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How Are Banks Reclassifying Underwater Commercial Loans With Uncle Sam’s Blessing?

Banks are moving quickly to restructure commercial mortgages under new U.S. guidelines that are more forgiving of battered property values and can help banks avoid bigger losses. Under old policy, banks are required to maintain capital requirements in the event that loans default. Banks are borrowing at nearly zero from the government, in no small part to hoard cash when the day of reckoning comes for marking such assets to market. Nevertheless, Uncle Sam is providing a huge bone to lenders in order to minimize their capital requirements. As the WSJ chart below shows, they can simply peel away layers of the loan. Banks need only keep adequate capital for a portion of the loans, not the entire amounts.

(Click the chart below to enlarge it.)

“The people who are complaining the loudest are the people who want to buy the real estate,” said Pat Goldstein, head of real estate for Emigrant Savings Bank in New York City.

On the flip side, the people most in favor of eliminating mark-to-market accounting practices, and endorsing these new ad hoc guidelines, are the banks.

Banks with large exposure to MBS (mortgage backed securities) experience large excess returns when fair-value accounting rules are relaxed. On April 9, 2009, The Financial Accounting Standards Board (FASB) granted banks wide latitude in determining the value of their assets. With this great power, came great irresponsibility.

A recent in-depth analysis by economists Harry Huizinga and Luc Laeven revealed that while only 8% of banks at the end of 2001 had a market-to-book value of assets ratio of less than one, by the end of 2008, more than 60% of US bank holding companies made that claim.

Over the same period, the average ratio of Tier 1 capital to bank assets stayed constant at about 11%. The market value of bank equity thus dropped precipitously against a backdrop of virtually constant book capital. In other words, if the bank has the same amount of assets to protect itself from a default, and the assets have clearly dropped in value, then their cushion is woefully insufficient.

1. Banks’ balance sheets overvalue real-estate-related assets compared to the market value of these assets.

2. Banks with large exposure to MBS (mortgage backed securities) experience large excess returns when fair-value accounting rules are relaxed. On April 9, 2009, The Financial Accounting Standards Board (FASB) granted banks wide latitude in determining the value of their assets. With this great power, came great irresponsibility.

3. Banks use accounting discretion regarding loan losses and the classification of assets to preserve book capital. Banks have considerable discretion in the timing of their loan loss provisioning for bad loans and in the realisation of loan losses in the form of charge-offs. This gives otherwise zombie banks (dead by any clinical definition) a new lease on life.

Until Uncle Sam forces the banks to come clean, commercial real estate prices, including the multifamily asset class, will continue to crater, let alone stall.

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