Wall Street Gears for Its New Pain

After suffering a beating from their exposure to home loans, banks and securities firms are about to take their lumps from office towers, hotels and other commercial real estate. And the losses could last longer than those from the subprime shakeout. As the economy wobbles and financing costs rise because of the credit crunch, commercial-real-estate values are starting to slide, with analysts at Goldman Sachs Group Inc. projecting a decline of 21% to 26% in the next two years. That means misery for securities firms with large exposure to commercial-real-estate loans and commercial- mortgage-backed securities. William Tanona, a Goldman analyst, expects total write-downs of about $7.2 billion by Bear Stearns Cos., Citigroup Inc., J.P. Morgan Chase & Co., Lehman Brothers Holdings Inc., Merrill Lynch & Co. and Morgan Stanley in the first quarter. The six firms had combined commercial-real-estate exposure of $141 billion at the end of the fourth quarter. A team of Goldman analysts predicts the financial damage from commercial real estate could last as long as two years, which would mean "a significantly longer tail than subprime." That is because only 28% of commercial-real-estate loans have been packaged into securities since 1995, while about 80% of subprime loans have been securitized; the higher level of securitization subjects the subprime assets to more-immediate mark-to-market accounting, which is playing out in the form of the write-downs that are dominating headlines. Wall Street has set itself up for a hard fall in commercial real estate. Banks and securities firms are facing exposure from loans and financing commitments made on commercial-real-estate projects, property they own directly and commercial-mortgage-backed securities that no one wants to buy. If there is a silver lining to the latest dark cloud over Wall Street, it is that the excesses that overtook the U.S. housing market aren't as prevalent in commercial real estate. Overbuilding of shopping malls, office parks and other commercial property hasn't been rampant, although vacancy rates are climbing in such markets as Orange County, Calif., and Las Vegas, which have been hit by the weak housing market. Market values of commercial-mortgage-backed securities, which are pools of mortgages that are sliced up and sold to investors as bonds, are down about 5% since late last year, compared with declines of roughly 50% or more last year for some collateralized debt obligations. CDOs are debt pools of repackaged residential-mortgage bonds, and they have been brutally hit by losses on mortgage investments Overall, commercial-real-estate write-downs in the first quarter are expected to rival those for CDOs and leveraged loans. Mr. Tanona predicted write-downs of commercial-mortgage-backed securities should "intensify" in the first quarter to $7.2 billion from $1.8 billion in the fourth quarter. By comparison, he foresees first-quarter write-downs of $10 billion in CDOs and $5.8 billion in leveraged-loan commitments The sluggish economy will add more stress, because demand for office and retail space is likely to suffer. On the other hand, the commercial-property market hasn't seen the kind of excessive supply that caused property values to tumble in the last recession, which could help maintain real-estate prices. Still, it isn't easy to size up the potential damage. Financial firms' public reports "don't paint a full picture," says Peter Nerby, a credit analyst at Moody's Investors Service. For example, Morgan Stanley reports commercial-mortgage exposure before and after the effect of offsetting transactions, or hedges, while Bear, Goldman and Lehman don't. When times were good, underwriting commercial mortgage-backed securities was a bonanza for Wall Street. Global volume of those deals more than tripled to $294.8 billion last year from $85.8 billion in 2003, according to data tracker Dealogic. The surge helped fuel rising values on commercial property. But demand for commercial-mortgage-backed securities has plunged because investors want higher returns to compensate for growing risk. As a result, deal flow has slowed to a trickle, drying up a lucrative profit stream for investment banks. January was the first month in more than a decade in which not a single issue was sold, according to market participants.