Should Banks Extend and Pretend?

There was a nice little debate among the Reuters commentary group this morning about an increasingly common way of dealing with dodgy loans: what some are calling “extend and pretend” and others refer to as “delay and pray”. Basically, you just roll over bad-but-performing loans as they come due, rather than take any losses associated with the borrower’s inability to make a big principal repayment. Rolfe Winkler, for one, thinks it’s a very bad idea:

Banks argue that loans should not be marked down if they’re still “performing.” As long as borrowers are meeting their contractual obligations, there’s no reason to take a writedown. The problem is, this gives banks an excuse to extend, amend and pretend. They can make concessions on loan terms or delay foreclosure notices, if only to maintain the fiction that borrowers will make good…

As the Japanese can tell you, this is just a recipe for stagnation. Thanks to a debt bubble that authorities refused to deal with decisively, that country is now entering its third consecutive lost decade.

This is true — especially if, like Rolfe, you think that the collateral underlying these loans is going to continue to decline in value. Very few upside-down loans are worth more than the property they’re secured against, and if you’ve lent money against a declining asset, then the sooner you can take your losses and move on, the better.

On the other hand, the person you’re selling that collateral to doesn’t think it’s going to fall in value. And really what we’re faced with here is a distribution of possible future states.

The calculation which needs to be done is pretty complex, and involves the future path of three uncertain variables. First there’s the lender’s own cost of funds: at the moment it’s low, but there is a chance it could rise substantially by the time the extended loan matures. Secondly there’s the income stream from the loan: while most of these loans are performing right now, and making their interest payments on time, there’s a significant chance of future default on many of them. And thirdly there’s the future course of property prices, or other assets securing the loans.

The last two, of course, are highly (but not perfectly) correlated: if the value of collateral declines, then the chances of the borrower defaulting on the loan increase. But in an efficient world, every lender, on a case-by-case basis, would work out the expected profit or loss from extending the loan, taking into account the amount of volatility we’ve seen in all three variables, and then compare that to the known loss they’d need to take if they just foreclosed tomorrow. If the expected loss from extending is higher than the loss that would need to be taken today, then they extend.

In the real world, however, bankers are human, and they’re liable to fudge the figures so that extending the loan always makes sense: tweak a volatility assumption here, put in a favorable interest-rate assumption there, and it’s not hard to get the answer out that you wanted in the first place. They have a very strong incentive to do this, because much of the time if they take their losses now, they’ll become insolvent: everybody wants to survive, first and foremost.

So that’s where the regulators come in. At the moment, it’s far from clear that they have either the ability or the inclination to force banks to face reality — especially when they’re dealing with big banks. To the contrary, “extend and pretend” has obvious attractions for technocrats, too: it allows them to kick the hard decisions down the road, which is something nearly all politicians love to do. And when it comes to non-bank lenders, the regulators are pretty much out of the picture entirely.

There’s definitely a part of me which is sympathetic to both borrowers and lenders who manage to come to a “one more chance” agreement. There are significant costs to default and foreclosure, and such agreements mean those costs don’t have to be taken — at least not in the immediate future. When hope becomes delusion, then regulators must step in and force write-downs. But the calculations you need to do in order to tell the difference are pretty complex.

Comments

[Andrew Butter:]

It's called foreberance

Aug 21 02:50 PM

[Pat C:]

I spent a little time in the auto finance business and we specifically tracked extensions (along with transfers of equity, etc. etc.) and computed the impact they had on delinquencies in our reporting. In addition, limits of both the # of extensions and duration of extensions were strictly controlled. Moreover, a fee was charged to the customer and fee waiver's were strictly controlled. Regulators don't track this too?

Aug 21 03:25 PM

[Robespierre:]

"very few upside-down loans are worth more than the property they’re secured against, and if you’ve lent money against a declining asset, then the sooner you can take your losses and move on, the better."

The goal here is to kick the can down the road, book fake profits, get outrageous bonuses based on those fake profits and move on to a different job after the can can not be kick down the road any longer. So this is a surprise to the gullible to people who have seen this type of systemic corruption before then not so much. Separate the players from the game and you will soon realize that this is all rigged in favour of the players and damn the game.

