The Federal Reserve last month secretly expressed concerns that U.S. banks are dragging their feet in an “extend and pretend” philosophy to avoid booking losses on their ailing commercial real estate loans, the Wall Street Journal reported this week. In a late-September report presented to financial regulators, the Fed said that because those banks “are slow” to acknowledge losses on rent defaults and lower property values, the government should prepare for a new avalanche of housing-related losses by banks that remain highly leveraged in the commercial sector. “Banks will be slow to recognize the severity of the loss — just as they were in residential,” the Fed presentation concluded, according to the Journal report. The paper noted that the presentation’s author, real-estate researcher K.C. Conway of the Atlanta Federal Reserve Bank, did not represent a formal opinion by the agency.

But it said concerns about a second, commercial-related property downturn are beginning to circulate throughout the Fed. Bill Dudley, the New York Fed’s president, echoed those worries in a speech he gave Monday. “More pain likely lies ahead for this sector and for those banks with heavy commercial real estate exposures,” he said. The Journal’s own analysis underscored that sentiment. According to the paper’s estimate, more than 800 banks that are highly leveraged in commercial real estate set aside only 38 cents in cash reserves for every dollar they held in bad loans through the second quarter. By contrast, the banks held four times that amount in reserves at the beginning of 2007. Conway’s report said the news would only worsen over the next year or more. He said vacancy rates for apartments, retail space and warehousing were already greater than they’d been during the last real-estate bust in the 90’s. He also projected 45 percent losses in commercial real estate for 2010. As a result, many banks are extending loans when they come due, even if the underlying properties are “underwater” and the loans couldn’t be made now. They’re forestalling losses on their portfolios out of “capital concerns”. That’s “an extend-and-pretend philosophy by banks to forestall hits to their balance sheets that might occur,” Patrick Phillips of the Urban Land Institute told the Journal. Of particular concern to Fed regulators are “interest only” loans, the commercial paper most likely to be toxic. The borrowers repay interest on a monthly basis but not principal. With interest rates so low, most of those borrowers are now staying current, Michael Straneva, Ernst & Young’s real-estate head, told the paper. “But the question is whether the loans will get paid off when they come due,” he said. Plenty of banks are willing to pretend that those loans will get paid, said Matthew Anderson, of the research firm Foresight Analytics. “It’s like taping paper over a hole in the wall,” he said.