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Recent Trends and Outlook for U.S. Commercial Real Estate Mortgages



Background



Rising losses on CRE loans could hamper the economic recovery in the U.S.

and thus warrant closer analysis



Growing losses on commercial real estate (CRE) loans could exacerbate the

negative feedback loop between the financial sector and the real economy,

thus delaying an economic recovery. As a result, a close analysis and monitoring of U.S. CRE loans is needed.





CRE Market



Structure : Most CRE loans are held directly by banks and are a major part of

their loan portfolios.



Although large writedowns on CMBS have been the focus of much attention, only 25%

of CRE loans are packaged into CMBS while 50% are held directly by banks.

Prices : Like home prices, CRE prices are declining dramatically

CRE prices have fallen 39% from their peak, while home prices have fallen 33%.

CRE Loan Deterioration



Loans Held Directly by Banks : Chargeoff and delinquency rates for CRE mortgages are rising quickly



The chargeoff rate for CRE loans is rising rapidly, doubling YoY to 2.24% as of 2Q09.

Likewise, the delinquency rate for CRE loans as surged to 7.67%

Securitized CRE Loans : CMBS has had smaller writedowns than RMBS but higher loss rates, and delinquencies on the underlying CRE loans have been rising rapidly

U.S. banks have recorded about $20 bn in writedowns on CMBS since 2007, far lower

than the $97 bn in writedowns taken for RMBS.

However, the balance of outstanding RMBS is roughly 10x that of CMBS, implying

a loss ratio for CMBS that is about 2x that for RMBS.

The delinquency rate for CRE loans that have been packaged into CMBS recently surged from 1.89% in 1Q09 to 4.66% in 2Q09, highlighting the rapid pace of deterioration.





Outlook and Key Risk Factors



Losses on CRE mortgages are certain to grow, but pose a lesser threat than residential mortgages and are unlikely to trigger a repeat of the financial crisis



The IMF is forecasting higher rates for CRE loans and CMBS than for residential loans and RMBS, but RMBS will suffer larger losses, and thus pose a greater threat to financial stability.



A large volume of CRE loans will mature in 2009~10 and will face difficulties in refinancing, which could, in turn, lead to defaults and further declines in CRE prices



A large volume of CRE loans will mature in 2009~10, and since most CRE loans have balloon payments or are interest-only, they will need to be refinanced.

However, banks are tightening their underwriting standards and CRE prices continue to fall. As a result, a large portion of maturing CRE loans will fail to qualify for refinancing.

This refinancing risk could trigger a wave of defaults and increase losses for banks.





Implications



CRE prices will fall further, losses on CRE loans will grow and refinancing risk could create a significant shock to the system



The U.S. economy is likely to remain weak in 2H09 and 2010, employment conditions

could deteriorate further, and unlike the housing market, CRE has not shown any signs of reaching a bottom. As a result, further price declines are likely and losses on CRE mortgages will grow.

In particular, the wave of CRE loans scheduled to mature in 2009~2010 will face difficulties in refinancing amid the ongoing decline in CRE prices. As a result, defaults will rise sharply.



CRE mortgages pose a greater threat to small-to-mid size banks, and deterioration

in the CRE markets will lead to a rising number of bank failures



CRE mortgages account for a larger portion of the loan portfolio for small-to-mid size

banks than for large banks, and growing losses on CRE mortgages could cause a large number of small-to-mid size banks to fail.