Between September 19, the Friday before investment bank Lehman Brothers filed for bankruptcy protection, and October 15, the day the U.S. government invested $125 billion directly in nine major U.S. banks, the world financial system roiled as part of the worst financial crisis since the Great Depression.

That downward spiral came to an end — at least temporarily — when Treasury Secretary Henry Paulson opted to directly recapitalize banks (a move he had derided weeks earlier), rather than spending the entire $700 billion authorized by the Emergency Economic Stabilization Act to buy toxic assets from banks at above-market prices. That move helped begin to thaw frozen short-term lending markets. Along with Paulson's about-face, central banks and governments across the world took an unprecedented set of actions during that four-week period. Coordinated global interest rate cuts, promises to insure all manner of deposits, bank recapitalizations in Europe, the Federal Reserve's direct intervention in the commercial paper market and other measures were all adopted.

After October 15, the jittery short-term lending market began to ease from crisis levels. (They began to seize again on October 24, as Retail Traffic went to press). The TED spread is an indicator of perceived credit risk. The spread, the difference between the interest rates for three-month U.S. Treasuries contracts and the three-month Eurodollars contract, hit 4.63 percent on October 10 — its highest level in decades. As of October 21, the TED spread had dropped to about 2.5 percent. That's a major relief, although it was still above where it sits in normal times, when the spread is less than 0.50 percent.

Despite the passing of the immediate crisis, the outlook for commercial real estate grew quite a bit darker during the month. The Morgan Stanley REIT index dropped 38 percent between September 19 and October 15 and was down 54 percent from its all-time high in February 2007. That's steeper than the drop in the Dow Jones Industrial Average, which fell 22 percent during the month of crisis and was down about 36 percent from its high in October 2007.

Several public retail real estate companies face major problems. Australian limited property trust Centro Properties Group, the fifth largest owner of retail real estate in the U.S., may not survive the crisis as it continues to struggle to find ways to refinance or pay down its debt. The second largest regional mall REIT, General Growth Properties, may be facing bankruptcy or a forced sale because of its debt load. The smallest mall REIT, Great Neck, N.Y.-based Feldman Mall Properties, was dropped from the New York Stock Exchange and said it might not be able to continue as a going concern past the end of 2008. And in late October, Beachwood, Ohio-based Developers Diversified Realty got hit with a flurry of bad news. Its CEO was forced to sell stock in the company because of a margin call. It was deeply affected by Mervyns LLC's decision to switch from Chapter 11 to Chapter 7 bankruptcy. The company has 38 Mervyns at its 730 malls. It is also drastically slowing its international development in Brazil and Russia. Ultimately, analysts don't see Developers Diversified in quite the same straits as General Growth or Centro, but it's another reminder that things are changing at alarming speed in the current environment.

Despite all that, there is a case to be made that the most severe part of the crisis is over, even if the financial system is not fully out of the woods just yet. At the same time, the four-week stretch brought with it many earth-shattering developments that on their own would typically be analyzed and digested for days or weeks. Instead, these moves occurred at such a blitzkrieg pace that few have begun to take stock of the implications for the retail real estate sector. To sum up, the financial world witnessed the bankruptcy of Lehman Brothers, the acquisition of Merrill Lynch by Bank of America, the conversion to bank holding companies by Morgan Stanley and Goldman Sachs, the collapse of Washington Mutual, the acquisition of Wachovia by Wells Fargo, the potential suspension of mark-to-market accounting and the ability of the government to purchase mortgage assets, both residential and commercial mortgage-backed securities, as well as whole loans. Lastly, before the fall, many had hoped for a shallow and short recession. Now many observers think the U.S. economy could be facing its deepest and longest recession since the 1970s. All of this will have an effect on retail real estate.

In the following pages, Retail Traffic breaks down the bailout, the falls of Wachovia and Washington Mutual and the extinction of the five large investment banks and how they will affect the industry going forward.

What’s In It for Me?

The bailout gives the government the ability to buy CMBS and suspend mark-to-market accounting.

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.

Transforming the Banking Sector

Mergers and acquisitions have major ramifications for retail real estate lending.

It’s not unusual to see two or three bank failures a year, either from fraud or abuse of power or something less criminal, like mismanagement of funds. This year, however, the number of bank failures stands at 13 and more than 100 banks are on the FDIC’s failure watch list. Some analysts peg the number of possible failures even higher—up to 1,400.

Perhaps most surprising is the fact that two of the banks that failed—Washington Mutual Inc. and Wachovia—were among the largest banks in the United States. And even more disheartening for commercial property owners, Wachovia was one of the largest players in the commercial real estate financing arena, according to the MBA.

The fallout for retail real estate owners is considerable. Bob Seiwert, head of the American Bankers Association’s Center for Commercial Banking and Business Lending, says commercial real estate players looking for debt—regardless of whether the loan is for a new development, acquisition or refinancing—aren’t likely to get money from a bank or a thrift. And marginal borrowers or borrowers with a limited or no track record are completely shut out of the market.

