A maturity wall in having a loan mature is a normal credit enhancement, credit risk management tool that bankers do. They touch a file multiple times a year. They and it required at least annually to look at it. It gives a good way to look at repricing. Look at your debt service coverage. Look at your net operating income or get the borrower's net operating income to look forward looking how it's going to perform in the future.
From the American Bankers Association, this is the ABA Banking Journal podcast. Welcome back. I'm Evan Sparks. Today's episode is presented by R&T Deposit Solutions, and I'm here with two of my colleagues who are experts on commercial real estate finance and and the economics around commercial real estate finance. We have Sharon Whitaker, who is a VP for CRE finance policy here at ABA. Hi, Sharon.
Hello.
And we also have Jeff Huther, who is a VP for Banking and Economic Policy Research in our Office of the Chief Economist. Jeff good to see you.
Good to see you as well. Thank you.
So I, I wanted to bring y'all here together today. You and, and one, one other ABA colleague recently wrote an ABA data bank Essay on critiquing a paper from the New York Fed called, "Extend and Pretend in the U. S. CRE Market." And this is up on our website at ABA. com slash banking journal.
The, the, the the response to this paper and so I'd love it if maybe Jeff, if you could kind of give us a quick summary of what the New York Fed put out or the New York Fed researchers have published and then why and then, and then we'll get into some of the details about why we disagree, why you disagree with this assessment and what things actually look like in the CRE sector today.
Well, briefly, the authors argue that banks are engaged in taking troubled loans and, and the process of extending their maturities lease. Okay. and pretending that they're good loans when in fact they're likely to default. And these loans, and they're focused on the commercial real estate sector. And then they identify consequences of this practice. By saying it increases financial fragility and it crowds out provision of credit by, by affected banks.
And that it's leading to a maturity wall, which could lead to a disastrous outcome.
Yeah. So Sharon, I'd love it if you could kind of talk through a little bit, what is this whole concept of "extend and pretend" and how does this, you know how does this work in the, in the, in the banking se sec, in the banking sector for any, for folks who are not f as familiar with commercial real estate finance?
Sure enough. And, and I'm gonna just let you know, my pet peeve to start with the phrase extend and pretend is to me offensive as a former banker and, and those of our members that are, that are in the industry. I mean, it is an accounting standard that you really have to assess each of your credits.
And take a look at whether or not it's impaired or not impaired and where the valuation and manage each credit to imply that you're extending and pretending that the loan is going to perform actually is it goes against all accounting principles that banks are required to follow. So, with that said, I think Extend and Defend is a great title for those creative folks that came up with it really to describe what's happening.
A maturity wall in having a loan mature is a normal credit enhancement, credit risk management tool that bankers do. They touch a file multiple times a year. They and it required at least annually to look at it. It gives a good way to look at repricing. Look at your debt service coverage. Look at your net operating income or get the borrower's net operating income to look forward looking how it's going to perform in the future.
So those maturity walls which are a really large discussion here, really are a normal management tool for banks and it's not unusual to do so. Jeff, I'm gonna pause to see if you have anything to add to that. I don't wanna go too deep in the weeds, but I don't wanna give a gi good, broad aspect.
No, I think that's a nice start.
We've seen this in some of the other areas, you know, with the CFPB using the term "junk fees" where, you're setting the table for a discussion with the terms you choose to use. And so so obviously we're using this term to in this, for the purposes of this conversation, because we're discussing this paper. But, you know, Jeff, I'd love it if you could kind of walk us through some of the data that you saw, you know, the, the analysis in the paper, you know, what was.
You, we talked, you talked in the article about some of the definitional weaknesses about these, you know, the weaknesses and the, how do we characterize it, in which Sharon already talked a little bit about, with this concept of extend to pretend. What are some of the other weaknesses that you see in the in this paper, and why did ABA office of the Chief Economist think it was important to respond to it?
Okay. Well, maybe starting at the back and, you know, we felt as though it was important to respond because it, this, the paper had gained some, some attraction in the press and you know, not, and, you know, largely based on the, the title being kind of a sexy topic. Well, maybe there's a problem here that is going to bring down the financial system again because banks are hiding weaknesses.
