Most experts agree that one reason Japan’s economy has taken so long to recover from its bubble crash is that Japan’s banks spent the first decade in denial.
Specifically, when loans went bad, the banks didn’t write the loans off–they lent the bankrupt borrowers more money so the borrowers could keep paying interest on the original loan. Thus, the bank and the borrower could pretend that everything was hunky dory.
Except it wasn’t. Because the borrowers were bankrupt. And, eventually, everyone figured that out. And, finally, more than a decade into the collapse, the banks began owning up to reality and writing off some of the bad loans.
This practice, “extend and pretend,” isn’t always a bad strategy. If the economy recovers strongly and quickly, sometimes banks can make more money (or at least lose less) by working with with troubled borrowers who will eventually make good on their debts. This is what most of the ideas to “save the housing market” have been about–encouraging banks to restructure mortgages to keep borrowers in their homes. And sometimes, it actually works.
But, usually it doesn’t–especially when practiced on an industry-wide scale, and especially when borrowers aren’t just temporarily strapped. When banks “extend and pretend” just to avoid write-offs and protect their capital, they’re just delaying the inevitable. And the financial health they’re bragging about in the quarterly reports becomes bogus.
And that’s what appears to be happening in the commercial real-estate market right now.
The value of commercial real estate has fallen 42% from the peak, and it hasn’t recovered much. Meanwhile, the companies that occupy that real estate (office buildings, hotels, malls, etc.) have eliminated more than 8 million jobs. Consumers have cut back, reducing the need for retail space. And given the massive debt loads consumers and the government still carry, it doesn’t seem as though demand for commercial real estate is going to leap back to 2007 levels anytime soon.
So the banks are extending and pretending!
Restructurings of nonresidential loans stood at $23.9 billion at the end of the first quarter, more than three times the level a year earlier and seven times the level two years earlier…
Banks hold some $176 billion of souring commercial-real-estate loans, according to an estimate by research firm Foresight Analytics. About two-thirds of bank commercial real-estate loans maturing between now and 2014 are underwater, meaning the property is worth less than the loan on it, Foresight data show…
In the first quarter, 9.1% of commercial-property loans held by banks were delinquent, compared with 7% a year earlier and just 1.5% in the first quarter of 2007, according to Foresight.
To fully appreciate this, it helps to reduce it to the individual property level. Assume you bought a $100 million shopping mall in 2007, financing it with $10 million of investors’ money and $90 million of borrowed money. The mall is now worth $58 million. And your loan is coming due.
If you were forced to sell today, your investors would lose their entire $10 million, and your bank would lose $32 million of its $90 million loan. So, for obvious reasons, no one wants you to sell today.
So you extend and pretend! (And pray).
Your bank extends the repayment date of your loan to 2020, which takes the pressure off. You have enough cash from the original loan left that you can keep making interest payments. That means the bank can keep telling its investors that your loan is “performing.” And you can keep pretending that you’re a fat cat real-estate mogul (even though you owe $32 million more than you’re worth).
And if the economy comes roaring bank by 2020 and the value of your mall climbs back to $100 million, then it will all work out! You’ll be able to repay your loan in full by refinancing it with some other bank, and disaster will have been avoided.
If the economy comes back.
If it doesn’t–if this is a “new normal” where we just don’t need as much commercial real-estate as we did when we were fueling spending by borrowing more and more every month–then the value of your mall will never rise to $100 million again and you won’t be able to refinance your loan. And you’ll have to default. And your bank will have to take its write-off. And the bank capital that might have been used more productively somewhere else will just have been sat wasted for a decade instead of becoming a cheap mall purchase for someone else.
(Because there are plenty of folks out there with cash would would like to buy malls from people who make dumb bets at the peak).
Anyway, that’s what’s happening in the commercial real-estate market right now. And that’s why you’re not hearing about what a disaster it is.
Will it all work out in the end?
Or it might just be another step toward our becoming Japan.
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