Commercial Mortgages: The $400 Billion Ticking Time Bomb

The sub-prime mess could pale in comparison to the calamity that rising commercial mortgage delinquencies are threatening. Since the S&L crisis, commercial banks have increased their holdings of commercial mortgages at an accelerating rate. The Commercial Mortgage Security Association (CMSA) estimates that in 1991 commercial banks held $410 billion in mortgages and by 2006 banks held $1.28 trillion.

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The primary driver for banks holding so many commercial mortgages was the securitization market. Mortgage backed securities allowed banks to liquidate holdings via a commercial mortgage backed security (CMBS) or a collateralized debt obligation (CDO). In fact, bank holdings of commercial mortgages correlated with the growth in issuance of both CMBS and CDOs.

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This chart illustrates that CDO issuance was at its peak from 2005 to 2007, similar to the housing market. It is also easy to see that in 2008, CDO issuance has dropped precipitously. According to the CMSA, there have not been any CDOs issued since June 2008. A similar pattern is found with CMBS issuance.

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A reasonable person would look at the data and conclude that banks probably decreased holdings in commercial mortgages as the securitization market dried up…by now, we all know that the people running the banks are neither reasonable or rational.

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The irrational behavior is glaring, from Q1 2007 to Q3 2008 banks increased commercial loan holdings by 15% while the securitization market collapsed. It is now estimated that commercial banks hold 43% of the $3.4 trillion commercial mortgage loan market. In a previous post, I discussed the rising delinquency rates in the commercial mortgage loan market. Deutsche Bank estimates that delinquencies will rise to 3% by the end of 2009. Interestingly, during the S&L crisis the delinquency rate rose to 30% and currently, many CMBS are pricing in that scenario.

A back of the envelope stress test for banks under various delinquency rates is presented below. The table was constructed using CMSA data for bank holdings of commercial mortgages totaling $1.493 trillion.

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The low end of the stress test is the 3% delinquency rate estimated by Deutsche Bank, while the upper bound is the delinquency rate being priced in to some CMBS. The billion-dollar question is who is right? If the low end prevails then the banks are facing $44 billion of additional write-offs, and if the CMBS market is correct then losses soar to $447.9 billion. Recall that banks received $250 billion + to fill the hole caused by the residential mortgage market, and the 90+-day delinquency rate on sub-prime mortgages is running about 30%.

According to the FDIC, 18% or $2.1 trillion of the $11.4 trillion residential mortgage loans outstanding are held by commercial banks. The commercial real estate market is smaller, but the banks hold a larger portion. The CMSA reports that 43% or $1.49 trillion of the $3.4 trillion commercial mortgage market is held by banks.

Given that the current economic environment is much worse than during the S&L crisis, it is not hard to understand why the CMBS market is pricing for a 30% default rate. Since the banks own a higher percentage of commercial mortgages, the resulting losses could be larger than the so-called “sub-prime” losses. So while Congress debates whether or not the TARP was put to good use, the $400 billion commercial mortgage time bomb is ticking.

Disclosure: I am long SKF and SRS.

Comments

[investor88:]

Thanks to Brian for identifying another time bomb that investors/traders should be aware of.

Many [just read all the articles in the internet] are calling for a boom. OK but also be mindful of the time bombs like those identified by Brian; this is not all and there could be others.

Jan 11 09:08 AM

[Karen Consumer:]

The ticking time bomb is already exploding. I work in a city (200,000 population) and 1 commercial property (apartment complex of 400+ units) is in foreclosure. The problem: the city, apt. management, and owner are aware; the tenants (including those signing their first lease with the complex) are not. The owner has no intention of saving the property, which means in short order 400+ families will be looking for more housing.

Which leads to problem 2: the city has two Archstone properties that have vacancies but are out of reach of the 400+ families. We have several properties (by other owners) that were just completed in 2007/2008 but are not 'affordable' (rents range from $1,000 to $2,000) to the middle income population that call the city home. And many of these families are sub-prime, so they have either lost their homes or have no ability to buy foreclosed homes.

One house gets foreclosed, that family can move in with friends or into an apartment complex. One apartment complex gets foreclosed and we have an instant homeless crisis.

You think consumer confidence is in the crapper now, you ain't seen nothing yet.

