Final installment of “The Second Wave of the Credit Crisis” series; with reporting from Fox News analyst James Farrell

The $3.5 tn commercial real estate market is eroding, defaults are doubling on loans for apartment buildings, office buildings, housing complexes, strip malls, hotels, hospitals,  and a staggering amount of loans must be rolled over this year into refinancings, or else go bellyup.

Prices in commercial real estate have fallen about 39% from the peak in mid 2007, according to the Massachusetts Institute of Technology's Center for Real Estate, with no signs of the plunge stopping. Data from Moody's Investors Service show similar declines.

The 39% drop in commercial real estate prices has already eclipsed the 27% decrease during the S&L crisis of the late '80s to early '90s.

And the derivatives, the ticking time bonds built on the backs of these potentially Kryptonite loans, could deepen the crater already blown wide open on Wall Street by the more than $1.5 tn in writedowns and losses taken so far in the housing and credit meltdown.

Big banks from Wells Fargo, Citigroup, Bank of America to Regions Financial, SunTrust, KeyCorp are already getting hit with losses in their commercial property book. Both Wells' and Morgan Stanley's most recent quarter suffered heavy losses from commercial real estate as bad loans surged.

Regions, Marshall & Isley, SunTrust, Zions, and Comerica all spilled red ink in their last quarters, and may report losses well into 2010 as they struggle to build bad loan reserves. Already, KeyCorp, Regions and Zions trade at half their book value on a hard asset basis (after stripping out intangibles like goodwill).

Other companies like General Electric, Marriott International and the government-run Fannie Mae and Freddie Mac are seeing hemorrhaging as well.

The problem now is, the US government, meaning taxpayers, may be called upon once again for even more bailout help for this struggling sector, beyond the $23.7 tn in gross exposures already in the bailout programs to date (gross exposures are an Armageddon scenario, although they do show what the government has committed, according to the inspector general for the Troubled Asset Relief Program, Neil Barofsky).

To date, the government's bailout programs have been hotly criticized for not being so cinematically picture perfect, although the stock market is behaving as if they were flawlessly executed.

About $1.4 tn of commercial real estate mortgage loans will be maturing within the next five years, and as much as $750 bn will be maturing in less than three years, says Steven Sandler, chief executive officer of the private equity firm Crosswind Capital in Rye, NY.  An estimated $165 bn to $204 bn in U.S. commercial real estate loans could be maturing this year alone, analysts estimate. All of these loans will likely need to be refinanced in an already jammed-tight lending market.

And Sandler notes there isn't enough money on the sidelines, perhaps a maximum $250 bn levered off of $75 bn in initial capitalization, to take care of the looming problems. Banks and insurance companies don't have the balance sheet capacity to refinance the maturing commercial loans, and the securitization is virtually moribund.

In Steps the Federal Reserve—Again

By expanding the Term Asset-Backed Securities Loan Facility, or TALF program, the Fed can offer loans at cheap rates to investors to buy commercial mortgage-backed securities, or CMBSs, and not just securitizations for consumer financings such as auto loans and student loans.

And it's quietly doing just that, on top of the $6.8 tn in gross exposures the central bank has already taken on in the bailouts.

The Fed last May said it would open the door on the TALF, which it has said may grow to $1 tn in size, to commercial mortgage-backed securities (CMBSs) that were issued in 2009. The New York Federal Reserve is overseeing this bailout program.

Beginning June 1, commercial mortgage-backed securities (CMBS) qualified as eligible collateral for five-year loans under the TALF.

Additionally, the Fed said up to $100 bn in TALF funds will immediately be eligible for loans with five-year maturities. The TALF lets the Federal Reserve Bank of New York make loans secured by asset-backed securities rated triple A. Also, in the case of CMBS, the securities now can be backed by mortgages originated on or after July 1, 2008.

