Extend and Pretend is Now Policy

It’s eerie how much official government policy is beginning to mirror those that were tried with no success during the commercial real estate debacle of the 1980s and early 1990s.

Lindling Wei has a nice short article in the WSJ that details federal approval of “extend and pretend” as an accepted alternative for banks to deal with problem commercial real estate assets. From his article:

The new guidelines are targeted primarily at the hundreds of billions of dollars worth of loans that are coming due that can’t be refinanced largely because the value of the properties have fallen below the loan amount. In many of these situations, the properties are still generating enough income to pay debt service.

Banks have generally been keeping a lid on commercial real-estate losses by extending these mortgages upon maturity. However, that practice, billed by many industry observers as “extending and pretending,” has come under criticism by some analysts and investors as it promises to put off the pains into the future.

Now federal regulators are essentially sanctioning the practice as long as banks restructure loans prudently. The federal guidelines note that banks that conduct “prudent” loan workouts after looking at the borrower’s financial condition “will not be subject to criticism (by regulators) for engaging in these efforts.” In addition, loans to creditworthy borrowers that have been restructured and are current won’t be reclassified as “high risk” by regulators solely because the collateral backing them has declined to an amount less than the loan balance, the new guidelines state.

So policy is now to make new loans on commercial real estate that exceed the value of the collateral. No need to worry as the world will right itself and all that excess commercial real estate space is going to be absorbed magically. Just a year or two and we’ll be back to the roaring market that got us into this mess.

The problems here are manifest. For one thing by keeping alive zombie properties you tend to suck those that are hanging on by their fingernails into the whirlpool. Give the guy that owes you a lot of money a sweetheart extension to keep him afloat and he undercuts the rent of the office building down the street. It becomes “beggar thy neighbor” on Main Street.

That will work for awhile but those old leases that are generating cash flow in spite of current market rents are going to expire sooner rather than later and that cash flow is going to vaporize.

Commercial appraisals are different than residential ones. They value a company based on current rental rates and expenses. When one comes in below the value of a given property you can bet your bottom dollar that whatever the current income on that property might be, it is going to decline absent some rather substantial change in the underlying economics of the local commercial real estate market.

The Feds know that they have a disaster that’s roaring down the tracks and this is nothing more than a desperate attempt to kick the can down the road. We’ve seen it before and we and they know full well it won’t work. The hope, of course, is that it gets them through the 2010 elections. It might but it will only increase the eventual cost.

When it all hits the fan remember that you and everyone else knew it was going to happen. Sadly, you get stuck with the bill for a bigger cleanup than probably would have been necessary.

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