Japan's economy was paralyzed for a decade as banks failed to deal with their troubled loans. That's why it's nothing short of stunning to discover some U.S. banks are doing the same thing now.
Despite all the tough talk out of Washington and Wall Street about how the U.S. can't repeat what happened in Japan, the reality is that banks are granting extensions to borrowers in one key category, commercial real-estate loans, so they don't default. It's a bet that economic conditions will improve before the loans come due.
"They are kicking the can down the road, hoping things will be better soon," said Barry Ritholtz, head of the financial research firm FusionIQ and author of the new book "Bailout Nation."
This maneuvering is being called "extend and pretend" in financial circles, reflecting banks' willingness to extend loan maturities because they believe -- or hope-- rental rates and building values could come back to levels seen during the peak of the real-estate market in 2007.
Ritholtz and other financial experts worry that banks are just delaying the inevitable by not dealing with troubled loans now. And since commercial loans are such an important part of the portfolio of many small and midsized banks, it also could constrain their ability to make other new loans. An average of 20 percent of local and regional banks' loan exposure is in commercial real estate vs 4 percent for the nation's biggest banks, according to data from Deutsche Bank.
"This is a bad strategy," said Bryan Marsal, CEO of the corporate restructuring firm Alvarez & Marsal. "It is really about not facing up to where you are today."
Unlike fixed-rate home mortgages, most commercial property loans are structured as balloon notes. Borrowers pay only interest for the first five or 10 years until the loans mature, and then the entire amount must be paid back.
In the boom years, rising rents and property values made it easy for borrowers to find multiple lenders willing to roll over these loans into new and often larger principal amounts that allowed owners to take out millions of dollars in cash to buy other properties.
That game has come to a crashing halt. Cash flows are down on many properties as rental and occupancy rates have fallen, causing the value of many properties to drop significantly. That's made it tougher for owners to refinance their loans.
Delinquency rates on commercial loans have doubled in the past year to 7 percent as more companies downsize and retailers close their doors, according to the Federal Reserve.
In some cases, banks are offering a temporary fix by granting borrowers an extension on loan maturities. On paper, that looks like a plus for the bank because the borrower pays a fee or agrees to pay a higher interest rate, or both. This allows banks to avoid having to foreclose or write down these loans as impaired assets. They also can keep the loans on their books as if nothing were amiss.
"This lets the banks post results that are misleading because the loans have more risk to them than they are disclosing," said Len Blum, managing partner at the investment-bank Westwood Capital. "They can pretend things are better than they are."
That's just what banks in Japan did back in the 1990s. After its debt-fed real estate bubble burst, Japan slid into what has come to be known the "lost decade" because of its drawn out economic and financial malaise.
Even though the Japanese government injected trillions of yen into its banking system, new lending was constrained because troubled loans clogged banks' balance sheets. In some cases, banks refused to foreclose when owners couldn't even pay the interest. Instead, they added the unpaid interest to the loan's principal in the hope that borrowers' problems would be alleviated by an improving economic climate, which never materialized.
What's worrisome is the lack of transparency about how often this is happening now in the United States. Due to privacy issues, banks aren't required to disclose details of specific loan extensions, and most news that does trickle out comes from public companies announcing that they have reached accommodations with their lenders.
Just this week, Bluegreen Corp., a Boca Raton, Fla.-based timeshare resort developer, said it had gotten the maturity dates of a combined $130.1 million in liabilities extended. Others getting loan extensions in recent months were Toys R Us, Tanger Factory Outlets and Washington Real Estate Investment Trust.
The Federal Deposit Insurance Corp. believes that extending the maturity on commercial real-estate loans can be a "value-maximizing and prudent approach," said FDIC spokesman Andrew Gray.
Gray said that its examiners are trying to make sure the loan extensions are being done prudently, and that credit losses are being recognized appropriately. The FDIC directly examines and supervises about 5,160 banks and savings banks.
Bob Seiwert, who heads the Center for Commercial Lending and Business Banking at the American Bankers Association, said loan extensions should be done on a case-by-case basis and aren't necessarily a bad thing. Banks need to assess the chances of the principal amount being repaid and evaluate the viability on the loan on an ongoing basis, he said.
"It may still be a good project," Seiwert said. "It just may need more time."
There are already clear signs that worries about the commercial real estate market have constrained lending. The latest Federal Reserve Senior Loan Officer Opinion Survey, from April, showed almost two-thirds of domestic banks had reported tightening lending standards and terms on commercial real estate loans over the previous three months.
"When lenders do the 'extend and pretend' routine because they don't want to deal with the problem ... what that causes them to do is to restrict their future lending. They pull back into their shell," said Marsal, who is also leading the liquidation of Lehman Brothers. "When and if we do have an economic recovery, what it will do is slow the pace."
Now imagine if the loans that are being extended turn up rotten a year or two from now. That could further hamper lending at local banks -- the backbone of many small-town economies -- meaning companies wouldn't be able to get loans to build new facilities or do renovations or repairs. Hiring would be curbed or more jobs cut, slowing consumer spending.
"The banks seem to think it is OK to hide their head in the sand and keep these kinds of loans on their balance sheets," said Westwood Capital's Blum. "Until the banks really clean up their books, we risk repeating what happened in Japan."
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