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by Pam Martens and Russ Martens, Wall St On Parade:
The New York Fed, long the quintessential keeper of secrets for the Wall Street megabanks that it has been bailing out since the financial crisis of 2008, has suddenly decided to come clean on a big threat to capital at these and other banks.
The New York Fed has created gasps in the corridors of power in the banking world by releasing a paper that documents how banks have ginned up their capital by “extending and pretending” on their underwater commercial real estate (CRE) loans.
The new paper was written by Matteo Crosignani, Financial Research Advisor at the New York Fed, and Saketh Prazad, a former Research Analyst at the New York Fed who is now a Doctoral Student in the Business Economics program at the Harvard Business School.
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The authors get right to the crux of the matter on page two of the report, writing this:
“In this paper, using detailed supervisory data, we document that banks have ‘extended-and-pretended’ their distressed CRE mortgages in the post-pandemic period to delay the recognition of losses. Banks with weaker marked-to-market capital—largely due to losses in their securities portfolio since 2022:Q1—have extended the maturity of their impaired CRE mortgages coming due and pretended that such credit provision was not as distressed to avoid further depleting their capital. The resulting limited number of loan defaults hindered the reallocation of capital, crowding out the origination of both CRE mortgages and loans to firms. The maturity extensions granted by banks also fueled the volume of CRE mortgages set to mature in the near term—a ‘maturity wall’ with the associated risk of large losses materializing in a short period of time.”
One of the scariest potential outcomes referenced by the authors is their so-called “maturity wall” when the debt bombs come due and losses pile up suddenly. The authors write this:
“…we document that banks’ extend-and-pretend has led to an ever-expanding ‘maturity wall’, namely a rapidly increasing volume of CRE loans set to mature in the near term. As of 2023:Q4, CRE mortgages coming due within three years represent 27% of bank marked-to-market capital, up 11 percentage points from 2020:Q4—and CRE mortgages coming due within five years represent 40% of bank marked-to-market capital. We show (i) that weakly capitalized banks drive this expansion, consistent with their extend-and-pretend behavior, and (ii) that the maturity wall represents a sizable 16% of the aggregate CRE debt held by the banking sector as of 2023:Q4.
“Taken together, our results highlight the costs of banks’ extend-and-pretend behavior. In the short term, the resulting credit misallocation might slow down the capital reallocation needed to sustain the transition of real estate markets to the post-pandemic equilibrium—for example supporting the conversion of office space into residential units and recreational spaces in large urban areas. In the medium term, the delayed recognition of losses exposes banks (and all other holders of CRE debt) to sudden large losses which can be exacerbated by fire sales dynamics and bankruptcy courts congestion.”
The authors refer to this extend-and-pretend behavior as another “manifestation of zombie lending, namely the provision of subsidized credit to impaired borrowers.”
The phrase, “zombie lending” reminded us of a scene from the movie, The Big Short, based on the Michael Lewis book by the same name on the 2008 financial collapse. This is the scene where actor Steve Carell, playing the character Mark Baum, is sitting in the audience at the American Securitization Forum and interrupts the speaker on stage who has just stated that he expects subprime losses “will be contained at 5 percent.” Baum stands up and boisterously asks: “Would you say that it is a possibility or a probability that subprime losses stop at 5 percent?” The speaker says: “I would say that it is a very strong probability, indeed.” Baum sits back down in his seat in the audience but then begins to waive his arm in the air, forming a zero with his fingers. Baum then shouts out: “Zero! Zero! There is a zero percent chance that your subprime losses will stop at 5 percent.” (You can watch the scene in the video below.)
The character in the movie, Mark Baum, was based on a real Wall Street person, Steve Eisman. For the hubris of that story involving the Fed, see our report: Steve Eisman and FrontPoint Were Shorting Wall Street Banks While the Dumb Fed Was Giving FrontPoint Emergency Loans – and that’s not the Worst Part of this Story.
The authors of this extend-and-pretend study, Crosignani and Prazad, are effectively doing what the Baum character in that scene from The Big Short did. They are yelling out in a public forum that this banking era of extend-and-pretend is unlikely to end well.
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Originally Posted at https://www.sgtreport.com
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