Yeah. And that, that whole story is built on the, the author's use of data that we can't see that this is data that banks have to provide to regulators and is and as a result, we can't tell exactly what they did, but what we see from how they describe the, the approach Is one that suggests there's some pretty substantial weaknesses in both the idea that there are vulnerabilities here and that banks are doing something nefarious in some way. The authors have loan level data on 22 large banks.
They identify the banks, but, you know, we don't have any information on the loans. And say that, well, 7 percent of these loans are commercial real estate, which is consistent with kind of the national data, but we find, you know, and separately we found, you know, just a small portion of So, yeah. Commercial real estate loans are to the, the, the sectors that we would think of as vulnerable at this point, the office sector in particular.
So you take 7 percent and then you'd take a much smaller portion of that. And you'd say, well, okay, that there's some, some number out there for these office towers in the major cities that are exposed. And the authors don't even go that into that kind of depth they're, they're kind of focusing on this broader 7 percent number and saying, well, that's, that's a sign of vulnerability across the industry. And then the, the authors use pricing from real estate investment trusts.
As a basis for the shocks that they're going to say, Okay, there's how, how badly hit as the commercial real estate sector been affected. And, you know, the one of the obvious problem with that is that real estate pricing while. The real estate that investment trust pricing is readily available and presumably reflects the underlying exposures of the these trusts to the real estate they've invested in. They're levered. And that magnifies the effects.
So if you saw investment trust that had fallen 20 percent in value say, but it's, it's levered to to that it borrowed half of that, it would imply that investors have seen exposures of the underlying investment fall only by 10 percent rather than the 20 percent that the value of that trust falls by as a result, it overstates as a starting point. The, the potential losses for those for those investments.
And then there's no clear relationship between those investments and what the banks have invested in, you know and banks in having even in the office sector, I have been strong investors in things that are unrelated to central business district office buildings that have been seeing prices fall. Just as a starting point, there's, there's some room there for, for saying guys, you may be overstating the problem.
Secondly, the authors developed a couple of metrics that are questionable as, as ways to define financial vulnerability. Their first measure is something called distress and They define that as any deterioration and all at all in that operating income and it, you know, net operating income from the day one when the loan is originated to where we are now or when the authors finish their data at the end of 2023.
You know, that can be an increase in taxes, obviously rates have gone up interest rates have gone up, you know, your, your cleaning fees for a building could go up it's not clear that that would necessarily signal that there's distress. So it, it it's, it's probably an overblown kind of descriptor of, of what the authors are measuring.
You know, I, obviously it'd be nice from a lender's point of view if net operating income continued to increase as the loan aged, but it's not necessarily a sign of distress as the authors call it. And then their second measure of financial vulnerability here is what they're calling undercapitalization, where they take the bank's capital, and then they bring in unrealized losses from securities portfolio that have obviously been well undercapitalized.
Publicized in the in, in, in the press and elsewhere and because of the, the, the sharp rise in interest rates that happened in 2022 this, and then, you know, so bank, this 20 list of 22 banks that the, the authors look at, they say, okay, the, the, the top 11 banks in terms of capital requirements, we're going to call well capitalized and the bottom 12 or 11 we're going to call undercapitalized. So again, we've got some overblown language here of what's well capitalized versus undercapitalized.
They're just drawing a line in the middle and saying, well, you guys are undercapitalized and then associating the commercial real estate findings to this, this metric. And that's where they get into this. Oh, well, bank, these, these vulnerable banks, these undercapitalized or distressed banks are the ones that are extending loans. So that's, that's the basic structure of the data. I'm sorry. I'm sure that's a lot more detailed than your listeners want to hear, but that's
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So coming back to this conversation you know, Sharon, I just love it if you could kind of give us a sense of, you know looking at this data, how does it map onto, you know, the way that commercial real estate that, that CRE lending banks are actually managing their exposure to real estate losses and what the actual intersection is between CRE and C&I lending right now in the industry.
So if you don't mind, I'd like to back up to a couple of comments that Jeff made, the assumption that any decrease in net operating income is going to make a loan distressed and likely to default. As Jeff said, it doesn't even consider the fact that it may still be performing above a one to one debt debt service coverage. So they make this broad assumption that any type of decrease, you know, it might've been underwritten at one, three, five.
