New York Fed Calls Out Dark Side of Extend-and-Pretend

The whole extend-and-pretend concept has been a fiction of process to help banks and borrowers. Don’t push problems to the point banks must recognize them, write down the associated loans on their balance sheets, and then foreclose or sell the loan at a loss. Cooperate and retain the property (at least for now) without insolvency or bankruptcy. Then, when the Federal Reserve cuts interest rates more, refinancing will be easier and all that wasn’t maybe so well will ultimately end well.

A new analysis from the New York Fed suggests that the attempt to plaster over problems and wait for a favorable rate change isn’t broadly helpful. Instead, the staff argues that the extend-and-pretend process led to increased financial pressure on banks, not decreased.

Matteo Crosignani and Saketh Prazad of the New York Fed’s staff used supervisory data, giving them greater detailed insight than exterior views of banks. Starting in the first quarter of 2022, as the authors put it, banks extended the maturities of impaired CRE loans and then pretended that the results weren’t distressed loans. Pushing the loans out also understated the conditions because these were typically balloon mortgages with interest-only payments and a “sizable loan principal balance” that needed repayment at maturity. Essentially, the shift downplayed the risk as the borrowers weren’t able to continue making those interest payments, let alone be ready for the balloon portion.

As the report says, there was an effect on capital, but not regulatory requirements so much. Instead, marked-to-market losses made it more likely that banks would come under increased regulatory and credit agency monitoring, which would alert investors and make the bank vulnerable to runs by uninsured depositors, as happened in early 2023 with the closures of Silicon Valley Bank, Signature Bank, and First Republic Bank.

“This incentive is particularly pronounced from 2022:Q1 onward as rapidly rising rates created large marked-to-market losses on securities held by banks, eroding their economic capital,” they wrote. However, the mounting potential losses on CRE loans could have similar effects.

In a five-part brief walkthrough of what they found, first banks, especially financially weak ones, were “sluggish” to assess losses from the credit risks. Next, using supervisory data again, they marked a loan as distressed if the property’s current NOI was less than the NOI at origination. They controlled for a number of factors.

Third, they confirmed the extend-and-pretend participation by weakly capitalized banks by looking at the indirect exposure of REIT lending. (The additional risk is a point that researchers at the NYU Stern School of Business; Georgia Institute of Technology – Scheller College of Business; and Frankfurt School of Finance, CEPR made in a paper in May, GlobeSt.com reported on.

Fourth, the NY Fed researchers showed that extend-and-pretend “leads to significant credit misallocation.” Weakly capitalized banks ultimately resulted in reduced CRE mortgage origination by between 4.8% and 5.3%.

Fifth and finally, extend-and-pretend grows the maturity wall problem because the move stockpiles debt into the future. By the third quarter of 2024, CRE mortgages that have maturity dates within three years now make 27% of marked-to-market bank capital, versus 11% in the fourth quarter of 2020. CRE mortgages with maturities within five years are 40% of bank marked-to-market capital.