Tackling the Hidden Dangers in Your CRE Book

Are “extend and pretend” practices masking asset quality problems in your bank’s commercial real estate portfolio?

In response to continued high interest rates and declining values for commercial properties, some banks have been modifying terms on impaired CRE mortgages to obscure problems with those loans, according to a recent paper from the Federal Reserve Bank of New York. That practice, dubbed “extend and pretend,” allows banks to delay recognizing losses that would impair capital, say the paper’s authors, Matteo Crosignani and Saketh Prazad. “Extend and pretend” is more common at thinly capitalized banks, and it could result in large losses across the industry when those loans mature.

But there’s a subtle distinction between “extend and pretend” and working with an otherwise solid borrower that happens to be going through a rough patch. By routinely asking some key questions about the CRE book and engaging in regular independent reviews of that portfolio, the board can ensure that the bank is not hiding credit quality problems that could later surface.

To start the conversation, directors can ask about exceptions being made in the CRE portfolio and how those compare with historical trends. If exceptions are increasing, ask what is causing those shifts, says Trang Sumpter, a director focused on risk management at Moss Adams.

An independent analysis of the CRE portfolio can provide an additional layer of assurance and a bird’s-eye view of what’s happening across the industry. “If you hire an independent party to do an evaluation, they can give you some insight as to whether or not they’re starting to see a trend in terms of the rate concessions or providing favorable terms for borrowers who wouldn’t necessarily qualify for these loans,” she says.

Certain types of commercial real estate have come under closer scrutiny recently. The widespread emergence of remote work and sluggish return-to-office rates have stressed the office sector in particular. As fewer office tenants renew their leases, some fear that occupancy rates and property values could decline, and borrowers could struggle to meet their debt obligations.

Regulators have long encouraged banks to work with troubled borrowers before writing them off, but problems can arise when bankers don’t update their risk ratings for those credits.

When working with borrowers, bankers need to appropriately evaluate those credits for the risk of loss and include that information in the bank’s current expected credit loss calculations. Those credits need to be properly identified and the allowance for loan losses adequately supported. “If they’re really modifying and extending those riskier loans and leaving them as pass-rated credits, that’s when the issues are going to be hitting,” says Andrew Billeter, a principal in the assurance group at Wolf & Co.

Additionally, directors could review past safety and soundness exams to look for potential issues examiners would likely raise during the next exam, says Gene Shugrue, a senior manager in the audit group at Wolf & Co.

“If the directors and management teams have been paying attention, they should have mostly what they need to know,” Shugrue says. “Go back and see if there’s anything they missed so they feel comfortable where they are, and if they come into a safety and soundness exam, they know how to respond to any queries from the regulatory community.”

The New York Fed researchers suggested in the paper that “extend and pretend” could be crowding out new commercial loan originations. Wolf’s Billeter expresses skepticism about this because credit demand has been sluggish in recent years anyway.

But the paper’s authors also say that “extend and pretend” could be creating a “maturity wall” — a large volume of commercial real estate loans, many of them potentially weaker, that are set to mature in the near term. That wall represented 27% of bank capital as of the fourth quarter 2023, according to the paper, setting the industry up for a wave of losses.

In addition to requesting an independent analysis and historical trends in loan exceptions, directors may want to ask how the bank’s CRE portfolio holds up under a stress test. Directors should consider this as part of the board’s broader duty to provide a credible challenge to management and protect shareholder value, Sumpter says.

“A lot of times, what happens is you have a board that is too comfortable with management, and then they don’t provide that credible challenge. Or, you have board members that may not necessarily understand how banking works, so they may or may not ask those questions,” she adds. “A strong board really needs to ask those questions.”