Commercial Real Estate’s $1 Trillion Time Bomb By Lingling Wei Wall Street Journal 09-01-09

Commercial Real Estate’s $1 Trillion Time Bomb
By Lingling Wei
The Wall Street Journal
September 1, 2009

Yesterday I wrote about a looming crisis in the commercial-mortgage-backed securities market. But there’s another time bomb ticking away in the commercial sector: U.S. banks are holding more than $1 trillion of mortgages backed by commercial property that is fast losing value.

According to analysts at Deutsche Bank AG, as property value declines and scarce credit continue to drive commercial property developers and investors into default, total lifetime losses on banks’ $1 trillion “core” commercial-mortgage holdings, or those backed by income-producing properties, would reach between 11.6% and 15.3%, or $115 billion and $150 billion. Those expected losses would be at least as large as those on loans originated and bundled into commercial-mortgage-backed securities, or CMBS, from 2005 and 2008, a period of cheap and reckless credit, the analysts estimate.

Indeed, problem real-estate loans are like a morning-after headache for the nation’s banks. During the boom times, bankers flocked to commercial real-estate lending, making such debt one of the largest lending categories, which also include home mortgages. Then, about three years ago, the real-estate slump started with the housing market, and gradually spread to construction loans to homebuilders and tied to residential projects. Commercial mortgages are the latest to take hits.

In contrast to home loans – the majority of which were made by only 10 or so giant institutions – thousands of small and regional banks loaded up on commercial property debt. As a result, commercial real estate troubles would be even more widespread among the financial system than the housing woes. At the present, more than 3,000 banks and savings institutions have more than 300% of their risk-based capital in commercial real-estate loans.

So far, banks in general have been reluctant to take losses on their commercial books. This “delay and pray” strategy is preventing most banks from issuing new loans as they prepare their balance sheets for potential future losses, experts say. “Banks will eventually sell as they cannot extend into perpetuity and the chances that the market will rebound to their highs are unlikely anytime soon,” said Bart Steinfeld, managing director of Jones Lang LaSalle’s Real Estate Investment Banking practice. “We expect the smaller, community banks to begin selling their small balance loans first.”

For many of them, what is at stake is survival. And even many banks that survive the current real-estate slump will be seriously weakened; funds that they set aside for potential loan losses must be subtracted from earnings or capital even before any losses are incurred.