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October 8, 2009 (LPAC)—The fear that the collapse of commercial real estate values will trigger huge losses in the already bankrupt U.S. and global banking systems, was reflected in a number of reports today in the financial press. Though the size of the commercial real estate market is less than the residential real estate market, the system is far weaker now than when the residential market cratered in 2007, and its collapse has the potential to blow what remains of the financial house of cards into oblivion.

Kiernan C. Conway, an analyst with the Atlanta Fed, gave a presentation Sept. 29, in which he "painted a bleak picture of the sliding real estate values and enormous debt that will need to be refinanced in the next few years," and "predicted that commercial real estate losses would reach roughly 45% next year," the Wall Street Journal reported today. The presentation, made to a group of banking regulators, warned that "banks will be slow to recognize the severity of the loss—just as they were in residential."

The latter point is hardly news, given the Fed's scandalous role in helping the largest banks cover up their fatal losses, but Conway's warning, as a member of the Fed's "Rapid Response" team, belies all the "recovery" pablum being spread by Fed chairman Ben Bernanke.

The most "toxic" loans on the banks' books, Conway said, were the so-called interest-only loans, or loans in which the borrowers make only interest payments during the term of the loan, and repay the principle only when the loan is due. Such loans are usually intended to be rolled over into new loans when they come due, a game which worked when real estate prices were rising, but no longer functions, as many of the borrowers owe far more than their devalued properties are worth, and are thus unable to refinance existing loans.

In addition, many construction loans included "interest reserves," in which the banks making the loans set aside money to cover the interest payments, and used those reserves to make the interest payments when the borrowers could not. Thus the loan would appear to be current, even in the borrower was not making payments.

Banks are also extending the duration of troubled loans, rather than demanding payments from struggling borrowers, and using the lack of sales of commercial properties to mask the declines in the values of properties, the Journal suggested.

The Fed report noted that, from 2010 through 2013, about $175 billion of five-year interest-only loans bundled into commercial mortgage-backed securities will come due, adding that that figure is low compared to the level of interest-only loans held by the banks that will mature. The report added that whereas the values of commercial real estate dropped some 30% from their peak due to the blow-out of the financial markets, dropping rents and higher vacancies are now causing further declines, and projected another 10%-15% decline in 2010.

Nationwide, the glut of office space is growing, with real-estate research firm Reis reporting a net decline in occupied office space of 64 million square feet in the first nine months of 2009, the highest negative absorption rate since Reis began tracking the data in 1980, with the national vacancy rate hitting a five-year high of 16.5%. Effective office rents fell 8.5% in the third quarter compared to the third quarter of 2008, the steepest decline since 1995, Reis said.

The level of desperation in the commercial real estate sector is indicated by the structure of a deal in which an office building in Birmingham, Alabama, was sold for $147 million. The buying group only had to put $1.3 million in cash up front, giving the seller a $5 million note and assuming a $140.7 mortgage. In addition, the buyers took out an insurance policy that guaranteed the sellers that a $47 million balloon payment would be made when it came due in 19 years, paying for the insurance with a $10 million note secured by the property.

Overall, the reports show that, behind all the smoke and mirrors, the commercial real estate market is a time bomb that is already set to explode, and that the denial factor is still quite high. Recall the statements in 2007 and even into 2008, that the effects of the so-called "subprime" problem were contained, only to explode spectacularly into public view in September 2008. Now another explosion is coming, one whose affect on our lives will be far worse. Now, more than ever, we need the emergency reorganization laid out in the LaRouche Plan.