For the past few weeks, bank investors have been wringing their hands and gnashing their teeth in frustration and anger at the Federal Deposit Insurance Corp. That’s because the FDIC this month issued guidance that it would not look unfavorably on banks that were making good faith efforts to carry commercial real estate loans on their books long after those loans should have been paid off.
That action by the regulator and insurer codified what’s been called “extend and pretend.” While loans for residential real estate are most often written in terms of 30 years, commercial real estate mortgages are most often written as five or seven-year notes, at the end of which the borrower must refinance.
But the securitization market for commercial real estate loans has effectively seized up. And the economy has slid down. That adds up to an inability of lenders to do anything but portfolio these loans, greatly reducing the number of available mortgagees. It also means that many of these buildings, bought at the height of the economy five years ago, now are underwater on their loan-to-value ratio. Both of those add up to a dramatically difficult market for commercial real estate paper.
It also adds up to a big conundrum for a lender whose borrower has a commercial real estate note coming due. In many cases, there’s just not going to be any way for that borrower to meet a demand to turn over the loan.
In such cases – and there a lot of them – lenders need to make an important assessment: can the borrower continue to make some kind of payment on the mortgage, either as written or modified, or are the borrower’s own business prospects so bad there’s no reasonable accommodation that can be made?
Under the new FDIC guidance, as long as a bank has a reasonable belief that the first scenario is the one it’s facing, the government won’t penalize it for extending or modifying the loan. That means banks won’t have to unduly characterize such loans as non-performing, and won’t take a hit to capital for continuing to carry them on their books.
Of course, that’s what’s got investors in such a twist. They believe that if borrowers are in a jam, it ought to be disclosed. They also believe that the government is letting banks essentially cook the books by allowing them to hide the extent of growing loan problems that are likely going to overwhelm the institution anyway – and take investors down with it.
It’s hard to blame investors for being skittish, and for wanting as much transparency as possible. They’re not keen on the idea of “extend and pretend” that everything’s OK. Yet every loan, from the day it’s made, is a gamble.
If a borrower is making its debt payments – or mostly making them – that’s a better scenario for a bank than being aggressive on enforcing terms and thus forcing an otherwise solvent borrower into foreclosure. As lenders have found with residential real estate, owning scads of foreclosed property is no picnic. In order to forestall a huge run up in bank-owned strip malls and office buildings, it’s prudent to extend a borrower’s term. It may even be prudent to do so with rates and a schedule modified to help the borrower’s balance sheet.
The FDIC’s guidance does not encourage banks to hold on to seriously problematic loans. The bank must have a good-faith belief that its efforts will keep the commercial real estate loan out of the non-performing category.
By doing so, regulators believe they may be able to tamp down a burgeoning fire of commercial real estate defaults. By doing so, they hope to keep banks merely singed by the mounting problem, not charred by it.
The FDIC is taking the right approach, but investors are also right that it needs to be closely monitored. If loans sour, lenders ought to be prompted to take immediate action. But with proper guidance, the economy might yet escape a major body blow that would have lenders, once again, kissing the canvas.
