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Banks' $300 Billion 'Pretend' Problem

Story updated to include additonal information.

NEW YORK ( TheStreet) -- Some of the largest U.S. banks may face similar questions that are now being posed to Regions Financial (RF - Get Report) as regulators crack down on so-called extend and pretend loan practices.

But the practice is only a symptom of a much larger problem that eventually will force banks to digest billions in losses on commercial real estate loans that could eventually drown some bank balance sheets.

"At the moment it's a game of musical chairs," said Dan Gorczycki, managing director of commercial real estate broker Savills. "It just depends who will be left without a place to sit."

The board of Regions is investigating whether bank management delayed the disclosure of loans that were losing value, according to an article in the The Wall Street Journal . The Journal cited court documents and people familiar with the matter, adding that the banks audit committee began the investigation after the Federal Reserve expressed concern.

At issue is the practice of extending a maturing loan while pretending its underlying book value hasn't declined. The practice artificially deflates nonperforming loans and credit costs in the current reporting period since the loan doesn't mature and losses aren't realized.

But the practice also allows problem loans to build up over time until they can ultimately collapse a bank's balance sheet.

Extend and pretend is "neither trivial nor rampant" in the banking industry, but banks with high concentrations in commercial real estate are most likely to fall into its trap, according to a report issued last month by ratings agency Fitch.

" [Banks] with decentralized credit functions, and concentrations in [commercial real estate] (CRE) loans, especially in areas with relatively weak CRE values, may be more prone to extending such high-risk loans without addressing inherent credit weaknesses," the report stated.

In fact, commercial real estate may turn out to be the next Achilles heel of the banking industry following the subprime residential mortgage crisis since so many loans have lost value but the losses have yet to be booked, Fitch said.

"Various industry reports suggest that roughly half of the $1 trillion of CRE loans maturing over the next three years are underwater, with as much as $200 billion to $300 billion being more than 20% underwater at maturity," Fitch said.
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