Jan 11 10:28 AM

[JohnnyT:]

on the apartment problem - they are going to kick everybody out ? then what ? demolish it to get it off the tax rolls ? give me a break, no one will be homeless, the tenants and their leases are an asset

Jan 11 11:28 AM

[FreddieBoy:]

Sorry the author has been in SRS. What a lousy "tracking" ETF. I don't know what it "tracks" but it a'int the commercial real estate market

Jan 11 05:02 PM

[Urbane Gori...:]

Commercial real estate doesn't just apply to apartments. We're talking Malls, storefronts, business premises, office blocks, factories and anything else that has commercial value. This could be ugly.

For teh record, before you go long SKF or SRS, you might want to check recent articles here on SeekingAlpha, or check 'Fund My Mutual Fund' by TraderMark. You might be surprised to find that these inverse-ultra ETFs don't necessarily pay the way you would expect. In fact, you can lose money when you would expect to gain.... Definitely a 'due-diligence' issue here....

And for JohnnyT... You would think that that is how it would work, but having seen many vacant apartment complexes in various cities across the US, I can attest that yes, they do go vacant. Banks are not set up to handle rentals.... Kind of a shame in a way. If they had made arrangements with rental agencies, maybe the home foreclosure issue would never had turned out so ugly and possibly our financial problems would have been a fraction of what they've turned out to be. It's better to staunch the flow of blood than it is to arrange a burial... (Mortgage lenders should have read 'Lateral Thinking' by Edward DeBono... )

jegan ;-)

Jan 11 05:12 PM

[Ela:]

So are we dealing with recession or depression. By the RGE Monitor , depression - is characterized by bursting of the multiple bubbles, and now are we talking about the USA depression or the Global depression?

Jan 11 06:01 PM

[Metzenbaum ...:]

SA is overrun with people half my age and less than half my smarts.
This is the best item from SA in a long, long time.

Jan 12 11:58 AM

[billp37:]

Insurance companies are also apparently large holders of commercial mortgages.

Cramer Thursday November 12, 2008

"Cramer makes room in the Sell Block today for a whole gang of misfits, based on analysis that Goldman Sachs released on Tuesday. Today's Sell Block detainees: life insurance companies like Lincoln [HIG 12.65 2.19 (+20.94%) ], Hartford [ Loading... () ], Prudential [PRU 25.24 0.10 (+0.4%) ] and Principal [PFG 16.83 -1.93 (-10.29%) ]. To put it simply, they're in "big trouble," according to Goldman's piece.

According to the report, these insurance firms sold too many annuities that guaranteed a minimum level of income for the buyers. Now they have to "make good" on these promises while suffering HUGE losses in the stock market in recent weeks. These "variable annuity" products contributed about 35% of these companies' income in 2007. But now it's time to pay up -- where will they get the money? "

apparently because

"Life insurance companies, hobbled by real estate investments and committed to paying some costly retirement contracts, face more cuts in their credit ratings before the year is up and have little choice but to seek capital in unforgiving markets. ...

Hartford Financial’s stock fell to $9.67 a share on Wednesday, a stunning 61 percent decline since last Wednesday. MetLife’s shares, which closed at $28, are down 22 percent in that period. Stock in Prudential Financial, which ended the day at $26.54, is down 32 percent. ..."

Reason we are tracking PRU, LNC, HIG, MET, ... is that Sandia National Laboratories and Jet Propulsion Laboratory retirees are paid by PRU.

We are looking what to do if our annuity pension checks stop arriving.

Jan 12 03:13 PM

[pitchingpen...:]

So, I wouldn't know about this, but a nagging and unsettling thought just keeps popping up as I read this article:

Who wrote the CDS's on these CMBS securities, and who rated them? Anybody we know?

Jan 12 11:28 PM

[georgeculolias:]

I'm long SRS also and have lost a lot of money. My question is, is there going to be a class action lawsuit against them? From what I've read recently, the index that they say SRS is supposed to go 2x inverse of, has dropped 50% and yet SRS instead of going up 100% as advertised has dropped 50% also! I would have done much better just shorting the index. Either the guys running SRS are crooks or they are unbelievably stupid. Either way they should be sued. Watch your back on these new ETF products, as this one has proven they can't be trusted! If anyone knows of a pending lawsuit against SRS please email me at georgeculolias@hotmail...

Jan 13 10:49 AM

[monday1929:]

YOU did, you silly Taxpayer.


On Jan 12 11:28 PM pitchingpennies wrote:

> So, I wouldn't know about this, but a nagging and unsettling thought
> just keeps popping up as I read this article:
>
> Who wrote the CDS's on these CMBS securities, and who rated them?
> Anybody we know?

Jan 14 07:59 AM