Bad Bank Policy

I never thought that financial authorities could let another Great Depression happen. I thought they were better educated, had better tools, and were more aggressive about intervening early to prevent what history taught could happen. Then the 2008 financial crisis hit and I learned a sad lesson: those in power don't "get it".

Here is a side story to that: those in power haven't learned the lessons of the Japanese "lost decade". From an AP story in the Augusta Chronicle:

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, the head of the financial research firm FusionIQ and author of the 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.

Mr. 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 midsize 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 Brian Marsal, the 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, then the entire amount must be paid back.

In the boom years, rising rents and property values made it easy for borrowers to find 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 their value 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.

This is tragic. Those in power know the facts, say they wall fall into the trap, then put their neck in the bear trap and use their hand to spring the trap closed. Stupid!