For the past six months or so, Wall Street has been bracing for what many fear may be the next shoe to drop on the already battered U.S. economy: a U.S. commercial real estate bust that could rival the housing market collapse.
Yet, lenders have been keeping that shoe in the closet -- forestalling foreclosures by extending loans, despite rapidly rising mortgage default rates.
In today's environment, it's obviously not very attractive to foreclose on a borrower, said Matthew Anderson, co-founder of real estate consulting services firm Foresight Analytics.
The U.S. commercial real estate sector has been grappling with a credit crisis that has dried up some of its most important sources of lending. That has left many borrowers unable to refinance maturing mortgages. Even when they can obtain financing, borrowers are often obtaining much less than they need.
Lending is based on a percentage of a property's value and prices are off 34.8 percent from their peak in October 2007. Many see the decline reaching 45 percent.
But banks have been loathe to foreclose on the mortgages and are extending them.
They're taking loans that don't have a cash-flow problem, but definitely have a valuation problem, and they're pushing those out to the future, Anderson said.
About 4.5 percent of bank commercial real estate loans were 30 or more days delinquent in the second quarter, up from 3.6 percent in the first quarter, according to Foresight Analytics. Nonaccrual -- or the percentage of the loan balances that banks believe borrowers will fail to repay -- rose to 2.6 percent in the second quarter from 2 percent the prior quarter.
Banks account for about $1.7 trillion, or half, of U.S. commercial mortgages outstanding. The delinquency rates have been increasing since the second quarter 2007, when they were 1.2 percent, according to Foresight.
Yet foreclosed loans as a percentage of nonaccruals has been declining, down to 19.7 percent in the first quarter from over 30 percent three years ago, according to the most recent statistics from Foresight.
The practice of extending loans has become so prevalent, it has earned its own catch phrases -- push-outs, kicking the can down the road and a rolling loan gathers no loss.
THE PERVERSE LESSON
Banks have many reasons not to foreclose.
First, it's an expensive processes. Secondly, banks are not in the business of owning real estate. When they sell a property, they face the same distressed market their borrowers would face, leaving them saddled with more losses.
They also have learned a perverse lesson from past commercial real estate downturns, Anderson said. After they dumped bad loans in the early 1990s, banks watched as buyers of the distressed loans, such as Goldman Sachs Group Inc's Whitehall Funds, made a fortune when the market rebounded.
Banks already are dealing with losses from other sectors, such as home mortgages and credit cards delinquencies. Pushing the commercial real estate problem further into the future may allow banks to be in a stronger position when they finally face the issue.
Rolling it over does not solve the issue, Daniel Penrod, senior industry analyst for the California Credit Union League said. But at this point, adding another negative to the current economy could be disastrous. If this were the only factor in the economy that was struggling, we could let it play out with all the other factors. Allowing it to catch its breath for six or 12 months may help shorten the current recession.
Property values could fall should loan extensions not be long enough to give borrowers confidence that they will retain the properties. A three to nine-month extension could discourage a borrower from paying for needed maintenance and improvements.
The thing I hear most frequently from borrowers is: 'Why would I put capital into it?' said Jere Lucey, managing director at Jones Lang LaSalle Inc (JLL.N: Quote, Profile, Research, Stock Buzz), Real Estate Investment Banking.
But the lending market for loans under $35 million has thawed since the start of the year, said Deutsche Bank research analyst Richard Parkus.
They should not be out there extending loans because there's a financing market, he said. If there's a loan that doesn't qualify, it shouldn't be extended unless it could be reasonably assumed to qualify in two to three years, given an extension.
A new mortgage might not cover the full payment due at maturity. But that shouldn't relieve a borrower from kicking in more equity or obtaining a mezzanine loan to fill the gap.
If a borrower can't get additional financing, it should be foreclosed and liquidated, Parkus said.
Postponing foreclosures may compound a bigger problem of loan maturities ahead. Some $270 billion to $275 billion of loans are set to mature next year. Ultimately, the refinancing of the rolled over loans may soak up the available capital at the expense of new loans.
If it continues, essentially for most of the next decade, we're really just going to be dealing with today's and yesterday's debt, Anderson said.
(Reporting by Ilaina Jonas; editing by Patrick Fitzgibbons and Gerald E. McCormick)