The New York Fed has raised concerns about the “extend-and-pretend” approach in regional banks’ commercial real estate (CRE) portfolios, warning that it may heighten financial instability. According to Bisnow, regional banks have been extending loan maturities rather than marking loans as distressed, contributing to a $400 billion surge in upcoming CRE loan maturities. This practice, which has slowed new mortgage origination by 4.8% to 5.3% since early 2022, has also driven the share of maturing CRE debt on bank balance sheets up to 27% of bank capital, compared to 16% in 2020.

The New York Fed’s data illustrates how loan extensions have increased the wall of maturing CRE debt, revealing a growing backlog. The report notes that delaying recognition of loan distress might reassure investors and regulators in the short term, but it also amplifies systemic risk. If multiple CRE loans were to default at once, regional banks could face a substantial hit to regulatory capital, potentially leading to bank runs, extensive foreclosures, and forced asset sales.

The report emphasizes that smaller, less-capitalized banks are more inclined to rely on extensions, being 0.2% more likely to defer CRE losses than well-capitalized institutions. With banks currently holding over half of the $5.8 trillion CRE loan market, the sector is exposed to potential decline. For example, New York Community Bancorp nearly collapsed this year, requiring a $1 billion infusion and management changes.

In summary, while regional banks’ approach to managing CRE loan distress has kept a credit crunch at bay, it complicates recovery efforts and reflects rising risks in the sector. Although challenges remain, recent Fed rate cuts and a Moody’s upgrade of the banking sector to “stable” may offer some relief, especially for CRE loan quality.