The Next Bailout Battle

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Much of the debate in the bank bailout battle has focused on helping the banks rid themselves of securities backed by ailing home loans—many in the last stage of foreclosure. But it’s becoming increasingly clear that bonds backed by commercial real estate loans will pose as great of a threat to the stability of the financial system.

The news that Moody’s Investors Service is reviewing the ratings on some $300 billion in bonds backed by commercial real estate mortgages is another body blow to the nation’s banks. A potential downgrade on so-called commercial mortgage backed securities would lead to a new round of write-downs and losses at the banks. And that, in turn, would likely mean many banks would have to go back to the federal government for another round of bail-out money.

But the decision by Moody’s to take a hard look at CMBS ratings should come as no surprise. The commercial real estate sector has been in a freefall for months now, with defaults and deliquencies on the rise as the recession worsens. Securities backed by loans on retail strip malls have been particularly vulnerable with so many retailers closing their doors.

Also worriesome are all those outstanding construction loans that banks made during the boom years. There’s also concern about loans to property managers that are backed by provisions that included escalating rent clauses. Right now, rents are going down, not up.

A good deal of the $15 billion in losses that Merrill Lynch incurred in the fourth-quarter involved write-downs and losses on commercial real estate-backed securities. The big losses at Merrill forced the federal government to put together a hastily arranged $138 billion bailout package to enable Bank of America to complete the acquision of the brokerage.

The failout from the plunge in commercial property values can be seen at Goldman Sachs. In the firm’s 2008 annual report, the value of hard-to-value Level 3 assets declined by 2% to $66 billion from the prior year. But the decline may have been greater, if not for problems in the commercial property sector. Goldman notes that the drop in Level 3 assets “were partially offset” by a rise the number of “loans and securities backed by commercial real estate due to reduced price transparency.”

Reduced price transparency is another way of saying that Goldman simply can’t put a value on some of its commercial property related assets. Given the way the economy is falling off a cliff, that lack of price transparency in commercial real estate assets is likely to worsen. And none of that is good new for the banks, or the prospects of an economic turnaround.

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