Aug 21 03:30 PM

[Pat C:]

Another point, our securitizations specifically limited the extensions that could be granted per loan. If exceeded, the extended loans were purged from the pool and our bond holders reimbursed accordingly. Ironically these limitations were requirements of the very same money center banks that seem to be abusing extensions now.

Aug 21 03:35 PM

[XRTrader:]

People fail to realize something. Previously the chance of default was somewhat (but not entirely) correlated with the relative value of the asset compared to the total loan amount. I do not think that will be the case as we go forward in this housing collapse. Look around you! How many people do you know who are "underwater" in their loans? I'm a young proffessional and the vast majority of the people i know have underwater loans. Many are considered "credit risks" by their mortgage companies (ARMs, etc). Yet, they continue to pay their loans on time....previously, there were isolated events that correlated to declining assett to value ratios...i think this was a proxy for loan defaults (and to a lesser extent a direct causitive factor). Today this is a more universal problem, and i doubt we will see nearly as high a correlation as historically indicated.

Aug 21 03:58 PM

[PainfullyAware:]

Pretend Only Works As Long As Others Play Along.

When The "Upset" Happens Many "Take Their Ball And Go Home".

Things are not so "Fun At The Park" in the aftermath.

The Worst IS Yet To Come.

Aug 21 04:21 PM

[Fighting Yoda:]

Fed has gobbled up 666 B of mortgage securties (as per ysdys Fed report), mor ewould be picked up by PPIP at even inflated prices now with al this green shoot hype. So who knows where we go form here.

Aug 21 07:12 PM

[Old Rick:]

"If the expected loss from extending is higher than the loss that would need to be taken today, then they extend."
----------------------...
In the context of the "efficient (rationale?) world", I didn't quite get the above statement. It seems inverse to me.

Aug 22 08:05 AM

[lower98th:]

New Jersey fraud case from S&L crisis, where loan appraisals were inflated 300%. The proceeds were pocketed and properties promptly abandoned. When decided 8 years later, the defense claimed it was not fraud because by the time of the settlement, the property value had risen to nearly the original appraised price.

Aug 22 08:53 AM

[Living4Divi...:]

I agree with Robespierre, they are kicking the can down the road.


On Aug 21 03:30 PM Robespierre wrote:

> "very few upside-down loans are worth more than the property they’re
> secured against, and if you’ve lent money against a declining asset,
> then the sooner you can take your losses and move on, the better."
>
>
> The goal here is to kick the can down the road, book fake profits,
> get outrageous bonuses based on those fake profits and move on to
> a different job after the can can not be kick down the road any longer.
> So this is a surprise to the gullible to people who have seen this
> type of systemic corruption before then not so much. Separate the
> players from the game and you will soon realize that this is all
> rigged in favour of the players and damn the game.

Aug 22 10:22 AM

[John Lounsbury:]

Felix - - -

Excellent article. I see Andrew Butter left a comment here, but didn't post a link to his article today that is closely related to this one. The link is seekingalpha.com/artic...

I left a comment there that also has application to this article.

Aug 22 12:46 PM

[Graham and ...:]

As my favorite business school professor once said, "It's all a con game, anyway."

Aug 22 12:56 PM

[miminni:]

I have this kind of interest only loan in a rental property I cannot afford to live in. Interest only for 3 more years, then renewable for 5 additional years. I just have to hope that the interest rate is lower in 3 years for lower payments for the next 5 years after that. I got this loan in 2007. I have a $350 negative each month. The hope is to break even on a sale someday and save my credit. Everyone is telling me to turn in the keys or do a short sale. The lucky thing is that I had insisted on a no negative amortization loan so while there has been no principal paydown, the loan is not getting larger.

Aug 22 01:14 PM

[La Marque:]

If a loan is performing, then there is no reason to write it down, extend makes sense. Why rush into default if one sees a light at the end of the tunnel. Part of the credit crunch is that there is little or no market for many of these loans.

The regulators allow this because, simply put, the FDIC cannot bail out the largest banks. They have no reserves - same as SS and Medicare.

