With everything else that's happened since mid-September, Henry Paulson's bailout proposal, which grew from a three-page memo to a 450-page monstrosity, has almost become an afterthought. After lobbying hard and eventually winning approval of a plan centered on having the government purchase toxic securities from banks, Paulson instead used the first round of bailout funds to buy preferred equity in financial institutions. In the first infusion, Paulson took $125 billion and bought stakes in nine banks. He has set aside another $125 billion for smaller banks. However, that still leaves $450 billion that ostensibly will be used for Paulson's original purpose. However, some observers estimate that only $100 billion of the $700 billion in the original bailout will end up being spent as Paulson proposed.

That plan, officially known as the Troubled Asset Recovery Program or TARP, drew criticism from economists and from enraged voters. The commercial real estate industry, however, represented by roughly 20 associations and organizations, strongly supported the bailout bill in its original form.

ICSC, for example, lobbied aggressively for the bill in its original form, despite the fact that the organization received plenty of negative feedback from members who disapproved of the bill, according to ICSC's director of federal government relations Jennifer Platt. “This was the bill that was on the table and it was coming from a very free market administration…. They really had to believe this was the best course of action,” Platt says.

Yet the plan has raised a lot of red flags — the biggest relating to the fuzziness in how the government will determine the prices of mortgage securities. The plan calls for using a reverse auction. The U.S. Treasury will announce an amount it intends to buy and a maximum price it will pay. At this point sellers will offer the quantities they are willing to sell at that price. If the quantity of assets put forward for purchase exceeds what the Treasury announced it will buy, it will lower the price and solicit new bids.

One concern is that the government will end up paying too high a price, which would eliminate any chance of recouping its investments down the line. On the flip side, if the government pays too low a price, that would force banks to write down book values even further to the new market value, according to John McIlwain, a senior resident fellow with the Urban Land Institute.

John Cohrane, a professor of finance at the University of Chicago's School of Business, describes the Treasury's initial plan as a “nuclear option” and says the only way TARP can recapitalize banks is if the Treasury raises the market value of all mortgages and mortgage-backed securities. To do that, it will have to buy these assets, whether they're good or bad, at full maturity value.

Today, some residential mortgage-backed securities have been marked down to 20 to 25 cents on the dollar, while commercial mortgage-backed securities (CMBS) have been marked down to 60 to 80 cents on the dollar, according to Ted Jones, senior vice president and chief economist for Stewart Title Guaranty Co.

“The price is very hard to determine, and the Treasury has to keep in mind that it will be setting the market for other buyers,” McIlwain says. Even suspending mark-to-market rules, which the SEC has the power to do because of TARP, won't help because investors will still feel insecure about the true values of assets.

Moreover, banks and other financial institutions that own these mortgages and mortgage-backed securities might actually prefer foreclosure over selling to the Treasury Department if the price is too low. Obviously, this doesn't bode well for the residential real estate market, and the repercussions could be significant for the commercial real estate side as well, McIlwain says.

Even though the majority of commercial property loans are still performing, defaults are increasing. Delinquency rates ticked up in the second quarter, but remained at the lower end of their historical ranges, according to the Mortgage Bankers Association (MBA). For example, the 30+ day delinquency rate on CMBS loans rose 0.05 percentage points to 0.53 percent, and the 60+ day delinquency rate on loans held in life company portfolios rose 0.02 percentage points to 0.03 percent. But, most industry experts are expecting delinquencies to increase significantly, especially for retail real estate.

“We're seeing a lot of shopping centers that are just now being completed and they're empty because they haven't been pre-leased extensively,” says Ryan Krauch, principal of Mesa West Capital, a Los Angeles-based lender. “It's likely those centers will sit empty for a while.”

Krauch also points out that a number of retailers are over-levered and on bankruptcy watch because they might not be able to get the credit they need for operations. That means several existing centers will see vacancies increase, which ties directly into co-tenancy violations.

If the government does end up owning some of these distressed commercial properties and CMBS, it will likely have a hard time working through them, McIlwain contends, pointing out that it will own various tranches of residential and commercial mortgage-backed securities, along with collateralized debt obligations (CDOs) and structured investment vehicles (SIVs) made up of all the above. And that means dear old Uncle Sam could get stuck with pieces of loans but no authority to modify them.