The Federal Reserve is taking aim at a banking practice known as "amend and pretend."

That's what bankers call the desperate strategy of extending or restructuring failing loans that are likely to eventually fail anyway, usually to delay the reckoning of hefty losses.

Of the Federal Reserve's public enforcement actions against banks this year, more than a third, or 22, include provisions that strictly limit the banks' ability to change loan terms for troubled borrowers without first getting approval from the banks' boards of directors. The regulatory agreements also note the Fed's specific concerns about restructured loans to bank insiders.

First Banks Inc. in Clayton, Mo., is one notable example of the recent Fed enforcement actions.

Less than two years ago, the U.S. Treasury used its Troubled Asset Relief Program, or TARP, to give the bank some $295 million in government funds--or more TARP funds than any other privately held bank. At least four other banks that received TARP funds are subject to the recent Fed actions.

Troubled TARP banks carry a tandem of risks for U.S. banking regulators, since failures can drain the government's deposit insurance fund, and also turn government investments in banks into losses.

In early April, the Federal Reserve disclosed First Banks had signed an enforcement action in which the Fed mandated First Banks and its affiliates "shall not...extend, renew or restructure any" of the bank's troubled loans "without the prior approval of a majority of the full board of directors."

Terrance McCarthy, First Banks chief executive, said: "The language in the provision...is almost identical to what was used by regulators 20 years ago" during the last banking crisis. "We don't consider it a limitation." He added, "Banks are not prohibited from extending problem loans if it's in the interest of the bank for the best collection of the loan."

First Banks' agreement with regulators marks the latest chapter in the bank's rise-and-stumble trip through the credit bubble and financial crisis.

During 2005 to 2007, the bank expanded in California, Florida and Illinois--now three hotbeds of the banking crisis--and also made big bets on commercial real-estate loans. The bank did well for a while, producing profit of $112 million in 2006.

Early last year, in a letter to TARP Inspector General Neil Barofsky, McCarthy said the bank had renewed $157.8 million in construction loans in January and February of 2009.

But by the end of last year, First Banks faced piles of failing loans. The bank lost $449 million in 2009--or about four years' worth of boom-time profits. In last year's fourth quarter, First Banks took $122 million in losses just from loans tied to construction projects.

Asked about the renewals, McCarthy said: "We regularly extend loans where there's a prudent course to do so. You'll find that at any bank working their way through the cycle."

The Federal Reserve has signed similar agreements with four other banks that received TARP. They are Heritage Commerce Corp. (HTBK), which received $40 million; Bankers' Bank of the West Bancorp Inc., which received $13 million; Idaho Bancorp (IDBC), which received $7 million; and Rising Sun Bancorp, which received $6 million.

The banks didn't have any immediate comment.

It can be nearly impossible to see from publicly available data which banks are extending or restructuring loans they believe will one day fail anyway. But bankers are privately adamant that many struggling banks are using amend-and-pretend strategies to delay coming losses, especially from commercial real-estate loans.

Extending highly distressed loans can have two significant effects in the broader banking system. First, extending troubled loans can conceal coming losses and lead to costlier bank failures that strain deposit insurance funds at the Federal Deposit Insurance Corp.

But lenders also risk becoming "zombie banks" when they extend or restructure too many failing loans. That's because when lenders know they're at high risk of loss, they have little incentive to make new, sounder loans, since they know they'll eventually need their capital to offset losses.

-By Marshall Eckblad, Dow Jones Newswires; 212-416-2156; marshall.eckblad@dowjones.com
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