NY Fed: ‘Extend and Pretend’ Fuels CRE Credit Misallocation

A recent analysis by the Federal Reserve of New York found that the “extend and pretend” practice by several US banks, a practice of giving maturity extension to distressed loans to avoid writing off their capital, led to increased credit risk and misallocation over the past two years.

Using loan-level supervisory data on maturity extensions, bank assessment of credit risk, and realized defaults for loans to property owners and REITs. The analysis found that "extend-and-pretend" activity has crowded out new originations over the past year and a half.

According to the Mortgage Bankers Association’s commercial and multifamily originations activity index, origination volume dropped by 20% between Q1 2022 and Q3 2024. While origination activity was undoubtedly dampened by higher interest rates, tighter credit standards, and heightened uncertainty, the New York Fed projects that distress-related maturity extensions contributed to between a 4.8% and 5.3% drop in commercial originations since Q1 2022, explaining roughly a quarter of the decline.

The downstream effect of the extensions is a jump in the share of CRE loans maturing in the near term. As of Q4 2023 projections, 27% of total bank marked-to-market will come due over the next three years.

While these extensions led to fewer defaults, banks took these actions due to weak underlying capitalization, which resulted in a strong positive relationship between maturity extensions for distressed mortgages and bank undercapitalization.

The findings of the New York Fed study suggest that in the short term, the impact of this misallocation will mainly show up through slower development of key post-pandemic market transitions in the real estate sector, such as office-to-residential conversions and modernizing recreational spaces in large cities.