With the credit markets seized, the avalanche of bad news surrounding investment banking giants Lehman Brothers and Merrill Lynch and insurance provider AIG has caused 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 international real estate assets.

The question now is, 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 auction block, according to David Akeman, director in the capital markets group of Stan Johnson Company, a Tulsa, Okla.-based commercial real estate investment firm. Before filing for bankruptcy last week, Lehman had planned 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 its September 14 bankruptcy filing, Lehman will not likely 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. Its domestic CMBS holdings make up between $600 million and $900 million.

Meanwhile, given the perception of risk that goes along with CMBS, Bank of America will also try to get rid of Merrill’s commercial holdings, says Akeman. As of March, 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, says 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 worsen.

“If companies are forced to de-leverage, it takes a mild recession and pushes it deeper,” says Mulvee. “If corporations de-leverage, we are losing jobs, and if we are losing jobs, the demand for real estate is falling.”

For now, nobody dares 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’s promise this week to provide an $85 billion loan in exchange for an 80 percent ownership stake in the company. Since AIG requires more time to deal with its problems, the cash infusion should help it survive the credit crisis, says Weissburg. In fact, industry insiders hope the government will bail out the financial services sector wholesale, with its $700 billion buyout package aimed at soaking up hard-to-trade securities. While the attention has largely been focused on residential mortgages, industry lobbyists are pushing for CMBS bonds to be included.

“Certainly, any action must include commercial real estate mortgages and commercial real estate mortgage-backed securities in the targeted class of illiquid assets,” said Real Estate Roundtable President and CEO Jeffery DeBoer in a statement.

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

--Elaine Misonzhnik