“The Continued Risk of Troubled Assets”, the latest report from the Congressional Oversight Panel (COP), points out the ongoing risks that commercial and residential mortgage-backed securities (CMBS and RMBS, respectively), along with other illiquid troubled assets, pose for financial institutions and the financial system.

Despite being a key spark that ignited the financial crisis and the headline focus of several of the most significant government programs — such as TARP, TALF and PPIP — these troubled assets continue to weigh on both bank balance sheets and the overall health of the financial system. I believe that they present particular risks for the eventual recovery of the commercial real estate sector.

The COP report estimates that a substantial portion of real estate-backed securities and whole loans remain on bank balance sheets. While the value of these assets has been written down substantially from the high marks preceding the recession, the lack of liquidity in the market and weakening fundamentals suggest that values may still be overstated.

In addition, tweaks in mark-to-market accounting rules that allow banks to carry troubled assets on their books at potentially higher than market values is further obscuring the actual risks. The report notes that additional losses threaten the viability of many financial institutions, particularly smaller banks, and that “the future performance of the economy and the performance of the underlying loans, as well as the method of valuation of the assets, are critical to the continued operation of the banks.”

The problem of troubled assets is especially serious for the balance sheets of small regional banks, whose assets are generally whole loans, as opposed to securitized loans, and which tend to have a much higher concentration of commercial real estate loans. The recent report that more than 400 banks are currently on the FDIC’s “Problem Institutions” list highlights the continued risk of additional bank failures.

Federal government provides triage

The Troubled Asset Relief Program (TARP), as initially conceived by former Treasury Secretary Hank Paulson, was intended to directly address the risks of troubled assets by purchasing them from financial institutions. That plan quickly gave way, however, to direct capital infusions to banks, which now total more than $360 billion.

I believe that the capital infusions provided stabilization to the financial markets and allowed banks to write down asset values while avoiding insolvency. They did not, however, address the complexities and risks of troubled assets directly. Nonetheless, 10 of the 13 banks that originally received TARP funds have been authorized to make repayments.

The Term Asset-Backed Securities Loan Facility (TALF) program was initially intended to support consumer-related asset-backed securities (ABS), such as credit card and auto loan debt. The program was successful in generating new issuance of ABS in those areas.

In May, the government announced the expansion of TALF to include commercial mortgage-backed securities (CMBS) as a means to bring liquidity to that market and encourage new issuance. CMBS spreads declined in response to the announcement, with the AAA CMBX Index spread over swaps narrowing by about 200 basis points from late April through mid-May. The BBB CMBX Index spread over swaps declined by almost 2,500 basis points during the same period. (The spread to swaps indicates the difference between the yield on the CMBS bond and the 10-year Treasury rate, with a smaller difference indicating a lower perceived risk in the CMBS bonds.)

The TALF program operates by providing low-interest loans to CMBS and other ABS purchasers. For CMBS, the rate is determined by the loan term. For example, a three-year loan is priced at 100 basis points over the three-year London Interbank Offered Rate (LIBOR) swap rate. A five-year loan is priced at 150 basis points over the five-year LIBOR swap rate.

TALF requires the borrower to contribute equity (the “haircut”) of at least 15% of the par value for any CMBS with an average life of five years or less, plus an additional 1% for each average life year above five. Assuming a legacy CMBS with a par value of $100 and a five-year weighted average life, the 15% base haircut would apply as follows:
• If the applicable price is 100% of par ($100), the Federal Reserve would provide a loan of $85 (100/15) and the collateral haircut is 15% (15/100) of the applicable price.
• If the applicable price is 75% of par ($75), the Federal Reserve would provide a loan of $60 (75-15) and the collateral haircut is 20% (15/75) of the applicable price.

Notice that the size of the haircut increases with the size of the discount from par. This is a means of recognizing that large discounts from par generally indicate higher credit concerns. Only the highest-rated CMBS tranches are eligible for TALF financing, to further mitigate the risk to the Federal Reserve.