Getting help for the commercial loan securitization market “will be important in determining the overall success of the program,” New York Federal Reserve president and chief executive officer William Dudley says. Industry groups are now pushing for the government to extend this program, due to expire in coming months, through the end of next year.

The Credit Rating Wrench

However, on May 28, 2009, shortly after the Federal Reserve provided this hopeful news to the CMBS market, S&P tossed a wrench in.

S&P at the time warned that it might downgrade billions of dollars of triple-A rated CMBS bonds because of proposed changes in its ratings methodology.

Reason: S&P said the loans made from 2005 through 2007 featured "increasingly more aggressive underwriting" than those made in prior years.

That potentially meant that billions of dollars worth of bonds would be disqualifed for TALF bailout help, and writedowns loomed.

Spooking the credit markets further, on July 14, 2009, S&P cut the creditworthiness on 19 classes of a $7.6 bn deal commonly known as GG10 (sold by RBS Greenwich Capital and Goldman Sachs Group in 2007).  S&P downgraded ratings on some classes of this deal all the way from triple A to just one notch above "junk" status.

S&P Reverses Course

Then, on July 21, 2009, S&P surprised the markets by reversing some of the CMBS downgrades that it had issued just a week earlier--including restoring some triple-A ratings which would then qualify those bonds for TALF funding.

S&P cited "recently updated criteria" for assessing losses on top-ranked CMBS bonds as justifying the ratings changes.

What about the other Government Bailout Program?

The TALF would work in sync with another US Treasury plan, the Public Private Investment Program, administered by the FDIC, which aims to move toxic assets, including commercial real estate loans, off bank books.

So far, financiers haven't shown much interest in either the TALF or PPIP for commercial real estate--analysts note the banks don't want to have to book the markdowns and are instead burying these assets in other line items to avoid the profit hits (see below).

The FDIC will lend qualified funds up to seven times the leverage in play to buy bank holdings, notes Barry Ritholz of the Big Picture Typepad, a heavily trafficked website with a big following on Wall Street (bookmark this site  on your favorites list, it's a highly intelligent, informative read).

“The United States is apparently going to use more leverage to work its way out of a situation created by using too much leverage. That seems a bit like trying to drink yourself sober,” notes Ritholz in his usual sherry-dry manner in his must-read book, “Bailout Nation,” (2009, John Wiley & Sons).

Looser Rules Help, But Can't Stop the Problem

Also, the Financial Accounting Standards Board, the board that sets U.S. accounting standards publicly traded companies use to book their earnings, recently gave companies more leeway in valuing assets and reporting losses.

Essentially companies, notably banks, can ease up on having to mark to market certain assets quarterly if they can prove they plan to hold them to maturity.

As a result, banks have been rapidly submarining impairment charges on debt securities into other line items on their financial statements, including “other comprehensive income, arguing they intend to hold onto their damaged investments until maturity, says Michael Rapoport in the Wall Street Journal. Earnings are in turn protected by the move.

Jack Ciesielski of the Analyst's Accounting Observer figures that, without the moves, 45 banks would have booked profits a median 42% lower, Rapoport says. Wells Fargo folded $664 mn in second quarter pre-tax impairment charges in to other comprehensive income to avoid the clip to earnings, on top of $334 mn in the first quarter, says Rapoport. The move also helps the banks avoid reducing their regulatory capital, Rapoport says.

Will These Moves Help?

Commercial real estate tends to lag behind housing, which means the second wave will roll out long after the housing crisis subsides.

Worth noting too is that the Office of the Comptroller of the Currency's Survey of Credit Underwriting Practices found that, although just 2% of banks were easing their underwriting standards on commercial construction loans in 2003, “by 2006 almost a third of them were relaxing.” That willy nilly granting of loans only exacerbates the problem--just like the no doc, no income loans of the housing crisis.

The commercial real estate market is paying the price for that hysterical blindness during the bubble, a bubble that is bursting now. The US economy, and the markets, are already bracing—for the worst.