It might be at one, two, five right now, which is still performing loan that because of that decrease that there's going to be a future loss. The other problem that Jeff kind of mentioned, and I want to enhance a little bit is that these reads that you're looking at you know what they're trading at.
Is not necessarily an assumption of what the underlying value is to the to what's collateralizing it So I see a complete mismatch there But when you look at our community banks and all of the member banks that we have all different sizes Not many of them have these really large exposures to the central business district You know many of them, you know are within their market. They may be different strip malls. They may be You know, whoever is located there.
They really have that boots on the ground management tool that they know where the leases are. They're looking forward 24 months from when a loan might mature as far as an even where the interest rate may go. They're doing Stressing of all of the loans on an individual basis, let alone their entire portfolio. So they're doing a bottom up in a top down stress scenario on all these loans. So they actually have their thumb on the performance of it on a go forward basis.
So I think when you look at Any decrease is going to make this assumption. And then, as Jeff mentioned, to go back to another point, that within their investment portfolio, they're hiding massive losses there. Well, within their investment portfolio, these are not mark to market investments. These are held to maturity. So there's a lot of assumptions in here that really kind of says, Oh my God, the banking Industry is in so much distress that we have so much to worry about. And there's there.
Undercapitalized and therefore, you know, they're really pushing these loans forward. They may be on what I'll call a watch list, which the anyone listened to it knows what it is, and it may not be a classified asset and a bank actually has to measure that risk rating. As I mentioned before, look at impairment. Write it down if necessary. Mark to mark it if there are some really strong underlying.
Many of our banks are going in there and I'm giving you more of an explanation than you ever asked for. But they're also looking at the covenants, securing these. So as they're touching these loans 18 to 24 months in advance of its maturity, they may be adding Covenants. They may be getting cash from a guarantor or, you know, whatever type of structure this loan has to make sure where are these leases? Where are they expiring? Do they have, you know, sub leases coming in?
What is the overall performance of the loan itself? So there's so much more tactile management and really enhanced credit management there. If you don't mind, I'm going to add one more thing.
Please do.
The prudential regulators are telling the banks, they have not pulled back any of their memos, work with your borrowers, make sure they're performing, measure it correctly, but you should be working with your borrowers. And I, I just got that itchy feeling like they were discouraging banks to working with, with borrowers to really, if there's any type of decrease to get them through that, but make sure they're still performing.
Yeah, that's you know, that, that makes a lot of sense. The you know, you're, if regulators aren't, aren't nervous about this, if there's, you know, if you, it, it seems like there's a kind of a, a much ado about nothing. And honestly, a bit of a, an effort to kind of create something, something that's. You know, fabricates some kind of a little bit of drama. That's actually not borne out by the data here.
Yeah. And I think there's a fear, you know, that, that the valuations could, could plummet. Central business district has had their issues, but, you know, I think it's almost a bit of a ringing the bell, scaring a little bit ahead of time before it perhaps could happen.
And it certainly, if we, as we've talked about previously on this show and, and in your, your, your ABA databank pieces, you know, the. Community banks and mid sized banks in particular have very minimal exposure to some of these CBD sectors and you're meanwhile you have a lot of exposure to CRE sectors that are performing extremely well like industrial and data center and hospitality and all kinds of other sectors that you know doing great right now. So this was really helpful.
Any final thoughts before we before we close off the close the discussion?
The commercial real estate weaknesses are not hidden. So it, and they've been around since the both the pandemic and then, you know, with the second hit on interest rates increases in 2022. So, you know, we're now almost two and a half years past that three years past the, the, the last shock to the sector, and people have had a lot of time to kind of think through. How to deal with this and what the implications are for for for credit risk.
So you know, I'd say we're we're we're in a situation where extending and print pretending and it's just not the right right way to describe the condition and mark. All right.
Well, thanks for being on the show with us today. Thanks to R&T Deposit Solutions for sponsoring this episode. You can find the the essay by Jeff and Sharon and our, and our colleague Dan Brown on a at aba. com slash banking journal. Thanks so much for listening. And we'll be back with you again, very soon.