As the credit markets remain frozen, the avalanche of bad news surrounding investment banking giants Lehman Brothers and Merrill Lynch and insurance provider AIG is causing a state of panic in the commercial real estate industry.

Merrill was exposed to about $18 billion between whole loans, conduits and direct real estate investments. Lehman, meanwhile, continues to hold $32.6 billion in commercial real estate between whole loans and CMBS bonds. About 11 percent of its portfolio is devoted to retail. AIG's exposure is harder to pin down. The company built up a $60 billion position in the credit default swaps market — some of which is tied to CMBS. The company also has $16 billion in real estate assets globally.

The question becomes, with Lehman in bankruptcy, Merrill Lynch in the process of being acquired by Bank of America and AIG sold off in parts by the government, what's going to happen to all those holdings?

In the case of Lehman and Merrill Lynch, their commercial real estate assets will likely end up on the sales block, according to David Akeman, director in the capital markets group of Stan Johnson Company, a Tulsa, Okla.-based commercial real estate investment firm. Just before filing for bankruptcy, Lehman was planning to spin off its commercial real estate portfolio into a stand-alone, publicly traded entity, Real Estate Investments Global, which would allow the bank to avoid a forced fire sale. But after the bankruptcy filing, Lehman will likely not be allowed to spin off one of its divisions, says Adam B. Weissburg, partner with Cox Castle Nicholson LLP, a Los Angeles-based real estate law firm.

Of Lehman's $32.6 billion commercial portfolio, $17 billion is located in the United States. Domestic CMBS holdings make up between $600 million and $900 million of that.

Meanwhile, given the perception of risk that goes with CMBS, the Bank of America will also try to get rid of Merrill's commercial holdings, says Akeman. As of March 2008, the firm held CMBS bonds worth $5 billion in its U.S. portfolio. The pressure to sell is bound to cause prices to drop in the commercial real estate market, according to Suzanne Mulvee, senior real estate economist with Property & Portfolio Research, a Boston-based real estate research and portfolio strategy firm, but the impact on the U.S. economy at large is likely to be even worse.

“If companies are forced to de-leverage, it takes a mild recession and pushes it deeper,” she notes. “If corporations de-leverage, we are losing jobs, and if we are losing jobs, the demand for real estate is falling.” At the moment, nobody dares to take a guess as to how much of a discount the banks will have to accept if they sell, but “it's not a good thing,” Mulvee adds.

AIG's situation gives more reason for hope, with the Federal Reserve promising to provide an $85 billion loan in exchange for an 80 percent ownership stake in the company. Since AIG just needed more time to deal with its problems, the cash infusion should help it survive the credit crisis, says Weissburg.

Most industry insiders hope the government is going to bail out the financial services sector wholesale, with a $700 billion package aimed at soaking up hard-to-trade securities. “I think it's the government's responsibility to try not to put those assets on the market at once, just because there is not enough capital out there to purchase them all at the same time,” says Jon Southard, principal and director of forecasting with CBRE | Torto Wheaton Research, a Boston-based research firm.

Meanwhile, even the people who work for Lehman Brothers don't know at this point what's going to happen with the firm's real estate portfolio, according to Merrie Frankel, vice president with Moody's Investors Service. “We are waiting to see where all this falls out,” she says.