Aug 22 01:32 PM

[Dan Schmeidler:]

I wouldn't call any of the balance sheets healthy here, and I certainly would not "bank" on income from loan originations at this point. Some banks are going under, while others are not, and the few surviving entities should emerge as winners and be rewarded with ample capital, regardless of their ailing and deteriorating balance sheets. But as Felix Salmon points out: The regulators are pretty much giving us all the clues as to where all of this is going.

Aug 22 02:14 PM

[Alok Swain:]

Agree!


On Aug 22 08:05 AM Old Rick wrote:

> "If the expected loss from extending is higher than the loss that
> would need to be taken today, then they extend."
> ----------------------...
> In the context of the "efficient (rationale?) world", I didn't quite
> get the above statement. It seems inverse to me.

Aug 22 07:15 PM

[bearfund:]

There's one variable that doesn't need to be considered: the cost of funds in the future. The Fed will ensure that it is as low as needed to make banks profitable, no matter what the cost to anyone else. With cost of funds at zero, all kinds of extremely marginal strategies start to make sense. And with everyone else doing the same thing, you are assured of a bailout if those strategies don't work.

The more things change, the more they stay the same.

One question, though: what happens when a bubble bursts while interest rates are already zero and QE is in place?

Aug 23 09:05 PM

[Credit Geek:]

I am an independent credit analyst who is being called in to look at portfolios and balance sheets of banks. I can tell you from recent, personal experience that regulators are starting to push the banks to revise their initial responses to the reviews conducted by the various regulators (regulators are also now often conducting more than just a single, annual review). Secondly, regulators are under quite a bit of pressure to get things right and not look foolish. However, therein lies a problem, if the regulators really push banks to start reclassifying assets and/or take write downs, earnings and balance sheets will suffer during a period where it is very difficult for (seeming healthy) small and community banks to raise additional capital. I agree with Mr. Salmon's premise that banks are really just doing the minimum, which is extend the loan, get a new appraisal and "hope" (which is word that should never be used in finance) that the borrower continues to make payments. Unfortunately, on commercial real estate, appraisers are still using 6.5% to 7.5% cap rates, which is no longer appropriate (nor ever really was) thus the values are still not adequately adjusted and assists banks in avoiding a substantial write down.

Aug 24 10:27 AM

[PD Quig:]

Rates have nowhere to go but up. You might try a recalculation of your negative cash flow at 6-8% and decide whether you can hang for another two years of dropping prices. I sold my last rental in Nov 2008 (way too late), and there is something to be said for sleeping at night.


On Aug 22 01:14 PM miminni wrote:

> I have this kind of interest only loan in a rental property I cannot
> afford to live in. Interest only for 3 more years, then renewable
> for 5 additional years. I just have to hope that the interest rate
> is lower in 3 years for lower payments for the next 5 years after
> that. I got this loan in 2007. I have a $350 negative each month.
> The hope is to break even on a sale someday and save my credit. Everyone
> is telling me to turn in the keys or do a short sale. The lucky thing
> is that I had insisted on a no negative amortization loan so while
> there has been no principal paydown, the loan is not getting larger.

Aug 24 12:39 PM

[y2kurtus:]

I work for a profitable, stable, well managed community bank. Never taken any bailout money, 5 star financial rating, pretty much as safe as a bank can get.

The issue of "extend and pretend" is a real one for us though. Our internal loan standards are tougher then required by statute and therefore tougher than market average. The problem is when commercial real-estate prices drop by as much as 50% and liquidity is low than there really is no other choice but to extend the loan on terms the borrower and bank can both live with.

The decision is actually simple when the gun is against your head... do you want to play a technical default card and force a liquidation that you know could not possibly result in a loan being paid in full?

Or would you rather keep the payments comming in at 6% knowing that your cost of funds were 2%?

It's not an easy position to be in for a bank... but IT'S A VERY EASY DECISION!!!

As long as cost of funds remain low this game can be played... if funding costs rise the numbers just don't work for the borrower or the bank.

Aug 26 04:45 PM