CFO Best Practices

Some banks have a special technique for dealing with business borrowers who can't repay loans coming due: Give them more time, hoping things improve and they can repay later.

Banks call it a wise strategy. Skeptics call it "extend and pretend."

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Extend
Darryl James for The Wall Street Journal

A Portland, Ore., bank has extended the original 2007 loans taken out to purchase this lot. The planned residential community remains undeveloped.
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Extend

Banks are applying it, in particular, to commercial real-estate lending, where, during the boom, optimistic borrowers got in over their heads to the tune of tens of billions of dollars.

A big push by banks in recent months to modify such loans—by stretching out maturities or allowing below-market interest rates—has slowed a spike in defaults. It also has helped preserve banks' capital, by keeping some dicey loans classified as "performing" and thus minimizing the amount of cash banks must set aside in reserves for future losses.

Restructurings of nonresidential loans stood at $23.9 billion at the end of the first quarter, more than three times the level a year earlier and seven times the level two years earlier. While not all were for commercial real estate, the total makes clear that large numbers of commercial-property borrowers got some leeway.

But the practice is creating uncertainties about the health of both the commercial-property market and some banks. The concern is that rampant modification of souring loans masks the true scope of the commercial property market weakness, as well as the damage ultimately in store for bank balance sheets.

In Atlanta, Georgian Bank lent $13.5 million to a company in late 2007, some of it to buy land for a 53-story luxury Mandarin Oriental hotel and condo development. The loan came due in November 2008, but the bank extended its maturity date by a year. The bank extended it again to May 2010, with an option for a further extension to November 2010, according to court documents.

Georgia's banking regulator shut down the bank last September. A subsequent U.S. regulatory review cited "lax" loan underwriting and "an aggressive growth strategy…that coincided with declining economic conditions in the Atlanta metropolitan area." Some of Georgian Bank's assets were assumed by First Citizens Bank and Trust Co. of Columbia, S.C., which began foreclosure proceedings on the still-unbuilt luxury development. The borrowers contested the move, and settlement talks are in progress.
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Also in Atlanta, Bank of America Corp. has extended a loan twice for a high-end shopping and residential project. Three years after a developer launched the Streets of Buckhead project as a European-style shopping district, all there is to show for it is a covey of silent cranes and a fence. The developer, Ben Carter, says he is in final negotiations for an investor to come in and inject $200 million into the languishing development.

Regulators helped spur banks' recent approach to commercial real estate by crafting new guidelines last October. They gave banks a variety of ways to restructure loans. And they allowed banks to record loans still operating under the original terms as "performing" even if the value of the underlying property had fallen below the loan amount—which is an ominous sign for ultimate repayment. Although regulators say banks shouldn't take the guidelines as a signal to cut borrowers more slack, it appears some did.

Banks hold some $176 billion of souring commercial-real-estate loans, according to an estimate by research firm Foresight Analytics. About two-thirds of bank commercial real-estate loans maturing between now and 2014 are underwater, meaning the property is worth less than the loan on it, Foresight data show. U.S. commercial-real-estate values remain 42% below their October 2007 peak and only slightly above the low they hit in October 2009, according to Moody's Investors Service.

In the first quarter, 9.1% of commercial-property loans held by banks were delinquent, compared with 7% a year earlier and just 1.5% in the first quarter of 2007, according to Foresight.

Holding off on foreclosing is often good business, says Mark Tenhundfeld, senior vice president at the American Bankers Association. "It can be better for a bank to extend a loan and increase the chance that the bank will be repaid in full rather than call the loan due now and dump more property on an already-depressed market," he says.

But continuing to extend loans and otherwise modify them, rather than foreclosing, amounts to a bet that the economy will rebound enough to enable clients to find new demand for the plethora of offices, hotels, condos and other property on which they borrowed. If it doesn't work out this way, the banks will end up having to write off the loans anyway.

At that point, if they haven't been setting aside sufficient cash all along for potential losses on such loans, the banks will face a hit to their earnings.

Banks' reluctance to bite the bullet on some deteriorating commercial real estate can have economic repercussions. The readiness to stretch out loans puts a floor under commercial real estate and keeps it from hitting bottom, which may be a precondition for a robust revival.
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More broadly, the failure to get the loans off banks' books tends to deter new lending to others. It's a pattern somewhat reminiscent, although on a lesser scale, of the way Japanese banks' failure to write off souring loans in the 1990s contributed to years of stagnation.