Recent discussions by Standard & Poor’s about changes to its rating methodology that could result in significant downgrades are posing a potential stumbling block for the program. The Fed recently announced that the TALF program for legacy CMBS will be extended by three months to March 31, 2010. The program for newly issued CMBS was extended to June 30, 2010.

The Fed has conducted three TALF auctions for CMBS assets to date. The first, in June, attracted no loan requests. The second, in July, resulted in $669 million in funding for legacy (pre-2009) CMBS assets. The August date saw requests for $2.8 billion for legacy assets. I believe the increasing volume is an encouraging sign. While no new CMBS has been issued with TALF backing at this point, most observers do expect some new origination before the end of the year.

To the extent the TALF program contributes to the revitalization of the CMBS market, I believe that it presents significant upside for the commercial real estate industry. A renewed securitization market could help address the wave of refinancing that is coming due over the next several years.

Without additional opportunities for mortgage lending, expect to see increasing defaults and distress that will further impact asset values. I believe additional structural changes to the CMBS model are also needed, however, in order to restore confidence in the market. These changes may include revising the role of ratings agencies and requiring originators to keep some skin in the game.

Public-private solution gains traction

Where the TALF program provides low-interest loans to investors in CMBS to help stimulate that market, with a particular focus on generating new issuance, the Public-Private Investment Program (PPIP) was designed as a more direct means of addressing existing troubled assets. The PPIP allows for the establishment of public-private investment funds (PPIFs) to purchase existing real estate loans (legacy loans) and RMBS and CMBS bonds (legacy securities) from financial institutions. The PPIP may also stimulate new CMBS issuance if increasing prices for the AAA securities narrow the overall costs to originate new loans.

The PPIFs would be funded with a mix of private capital, government equity, and government-provided or government-backed debt. Using $75 billion to $100 billion of funds along with capital from private investors, the PPIP was originally expected to generate between $500 billion and $1 trillion to purchase these legacy assets, though the program has since been scaled back.

Despite some delays, there has been some progress on the legacy securities program, with the U.S. Treasury selecting nine asset managers in July. Those nine managers are now in the process of raising funds to invest in existing AAA-rated tranches of CMBS.

While details of the fund-raising efforts have not been released, press reports suggest that the managers are seeing interest from a wide range of investors, including pension funds and sovereign wealth funds. The managers are aiming to raise $10 billion, with the fund-raising period expected to end in October. The U.S. Treasury will invest $30 billion alongside the privately raised capital. In some cases, the PPIFs will likely also be able to use TALF funding to provide additional leverage for qualifying purchases.

While many observers believe that legacy loans represent one of the largest risks for financial institutions, particularly the smaller regional banks, progress on this aspect of the government programs has been limited. The program was intended to help address troubled whole loans by providing liquidity and financing for these assets, while also helping to establish market prices.

Under the legacy loans program, funds would purchase these assets from banks or directly from the FDIC. Private investors would invest equity capital and the FDIC would provide a guarantee for debt financing issued by the funds to purchase assets.

The legacy loans program under the PPIP now appears to be effectively on hold. The FDIC announced in July that it intends to test a funding mechanism in a sale of assets this summer, following a model similar to the Resolution Trust Corp. (RTC) in the 1990s. While the FDIC originally announced that it expected to solicit bids for this sale of receivership assets in July, there has not been any action to date.

Gap between buyers and sellers

The COP report points out that valuation remains the central issue underlying the potential success of the PPIP programs. The intended effect of the program is to initiate an upward cycle, with increasing investment in the CMBS market pushing prices up and ultimately stimulating new issuance.

The converse also is possible, however. If potential buyers’ prices remain below the level where institutions holding the assets are willing to sell, the market could remain stalled. Sellers are understandably hesitant to sell at any price that will require substantial additional write-downs, especially if they have faith in the long-term value of the assets.

In summary, despite steps taken to stabilize the situation, troubled assets may continue to be a drag on the performance of both financial institutions and a risk for the larger economy for some time to come. Those risks may have a significant impact on the future performance of commercial real estate, if troubled assets limit the availability of new financing.

David Lynn is managing director and head of U.S. research and investment strategy with ING Clarion based in New York.