Banks face major commercial real estate storm in US

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Sooner or later, office buildings and other commercial real estate financed during the credit bubble will generate hurricane-scale losses for banks.

Banks in recent years have been hammered by losses on home mortgages, buyouts and corporate defaults. Now, lenders face big losses from loans backed by commercial real estate, where a stagnant economy will eventually take its toll, financial services executives told the Reuters Global Finance Summit.

"The commercial real estate business still has not been marked down. It's not been marked to market," Cantor Fitzgerald LP Chief Executive Howard Lutnick said. "The economy can't, in my opinion, grow fast enough that the tenants are going to go out and start hiring and growing and building and take up all these rents at USD 60 a foot. It's nonsense."

US banks held USD 1.65 trillion of commercial real estate loans on their balance sheets as of November 4, according to the Federal Reserve. Total assets were USD 11.8 trillion.

Yet banks have postponed their day of reckoning, extending loans in hopes the economy will improve and demand for space will rebound. Banks have resisted selling assets, or taking them away from underwater borrowers, in fear of setting a new and lower market price.

It is a strategy neatly summarized as "a rolling loan gathers no loss," Lutnick quipped.

Lutnick, whose firm is now building out a real estate restructuring business, noted the equity invested in almost every transaction during the peak bubble years of 2005 through early 2007 has been wiped out. Lenders are under deep stress, because the value of their collateral has fallen.

Friendly Fed

But there is a limit to how long landlords can hold out for the old pre-recession rents. And once one building is marked down to reflect lower rents, neighboring buildings also should fall in value.

Lutnick added most commercial loans come in the form of five-year balloon loans, so a wave of 2005-vintage assets will test creditors next year.

"When you're in the eye of the hurricane, it sure feels good until you look at the TV screen and then you say, 'look, the hurricane is all around you,'" Lutnick said.

Banks do have a few things going in their favor. Chief among them is a friendly Federal Reserve, whose policy of free money lets banks reap windfall lending profits.

"The Fed has pushed interest rates down to nothing. The spreads on portfolios and securities are generating a huge amount of net interest income," Broadpoint Gleacher Securities Group Chief Executive Lee Fensterstock said at the Summit. "That will enable them to resolve some of their commercial real estate positions."

The commercial real estate problem also pales in size next to the previous waves of mortgage, leveraged loan, credit card and other consumer loan losses.

FBR Capital Markets analyst Paul Miller, while generally negative on banks, on Wednesday played down the danger of commercial real estate losses.

"There's a lot of structural forbearance built into the commercial real estate market," Miller said, meaning it is easier for borrowers to postpone and amend their terms.

Even so, the combination of poorly underwritten loans and a slowing economy will lead to many landlords walking away and handing over the keys. Individual credits, meanwhile, are much larger.

"There's going to be a lot of empty buildings coming back to banks' balance sheets," Miller said.