According to the FDIC’s second quarter report, which is the most recent, commercial banks and thrifts had core capital equal to 7.9 percent of their assets. The FDIC says a “well capitalized” bank needs 6 percent. By that measure, more than 99 percent of the assets of banks and thrifts are held in well-capitalized banks. Seiwert says plenty of banks have overdosed on real estate and have decided to focus on business lines. For some banks, the fear of what a lengthy recession would do to commercial real estate is enough to prevent them from issuing any new loans.

The FDIC stepped in with enough time to save Wachovia from total failure, although the bank is being acquired by Wells Fargo. The $13.5 billion acquisition of Wachovia gives the company the most bank branches in the U.S. and would rival Bank of America Corp. in terms of deposits.

But the big effect of Wachovia’s merger with Wells Fargo won’t be on the tenant side, it will be on the lending side. Wachovia and Wells Fargo ranked Number One and Number Two on the Mortgage Bankers Association’s Annual Originations Ranking in 2007. Wachovia led the way with originations worth $90.4 billion. Wells Fargo was not far behind at $71.7 billion. Furthermore, Wells Fargo ranked as the largest intermediary with $32.5 billion in that business in 2007 while Wachovia ranked fourth with $15.7 billion. On retail specifically, Wachovia ranked first with $10.8 billion in originations and Wells Fargo second with $6.8 billion.

Merrill Lynch analyst Ed Najarian noted that Wachovia’s commercial and commercial real estate loan portfolios had aggregate delinquent and non-accrual loans of $6.3 billion—more than the nation’s six largest banks. Wachovia’s total delinquent and non-accrual loans were $21.7 billion at the end of the second quarter. Moreover, the company said it would take write-downs of more than $1 billion for commercial loans for the second half of 2007.

But in the case of Washington Mutual, or WaMu, it was residential real estate rather than commercial real estate that caused its problems. With more than 43,000 employees, roughly 2,200 branch offices in 15 states and $188.3 billion in deposits, WaMu specialized in providing home mortgages, credit cards and other retail lending products and services. It also had a significant multifamily lending group.

The housing downturn put WaMu under significant pressure, leading to three straight quarters of losses totaling $6.1 billion. As of June 30, 2008, the bank held $118.9 billion in single-family loans on its books, including $52.9 billion in payment option adjustable rate mortgages and $16.1 billion in subprime mortgage loans. At that time, the bank’s management disclosed that its credit quality had deteriorated and that it would likely suffer as much as $19 billion in losses on its single-family residential portfolio.

Investment Banks?

If securitization does manage to reemerge,

It’s the end of an era. The big Wall Street investment banks that survived two World Wars, the Great Depression and the Asian financial crisis were taken down by single-family housing. Lehman Brothers is bankrupt, Bear, Stearns & Co. had to be rescued, Merrill Lynch sold itself to Bank of America and Morgan Stanley and Goldman Sachs converted to bank holding companies.

From residential and commercial mortgage-backed securities (CMBS) to collateralized debt obligations the big five investment banks sliced, diced, and packaged, making a lot of money for themselves and investors—until everything went haywire. At the apex the investment banks were voracious in originating or buying loans and then pushing them out the door in securitizations. The bounty for them was the fees they reaped. When the whole thing came crashing down, banks were sitting on billions in toxic loans they had not yet been able to put into new securities.

Most of these loans—now rotting as delinquencies and defaults rise—remain stuck on bank balance sheets. CMBS originations are down 98 percent. At the end of the third quarter, Goldman sat on $14.6 billion in commercial real estate assets including securities and whole loans, Lehman on $24 billion, Merrill on $19.2 billion and Morgan Stanley on $19.5 billion, according to research by Sanford Bernstein and Co., Inc.

A year ago, the entire industry thought the freeze on the securitization machine was just temporary. Today, however, there are real questions about whether the CMBS industry will ever again grow to be a $230 billion domestic business as it was in 2007.

The more optimistic analysts believe the movers and shakers will create new investment banks. And, these newcomers will be smarter, faster, and produce better-looking securities, says Ryan Krauch, principal of Mesa West Capital, a Los Angeles–based lender. “Investment banking and securitization are both viable models—they just need to be tweaked,” he says. Others aren’t as sure.

In a best-case scenario, the new investment banks will hopefully know that being over-leveraged is a death wish and won’t make the same mistakes of gambling $30 for every $1 they had, says Bill Conerly, president of Conerly Consulting, a Portland, Ore.–based financial consulting firm. However, the danger of over-leverage has cropped up repeatedly during the past two decades from the corporate raiders of the 1980 to notorious hedge fund Long-Term Capital Management in 1998. Despite these near misses in the past, investment banks got drunk on debt.

One idea that’s being bandied about is that if investment banks get back into securitization, they should be required to hold equity in the issuances they produce. This will force a greater level of scrutiny on the assets. This will also mean investment banks will be held accountable and can’t just wash their hands of the securitizations once they’ve made their fees, says Elizabeth Corey, chair of law firm Foley & Lardners’ Real Estate Practice.