Commercial Magazine

‘Extend and pretend’ remains the playbook for troubled lenders

By Jeff Bond

Model of a Bank building with nails hammered into it from all sides

A growing throng of banking and commercial real estate experts are sounding the alarm about the nation’s small and medium-sized banks, which may be on the cusp of another crisis. John Murray, Pacific Investment Management Company’s head of global private commercial real estate, told Bloomberg in June that he expected more regional bank failures in the U.S. because they held a “very high” concentration of troubled commercial real estate loans.

The Klaros Group, an investment and advisory company, analyzed about 4,000 banks and found 282 with both high levels of commercial real estate exposure and large unrealized losses from the rate surge. This may force the banks to raise fresh capital or engage in mergers. Even Federal Reserve Chairman Jerome Powell has warned that there will be failures among small and mid-sized banks, thanks in large part to falling office values. He said that the financial sector will be working through this problem for years to come.

Rebel Cole, a professor of finance at Florida Atlantic University, took his own deep dive into the plight of the nation’s banks, and his results aren’t encouraging. Cole, who spent 10 years working at the Federal Reserve, primarily at the Board of Governors in Washington, D.C., found that 67 of the largest banks in the country — those with more than $10 billion in total assets — had exposure to commercial real estate loans greater than 300% of their total equity, as reported in the first quarter of 2024. According to a report from the university, bank regulators view any loan ratio of more than 300% of total equity as excess exposure to commercial real estate and puts the bank at greater risk of failure.

Those figures were just the beginning. According to information compiled by Cole and his colleagues, 1,871 U.S. banks of all sizes have commercial real estate exposure of more than 300% of their total equity; 1,112 banks have exposure greater than 400% of total equity; 551 have exposure greater than 500%; and 243 have exposures greater than 600%.

Two banks with the some of the highest exposure to commercial real estate loans included Flagstar Bank and Zion Bancorporation. According to the university’s screening process, Flagstar Bank had $113 billion in assets, including $51 billion in commercial real estate loans. But the bank only had $9.3 billion in total equity. So its total commercial real estate exposure was 553% of its total equity. Using the same method, the report found that Zion Bancorp had a total commercial real estate exposure of 440% of its total equity.

The situation is dire in the sense that smaller and regional banks are saddled with most of the loans on office buildings. Many of these properties no one wants, and no one needs. Only a small percentage of them are appropriate for housing. So, the valuation on those buildings is nosediving. A few that have been auctioned off because of default have gone for pennies on the dollar. That craters the value of the loans.

Also, a few quarter-point drops in the Federal Reserve interest rate won’t magically make the valuations on these buildings improve. A growing number of borrowers have simply walked away from their loans, leaving partially empty buildings to the lender’s care. Cole argues that banks with high exposure to office space only have a few options open to them.

“One, they somehow have to figure out how to raise equity or, otherwise, get rid of their exposure, which is unlikely” Cole said. “Two, they’re forced to merge with a larger bank that finds them attractive, which is also unlikely. Or three, the FDIC takes them over.”

Cole expects that most of the banks with exposures of 500% or greater, which number 551 by his estimates, will be gone in the next 12 months, one way or another. To put that in context, Forbes estimates that 465 banks failed during the economic crisis of 2008-2012. Cole expects that this will be a similar event, with perhaps as many as 500 banks failing.

Many observers have been expecting that some of these troubled banks would fail as a wave of commercial real estate loans mature and need to be refinanced. But that hasn’t happened. One of the reasons this hasn’t taken place is because of the old banking cliché, “extend and pretend,” which refers to the lender extending the length of the loan and pretending that the borrower will be able to pay in the future. A more drastic version of the term is “delay and pray.”

“You’re kicking the can down the road, and you are just pretending it will be better in the future,” said Ann Hambly, CEO of 1st Service Solutions, which specializes in commercial real estate advisory services. “For office deals it is more like ‘delay and pray.’ You are delaying the loan for a year or two and then praying that things get better. There really is no other choice for many of these banks.”

Extending has been big business this year. Approximately $22 billion in commercial loans have been modified in the past 12 months, ending in May of this year, according to CRED iQ, a commercial real estate data, analytics and valuation platform. That figure is up from $16.8 billion in 2023. CRED iQ estimates that a total of $210 billion in securitized maturities will come due this year, fueling even more modifications and extensions.

The question now is what is the catalyst that will end the banks being able to delay and pray? Cole said this is still the early phase in a very long process for the banks. But he expects that eventually it will be up to a combination of federal agencies to decide how long the extensions will be allowed to play out. At some point, the Federal Reserve, bank regulators, Federal Deposit Insurance Corporation or the Office of the Comptroller of the Currency will step in and force the process to stop.

But that could be a very expensive proposition. If hundreds of these lenders do fail, as some have predicted, the FDIC may be on the hook to cover some of their losses, which could conceivably cross into tens of billions of dollars or even more and drain the agency of its resources. “In that case, Congress will have to get involved,” Cole said. “Someone once said, ‘May you live in interesting times.’ We are about to live in very interesting times.”

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