho said. “Some of the banks we’ve liaised with recently believe it will be more of the same going forward, but others seem more apt to rip off the Band-Aid as they feel better about their capital levels.”

During the last credit cycle, banks were willing to work longer with borrowers, HKS Real Estate Advisors principal John Harrington told Bisnow, but the climate was different then, as the economy slowly crawled out of the Great Financial Crisis and low interest rates enticed spending.

“This time there's going to be a lot of product coming on onto the market for sale at discounts,” Harrington said, as banks up their loss allowances and CRE looks forward to stable, and perhaps falling, interest rates. “There's also going to be a fair amount of what we call DTOs, or discounted trade-offs.”

Harrington said he is working on one such deal right now involving a lender on a hotel that suffered greatly during the early pandemic and is now willing to take a $5M haircut on the loan.

Larger banks have increased their CRE loss allowance faster than smaller banks, according to Trepp, with larger banks more likely to have greater exposure to office loans. As of the third quarter of 2023, the latest quarter for which data is available, banks with assets of more than $100B had 2.1% CRE loss allowances relative to their total CRE loans, up from 1.9% the previous quarter and 1.5% a year earlier.

By contrast, banks with less than $100B only had 1.2% CRE loss allowances as a percentage of their total CRE loans in Q3 2023, up just barely from 1.1% a year earlier.

Earnings for the four large banks fell by an average of 40.8% year-over-year in Q4 2023, Trepp reports. The drop was especially large at Citigroup, which posted a quarterly loss of $1.8B. Total revenues for the four banks rose by 2.1% compared with Q4 2022, however.

Net loan charge-offs, which represent debt that the bank is unlikely to ever recoup, increased during Q3 2023 by 0.53% of average loans, Wells Fargo CEO Charlie Scharf said during the company's Q4 call in January, driven by commercial real estate office and credit card loans.

The increase in commercial net loan charge-offs reflected the higher losses in office-associated loans, while losses in the rest of the bank’s commercial portfolio were stable from the third quarter, Scharf said.

Losses started to materialize in Wells Fargo's CRE office portfolio as market fundamentals remained weak, Scharf said. The losses were across a number of loans in different markets and driven by borrower performance, lower appraisals or loans being sold at a loss.

The increase in commercial real estate loans no longer being paid was driven by a $567M increase in office loans that had gone sour, according to Scharf. 

“While the charge-offs we took in the fourth quarter were contemplated in our allowance, we are still early in the cycle,” he said.

For Bank of America, the overall increase in net charge-offs was driven by three factors, according to CEO Brian Moynihan, two of which were credit card losses and small commercial loans.

The third was CRE. $76M of the increase was driven by commercial real estate losses, primarily due to office, Moynihan said.

JP Morgan Chase likewise reported both an increase in charge-offs and loan loss allowances, with charge-offs up by $1.3B, said Chief Financial Officer Jeremy Barnum, who added that a main factor in the buildup in loan loss allowances was the deterioration in the outlook of commercial real estate valuations. 

The seeds for banks preparing for additional losses were planted not that long ago, as borrowers took advantage of cheap money before the full impact of the pandemic on the economy became apparent. Then, inflation and interest rate hikes came along.

“The things done at a high leverage a few years ago are, unfortunately, going to be underwater this time around,” Harrington said. “People say interest rates are going to come down, but I don't see rates coming down enough to change the dynamic of recasting a lot of these loans.”