Fed Worries About Commercial Real Estate

This summer, I noted that the commercial real estate market might be the next to sour. Separately, I mentioned that the Federal Reserve might want to think about that, since it has significant exposure to commercial real estate, given all of its efforts to save the financial industry. News out today indicates that the Fed is finally starting to worry about that market, but for a different reason: because banks aren't. Or at least, their loss reserves don't indicate that they're as concerned as they should be. Could this cause the same sort of financial crisis we saw last year spurred by residential mortgages?

The Wall Street Journal broke the story:

Banks in the U.S. "are slow" to take losses on their commercial real-estate loans being battered by slumping property values and rental payments, according to a Federal Reserve presentation to banking regulators last month.

The remarks suggest that banking regulators are girding for a rerun of the housing-related losses now slamming thousands of banks that failed to set aside enough capital during the boom to cushion themselves when the bubble burst. "Banks will be slow to recognize the severity of the loss -- just as they were in residential," according to the Fed presentation, which was reviewed by The Wall Street Journal.

So how bad are their reserves?

In another sign that many U.S. financial institutions are inadequately protected against potential losses on commercial real-estate loans, banks with heavy exposure to such loans set aside just 38 cents in reserves during the second quarter for every $1 in bad loans, according to an analysis of regulatory filings by The Wall Street Journal. That is a sharp decline from $1.58 in reserves for every $1 in bad loans from the beginning of 2007.

Banks appear to be in a similar pickle to the one they were in for residential real estate. That's troubling. Still, the commercial real estate market is a little different -- will the result be the same?

First, the market for commercial mortgages did not explode in precisely the same way it did for residential mortgages over the past decade -- there wasn't the same sort of bubble. That's probably because there weren't government agencies in place to overheat the market, like we saw with Fannie and Freddie for residential mortgages. As far as I know, the only government agency that comes close to being a player in commercial real estate would be the Small Business Association. Yet, SBA loans are generally quite small, and its reach is relatively limited. So even though credit was easy during a prolonged period for all loans, it wasn't quite as easy for commercial mortgages as it was for residential mortgages.

Second, to my knowledge, there was no subprime commercial mortgage market. Those bad loans in residential mortgages were the catalyst for last year's financial crisis. Yet, if you've studied the residential real estate market, you know that subprime loans actually accounted for a very, very small portion of all mortgages in the U.S. That means prime mortgages were also part of the problem.

Why did that happen? I'd attribute it to something like panic, or at least negative sentiment. Once people sensed there was a problem in the residential mortgage market, it all became toxic. Housing prices started declining and the dominos all started falling.

So even though there are no subprime commercial mortgages, the recession is causing far more businesses to default on their real estate than anticipated. That could cause a sort of contagion across the commercial mortgage market as well, providing a similar result to what we saw in residential mortgages last year.

I also find the structure of the commercial mortgage market even more problematic. Residential mortgage concentration was widely dispersed across large and small banks. But commercial mortgages, due to their much larger size, naturally end up being funded more often by larger banks, making their share of exposure greater.

Of course, like residential mortgages, commercial mortgages were also packaged through securitization and sold to investors as bonds. Commercial mortgage-backed securities are a huge market. If those securities become more toxic, we'll see losses there as well, just as we did with residential mortgage-backed securities.

All in all, I fear that another storm is brewing. The really scary part is that the Fed has already taken significant measures to prop up the commercial mortgage market. I'm not sure how much more it can do. Business' problems will likely continue until the economy shows real signs of improvement, meaning that commercial mortgages will continue to suffer. I'd hate to see history repeat itself, but if the commercial real estate market is as bad as some forecast, it could already be a runaway train on its way to wreak havoc on a financial system that was just starting to heal.