The Federal Reserve Bank of New York released a paper last week analyzing the effects of “extend-and-pretend” mortgage modifications on the broader financial system.
Since the first quarter of 2022, banks have extended the maturity of impaired commercial real estate mortgages and pretended that such credit facilities were not as distressed to avoid writing off their capital.
The paper warns that the strategy only creates additional pressure on banks. The misallocation of capital has crowded out the origination of new loans, leading to a 4.8% to 5.3% drop in commercial real estate (CRE) loan originations since the first quarter of 2022. The maturity extensions have also fueled the numbers of CRE mortgages set to mature in the near future—creating a risk of a large number of losses materializing in a short period of time. Data from S&P shows that such “maturity wall” will grow to nearly $1 trillion in 2025.
The paper does not recommend any specific action at this time. It notes that further research is warranted on the subject and concludes that “the materialization of this financial fragility depends on whether banks will be able to deal with rising defaults in an orderly fashion or whether widespread defaults will lead to sudden and extensive losses.”
In the interim, we recommend that lenders take precautionary measures when extending or modifying underperforming loans. Lenders should closely monitor the appraised values of the collateral to ensure they remain adequately collateralized. Increased reporting requirements, adjusted covenant tests, and mandatory amortization payments are a few measures lenders can take when extending or modifying a mortgage to help prepare for future defaults and reduce the risk of a “maturity wall.” Extensions should be kept as short as possible, but lenders can consider offering future extensions if the collateral coverage is adequate and the pricing is adjusted to market.
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