Commercial property loans in the U.S. are becoming increasingly precarious, with more borrowers at risk of defaulting for a second time. If this happens at the scale many analysts are expected, default levels would rise to rates we have not seen in a decade. This situation has led to growing concerns about a banking practice known as “extend and pretend.” Essentially, this approach allows banks to modify loans in a way that delays the inevitable write-off of bad debts, but it does little to address the core issues borrowers are facing, particularly in a high-interest-rate environment.
What’s happening? Lenders are attempting to resolve the problems with these loans without allowing them to default, but if interest rates remain elevated, many borrowers simply won’t be able to keep up with their payments despite the way these loans are being restructured to presumably help borrowers. Regulators are increasingly taking notice and getting wary, fearing that the ways these loans are changing may be distorting the loan markets rather than stabilizing them.
A recent paper from the New York Fed has added weight to these concerns, suggesting that many lenders are modifying loans not to help borrowers genuinely recover, but rather to postpone the inevitable financial reckoning. The study highlights that banks have engaged in “extend-and-pretend” practices with impaired commercial real estate mortgages since the pandemic, warning that these generous modifications could lead to misallocation of credit and a buildup of financial fragility.
The data is unnerving. By the end of September, the value of commercial real estate re-defaults surged by 90 percent over the past year, reaching $5.5 billion. This increase includes a staggering $1 billion rise in just the last quarter, marking the highest level of modified, non-performing commercial real estate loans since 2014. These loans are typically those where borrowers, already under financial stress, received some form of relief—be it a lower mortgage rate or a payment forgiveness—only to find themselves delinquent again.
In contrast to a decade ago, when delinquent mortgages were on the decline from the financial crisis, today’s delinquencies are concentrated in commercial properties. Office buildings, in particular, have suffered from reduced tenant occupancy since the pandemic, but malls and apartment buildings are also feeling the pinch. Although the total value of rising defaults remains relatively small compared to the nearly $2 trillion banks have lent in commercial property, the increase in delinquent loans to developers and investors has jumped by 25%, totaling $26 billion in the first nine months of this year.
Interestingly, while loan modifications have allowed banks to report a slowdown in new delinquencies, the reality is more worrisome. A Moody’s review found that the payment breaks offered by banks are often minimal, typically less than 2% off total payments. Instead of genuine relief, borrowers are frequently given extensions on missed payments, which may only serve to delay the inevitable.
Currently, about one-third of the modifications made in the past year have resulted in a second default for borrowers. Given the limited relief and the fact that many modifications are still fresh, Cilik anticipates that re-defaults—and consequently losses for banks—will continue to rise. He warns that we are only at the beginning of this curve, and if delinquencies keep climbing, it will become clear that these modifications are not working as intended.
As the situation unfolds, the implications for the banking sector and the broader economy could be significant. If banks continue to rely on temporary fixes rather than addressing the underlying issues, we may be setting ourselves up for a more serious financial crisis down the line.
