There was a nice little debate among the Reuters commentary group this morning about an increasingly-common way of dealing with dodgy loans: what some are calling “extend and pretend” and others refer to as “delay and pray”. Basically, you just roll over bad-but-performing loans as they come due, rather than take any losses associated with the borrower’s inability to make a big principal repayment. Rolfe Winkler, for one, thinks it’s a very bad idea:
Banks argue that loans should not be marked down if they’re still “performing.” As long as borrowers are meeting their contractual obligations, there’s no reason to take a writedown. The problem is, this gives banks an excuse to extend, amend and pretend. They can make concessions on loan terms or delay foreclosure notices, if only to maintain the fiction that borrowers will make good…
As the Japanese can tell you, this is just a recipe for stagnation. Thanks to a debt bubble that authorities refused to deal with decisively, that country is now entering its third consecutive lost decade.
This is true — especially if, like Rolfe, you think that the collateral underlying these loans is going to continue to decline in value. Very few upside-down loans are worth more than the property they’re secured against, and if you’ve lent money against a declining asset, then the sooner you can take your losses and move on, the better.
On the other hand, the person you’re selling that collateral to doesn’t think it’s going to fall in value. And really what we’re faced with here is a distribution of possible future states.
The calculation which needs to be done is pretty complex, and involves the future path of three uncertain variables. First there’s the lender’s own cost of funds: at the moment it’s low, but there is a chance it could rise substantially by the time the extended loan matures. Secondly there’s the income stream from the loan: while most of these loans are performing right now, and making their interest payments on time, there’s a significant chance of future default on many of them. And thirdly there’s the future course of property prices, or other assets securing the loans.
The last two, of course, are highly (but not perfectly) correlated: if the value of collateral declines, then the chances of the borrower defaulting on the loan increase. But in an efficient world, every lender, on a case-by-case basis, would work out the expected profit or loss from extending the loan, taking into account the amount of volatility we’ve seen in all three variables, and then compare that to the known loss they’d need to take if they just foreclosed tomorrow. If the expected loss from extending is lower than the loss that would need to be taken today, then they extend.
In the real world, however, bankers are human, and they’re liable to fudge the figures so that extending the loan always makes sense: tweak a volatility assumption here, put in a favorable interest-rate assumption there, and it’s not hard to get the answer out that you wanted in the first place. They have a very strong incentive to do this, because much of the time if they take their losses now, they’ll become insolvent: everybody wants to survive, first and foremost.
So that’s where the regulators come in. At the moment, it’s far from clear that they have either the ability or the inclination to force banks to face reality — especially when they’re dealing with big banks. To the contrary, “extend and pretend” has obvious attractions for technocrats, too: it allows them to kick the hard decisions down the road, which is something nearly all politicians love to do. And when it comes to non-bank lenders, the regulators are pretty much out of the picture entirely.
Tthere’s definitely a part of me which is sympathetic to both borrowers and lenders who manage to come to a “one more chance” agreement. There are significant costs to default and foreclosure, and such agreements mean those costs don’t have to be taken — at least not in the immediate future. When hope becomes delusion, then regulators must step in and force write-downs. But the calculations you need to do in order to tell the difference are pretty complex.