Banks Extend Commercial Real Estate Loans, Risking Financial System Stability: Fed Report

Banks are modifying the terms of commercial real estate (CRE) mortgages to delay acknowledging losses, potentially amplifying risks to the financial system, according to a Federal Reserve Bank of New York report released Wednesday.

Why it matters:

The CRE sector is under intense pressure from post-pandemic changes, with lockdowns and the shift to remote work reducing demand for office spaces. Rising interest rates between 2022 and 2023 further strained banks holding these loans.

• The report warns that “extend-and-pretend” strategies—extending loans to avoid write-offs—are leading to financial fragility and misallocation of credit, risks that could surface swiftly.

The big picture:

Fed officials expect manageable fallout for banks with CRE loan exposure, largely smaller institutions. So far, broader impacts have been limited.

• Key stats: Banks hold over half (50.7%) of the $5.8 trillion CRE loan market as of Q4 2023. Those with weaker capital positions are more likely to extend loan terms, creating a "maturity wall" as numerous loans near due dates with high potential losses.

What they’re saying:

“Nonperforming loans and net charge-offs remain low by historical standards, particularly among weaker-capitalized banks,” the report notes, though maturity extensions on distressed loans risk financial strain ahead.

• The report finds CRE mortgages from weaker banks are 0.2% more likely to see term extensions compared to better-capitalized institutions.

A ray of hope:

Recent Fed rate cuts could offer relief for CRE lending by reducing pressure on interest-sensitive loans. Moody’s upgraded its banking sector outlook to “stable” this week, citing asset quality stabilization, especially for CRE loans.

Zoom out:

A Goldman Sachs report in late September found limited signs of a CRE credit crunch, though loan growth is slowing significantly.

The bottom line:

As banks extend CRE loans to avoid losses, the sector faces looming risks from maturing debt, challenging the stability of smaller banks holding large CRE portfolios.