It's a Catch-22 for banks. As long as some of their capital is tied up in real-estate loans that are struggling—and as the banks see a pipeline of still-more sour real-estate debt that will mature soon—their lending is likely to remain constricted. But to wipe the slate clean by writing off many more loans would mean an even bigger hit to their capital.

"It does not take much of a write-down to wipe out capital," says Christopher Marinac, managing principal at FIG Partners LLC, a bank research and investment firm.

Federal bank regulators tackled the issues in October with a 33-page set of guidelines. Bank regulators have said they were concerned about commercial-property losses and debts coming due on commercial property.

Another problem they sought to resolve was that banks and their examiners weren't always on the same page. In some cases banks weren't recognizing loan problems, while in other cases, tough bank examiners were forcing banks to downgrade loans the bankers believed were still good.

The guidance was intended "to promote both prudent commercial real-estate loan workouts by banks and balanced and consistent reviews of these loans by the supervisory agencies," said Elizabeth Duke, a Federal Reserve governor, in a March speech. The guidelines came from the Federal Financial Institutions Examination Council, which includes the Fed, the Federal Deposit Insurance Corp. and the Comptroller of the Currency.

Although one goal was greater consistency in the treatment of commercial real-estate loans, in practice, the guidelines appear to have fed confusion in the markets about how banks are dealing with commercial real-estate debt. "I just don't believe that the standard is being applied consistently across the industry," says Edward Wehmer, chief executive of Wintrust Financial Corp. in Lake Forest, Ill.

In a May conference call with 1,400 bank executives, regulators sought to clear up confusion. "We don't want banks to pretend and extend," Sabeth Siddique, Federal Reserve assistant director of credit risk, said on the call. "We did hear from investors and some bankers interpreting this guidance as a form of forbearance, and let me assure you it's not."

Restructurings increased at some banks, like BB&T Corp. of Winston-Salem, N.C. Its total of one type of restructured commercial loan hit $969 million in recent months, the bank reported in April. That was a huge jump from six months earlier, when the figure was just $68 million.

The increase was "basically a function of implementing the new regulatory guidance," the bank's finance chief, Daryl Bible, told investors in May. "We are working with our customers trying to keep them in the loans."

BB&T's report showed a significant number of cases where it was extending loan maturities and allowing interest rates not widely available in the market for loans of similar risk.

Banks don't have to disclose how terms on their loans have changed, making it hard to know whether they are setting aside enough cash for possible losses.

In a large proportion of cases, modifying the terms of loans ultimately isn't enough to save them. At the end of the first quarter, 44.5% of debt restructurings were 30 days or more delinquent or weren't accruing interest, up from 28% the first quarter of 2008.

A case in Portland, Ore., shows how banks can keep treating a commercial loan as current, despite the difficulties of the underlying project.

A client called Touchmark Living Centers Inc. in 2007 borrowed $15.9 million, in two loans, to buy land for a development. The borrower planned to retire the loans at the end of the year by obtaining construction financing to build the Touchmark Heights community for empty-nesters.

Because the raw land produced no income, the lender, Umpqua Bank, had provided "interest reserves" with which the developer could cover interest payments while obtaining permits and preparing to build. The bank extended Touchmark a $350,000 interest reserve—in effect increasing what Touchmark owed by that amount.

In December 2007, the U.S. economy slipped into recession. When the loans came due that month, Touchmark didn't pay them off. Umpqua extended the maturity to May 31, 2008.

The bank also added $600,000 to the interest reserves. Though supplying interest reserves is common at the outset of a loan, when an unbuilt project can't produce any income with which to pay debt service, replenishing interest reserves is frowned on by regulators.

Asked to comment, a spokeswoman for the bank said, "Umpqua and Touchmark had determined that the project was still viable but not yet ready for development." Touchmark said it didn't pursue construction financing at that time because "it was not prudent to proceed with developing the property until the economy improves," as a spokeswoman put it.

In 2008 the bank extended the loans again, to April 2009. During this time, Touchmark began paying interest on the loans out of its own pocket.

Then in May 2009, Umpqua restructured the loans, lumping what was owed into one $15 million loan that required regular payments on both interest and principal. Touchmark paid down the principal a little and Umpqua set a new maturity date—May 5, 2012.