Following the previous significant financial crisis, during which numerous banks faced failure or required government bailouts despite appearing to have strong financial positions, the accounting rule makers in the United States began developing a fresh reporting system for credit losses. The aim was to ensure that lenders would promptly acknowledge these losses.

The new set of rules has been implemented for slightly over four years now. Investors might be questioning whether the current system is more effective than its predecessor.

The previous system was known as the incurred-loss model. In order to record a loss, a lender needed to determine that it was likely that a loss had already occurred. The term “probable” was not given a specific numerical definition, but it was generally understood to have a high threshold, possibly indicating a likelihood of 70% or higher. In the past, bankers often justified their actions by claiming that they would have reported higher loan losses if the regulations had allowed them to do so.

Since 2020, most large companies have implemented a new system where lenders are required to consistently assess their credit losses for the duration of a loan or bond. The threshold for recording losses is typically set at a lower level, based on the expectation of losses rather than waiting for them to actually occur. This was intended to result in a more assertive and prompt recognition of losses.

Investors’ confidence in the new expected-loss model is being put to the test by the office-loan market. Similar to other commercial properties, loan payments on office buildings typically consist of interest-only payments until the loan reaches maturity. During a period of extremely low interest rates, numerous lenders and borrowers entered into these loans with the expectation that they would be refinanced instead of being fully paid off at the end. As long as they can continue extending the loans, there would be no instances of defaults.

The pandemic caused a significant decline in office values in numerous major cities, as a growing number of individuals opted to work remotely. Unfortunately, for many borrowers, refinancing is not a viable solution due to the fact that the value of their buildings is lower than the amount they owe. Defaults are bound to happen. However, until that time, the owners may still be up to date with their payments. Hope is often seen as a source of optimism, but it can also be fleeting.

In a note dated July 24, John Murray and François Trausch from Pimco issued a warning regarding a significant amount of commercial real-estate loans maturing in the next two years, amounting to $1.5 trillion. “Lenders and borrowers will have to confront the consequences,” they wrote. If their analysis is accurate, it would suggest that the expected-loss model has not been performing as expected. Lenders retain significant flexibility in deferring the recognition of potential losses if they choose to do so.
Image: Wall Street Journal View Full Image
Image: WSJ

Until they reach their limit. At New York Community Bancorp, there has been a significant increase in credit losses on commercial real-estate loans, including office loans, over the past few quarters. This has led to concerns about the timing of management’s identification of these losses. Another cause for worry should be the undisclosed losses at other financial institutions that remain hidden from the public eye.

In a report last December, Carson Block, a well-known short seller, made a prediction about the future of Blackstone Mortgage Trust, a nonbank commercial real-estate lender. According to Block, the company would soon face significant credit losses. The company at the time criticized his report as biased and deceptive, asserting that it was well equipped to handle the current situation. Then in July, it reduced its dividend and reported its third consecutive quarterly net loss. The company’s net interest income was surpassed by significant credit losses in the last quarter.

Interestingly, there has been a higher occurrence of default rates for property loans supporting widely held commercial-mortgage-backed securities compared to similar loans on banks’ balance sheets. This highlights the greater flexibility of traditional lenders in assisting borrowers with their difficulties compared to the entities that issue commercial-mortgage-backed securities, which cannot as easily employ the strategy of “extend and pretend.”

Banking regulators have acknowledged the issue at hand, while also providing reassurance to the public that this situation will not replicate the events of 2008. It is worth revisiting an interview that Federal Reserve Chair Jerome Powell gave to CBS’s “60 Minutes” in February. When questioned about office loans from banks, he responded, “Anticipated losses are to be expected.” It seems like a challenge that will require our attention for an extended period of time. It’s a significant issue.

It is quite ironic that if Powell’s statement about the losses is accurate, banks should have already accounted for them based on the expected-loss model.