Further Notes on the Federal Reserve Release Re Commercial Real Estate Loans

I have received a few emails commenting on my interpretation of the Fed release regarding workouts of commercial real estate loans. The emails for the most part argue that this will allow banks to prop up their balance sheet with bad loans. Their argument tends to fall in line with the report from WSJ on the news:

Federal bank regulators issued guidelines allowing banks to keep loans on their books as "performing" even if the value of the underlying properties have fallen below the loan amount.

The volume of troubled commercial real-estate loans is skyrocketing. Regulators said that the rules were designed to encourage banks to restructure problem commercial mortgages with borrowers rather than foreclose on them. But the move has prompted criticism that regulators are simply prolonging the financial crisis by not forcing borrowers and lenders to confront, rather than delay, inevitable problems.

This is certainly a surface way to look at what the Fed is doing, and I did say there would be various interpretations. But the deeper news I am reading into the release is that the Fed is not going to be buying this junk, the way they bought who knows what kind of junk in Leg I of the crisis. Remember in Leg I, the Fed's balance sheet increased by a near trillion. There will be no such increase this time. They are going to force action on the loans, specifically workouts. And here's a point where vI completely differ with WSJ. If there is a workout, I think this means the loans will be written down to their present value when the workout is reached. The Fed will just continue classification of loans during the workout process, and once the workout is complete, as "performing loans".

Now what gets tricky here, and where I think the Fed will do its normal selective enforcement is when it comes to classifying an asset as a performing loan just because there are workout discussions. If a bank has a CRE loan outstanding that couldn't be paid at any price because there is no market for the building, the bank owning the loan has every incentive to claim it is trying to workout the loan and it should therefore be listed as performing. The Fed when it chooses can tell a bank to knock off the BS, or the Fed can turn the other eye when it chooses.

That's why these words in the release are scary (My emphasis):

Financial institutions that implement prudent loan workout arrangements after performing comprehensive reviews of borrowers' financial conditions will not be subject to criticism for engaging in these efforts, even if the restructured loans have weaknesses that result in adverse credit classifications. In addition, performing loans, including those renewed or restructured on reasonable modified terms, made to creditworthy borrowers, will not be subject to adverse classification solely because the value of the underlying collateral declined....The policy statement reiterates existing guidance that examiners are expected to take a balanced approach in assessing institutions’ risk-management practices for loan workout activities.

Bottom line: It's the Fed's game. Any bank that has, or develops serious CRE loan problems, will have its fate completely in the hands of the Fed. It is the Fed that ultimately determine what is "prudent","reasonable" and "balanced".

When they want to take out a bank, it will be because the bank wasn't able to conduct "prudent","reasonable" and "balanced" workouts. The knock will come and the messenger will say, "Bang you are dead."

Favored banks will of course all be conducting "prudent","reasonable" and "balanced" workouts.