‘Extend-And-Pretend’ Strategy On CRE Loans Poses Systemic Risk, N.Y. Fed Says

Regional banks are delaying disclosing the distress in their commercial real estate loan portfolios, creating greater fragility in the overall financial system, the Federal Reserve Bank of New York warned in a research paper published this week.

Regional banks' commercial real estate activity has come under increased focus since last year's collapses of Silicon Valley Bank, Signature Bank and First Republic Bank, and the report indicates that many lenders are trying to dodge scrutiny by masking the distress in their loan books.

In doing so, banks have been building up the wall of maturing debt — the report's authors estimated the banking sector has $400B in near-term CRE loan maturities. By keeping loans on their books for longer, lenders have reduced the number of new mortgages they have handed out. 

“The expansion of the maturity wall represents a financial stability risk as a sizable, and increasing, portion of bank regulatory capital is at risk should these CRE loans default,” authors Matteo Crosignani and Saketh Prazad wrote. “The possibility of a large and sudden capital hit for banks becomes more likely as the maturity wall becomes taller.”

Crosignani and Prazad wrote that extend-and-pretend has caused a 4.8% to 5.3% drop in CRE mortgage origination since the first quarter of 2022. Meanwhile, as of the fourth quarter of 2023, the maturity wall represents 27% of bank capital, up 11 percentage points from 2020, according to the report.

The practice of not recognizing distress on their books may provide short-term relief from regulators and investors, but a large number of defaults occurring at the same time would result in a huge capital hit for banks. Solvency concerns could cause a bank run by depositors, along with a flood of property foreclosures and fire sales, the authors wrote.

Despite a growing number of alternative lenders — largely coming to the surface because of traditional lenders’ inability to provide capital — bank balance sheets held 50.7% of mortgages in the $5.8T U.S. CRE market as of the end of last year.

Smaller banks are more likely to put off recognizing distress, the researchers found. 

Weakly capitalized banks assign a 0.9-percentage-point lower probability of default compared to their well-capitalized counterparts, indicating that they are giving more leeway to nonperforming loans. The authors wrote that difference is “sizable” considering the average effect probability of default for distressed loans is 4.8%.

Those weakly capitalized banks also have a 0.2-percentage-point higher probability of providing a maturity extension compared to similar mortgages granted by well-capitalized banks, according to the study. 

Delays in recognizing distress — and then doing so all at once — nearly took down one regional bank this year.

New York Community Bancorp teetered on the edge of collapse earlier this year when its leaders, after previously boasting of the bank's “stellar” commercial real estate loan book, recognized huge losses in January and slashed its dividend.

The revelation led the bank's stock price to plummet, and it took a $1B infusion of capital and a leadership shake-up led by former Treasury Secretary Steven Mnuchin to stabilize. 

The new leadership forced the bank to undergo a review of its loan book and found the pain was greater than previously disclosed. Its net charge-offs hit $349M in the second quarter, up from $81M, while nonaccrual loans reached almost $2B, more than the $700M in the first quarter.

The delay in recognizing weakness in the CRE portfolio triggered a class-action lawsuit against NYCB led by two of its pension fund investors. 

Before NYCB’s near collapse, five other regional banks were downgraded by S&P Global from “stable” to a “negative” outlook due to their CRE exposure.

The report further highlighted that the extend-and-pretend habit is a more recent phenomenon, largely due to the rise in interest rates following historic lows, which has prevented refinancing. 

But the new circumstances also delay what could be an end for a large number of futile office buildings, preventing reinvestment that could help turn around business districts' fortunes sooner.

“The resulting crowding-out of new credit provision slows down the efficient reallocation of CRE credit, likely hindering the downsizing of office districts in urban areas, also affecting cities’ tax revenues,” the authors said.