Fed May Need to Recast TALF on Commercial Real Estate (Update2)

Feb. 23 (Bloomberg) -- The Federal Reserve may need to loosen the terms of a new $1 trillion credit initiative aimed at averting a meltdown in commercial mortgage-backed securities, analysts and industry representatives said.

The Fed would prop up the CMBS market by lending against the securities for a five-year term rather than three years, and taking as collateral existing debt rather than just new bonds, they said. The Fed hasn’t said when the program, the Term Asset- Backed Securities Loan Facility, will begin accepting the debt.

“If we don’t get credit flowing again to commercial real estate” through programs like the TALF, “we’ll probably see a very significant increase in defaults on commercial mortgages and further stress on the balance sheets of banks,” said Richard Parkus, an analyst at Deutsche Bank AG in New York.

Failure by the Fed and Treasury to rekindle private investment in the $760 billion CMBS market may worsen the longest U.S. recession since 1982. Fed Chairman Ben S. Bernanke and Treasury Secretary Timothy Geithner are promoting the TALF as a cornerstone of plans to revive credit, end a decline in home prices and cleanse toxic assets from banks’ balance sheets.

The market for commercial mortgages bundled together and sold as bonds is souring, with the late payment rate for CMBS at 1.44 percent at the end of last year compared with 0.47 percent at the end of 2007, according to RBS Greenwich Capital data. The delinquency rate may rise to almost 6 percent by the end of the year and continue to increase into 2011, RBS said.

New Collateral

The Fed, through the TALF, could reduce the cost of financing commercial real estate by taking as collateral CMBS already traded in the secondary market rather just new bonds, said RBS analyst Lisa Pendergast in Greenwich, Connecticut.

Accepting bonds from the secondary market would be a “big deal” for reviving credit, said Jan Sternin, a senior vice president at the Mortgage Bankers Association in Washington.

The central bank also should make loans with at least a five-year term against CMBS, Pendergast said. The TALF is now geared to make loans of no more than three years against collateral, a misalignment with the typical five- or 10-year term of commercial mortgages.

“Nobody would buy a 10-year asset with a three-year loan,” she said.

The Fed initially proposed a one-year term for TALF loans it will make before revising to a three-year period in December.

Without TALF support, borrowers would have a tougher time refinancing maturing debt and avoiding delinquency or foreclosure, said Chip Rodgers, senior vice president at the Real Estate Roundtable, a trade group in Washington.

Seed Money

Geithner has backed using the TALF to aid commercial real estate and proposed increasing the Treasury’s seed money for the program to $100 billion from $20 billion. The Fed would then expand its loans to $1 trillion from $200 billion.

Bernanke said on Feb. 18 that the first phase of the TALF will begin “shortly.” That includes as much as $200 billion in loans for the auto, education, credit-card and small-business markets. The Fed has yet to provide details on the second phase, which would include CMBS and expand to $1 trillion.

The Fed chief may provide more details on the TALF when he delivers semiannual testimony to Congress tomorrow and the next day.

Atlanta Fed President Dennis Lockhart said today that commercial real estate is “the one domestic factor that keeps me up at night.”

“Many banks are pretty heavily exposed to commercial real estate,” he said in Orlando, Florida.

Sales Plummeted

Sales of CMBS plummeted to $12.2 billion last year, compared with a record $237 billion in 2007, according to estimates by JPMorgan Chase & Co.

Top-rated commercial mortgage bonds are currently trading at about 10.82 percentage points more than benchmark interest rates, compared with 2.32 percentage points a year ago, Bank of America Corp. data show. In January 2007, the debt traded at 0.22 percentage point.

Without the TALF, the high cost to sell the debt makes it unprofitable for investment banks to write new loans, choking off funding to commercial property owners.

Banks can’t profitably originate new loans at attractive rates for refinancing because the cost to securitize the mortgages and sell the resulting bonds would be too high given the current trading price for the securities.

By accepting CMBS already trading on the secondary market, the central bank could revive demand, making it cheaper to sell the securities and enabling lenders to offer lower rates, Pendergast said.

The Fed may compound the long-term burden on its balance sheet by taking on CMBS. The central bank has already doubled its assets to $1.92 trillion in the past year by creating other emergency credit programs.

‘Reverse Course’

Buying assets with terms of five to 10 years “poses a problem for the Fed in monetary policy, because in the longer run at some point they’re going to have to reverse course,” said former Atlanta Fed research director Robert Eisenbeis, now chief monetary economist with Cumberland Advisors.

The central bank may have to take losses on the assets or face higher costs of carrying them, he said.

The Fed may expand the TALF to include residential mortgage- backed securities for loans bigger than $417,000 and assets collateralized by corporate debt, the Treasury said on Feb. 10.

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net; Sarah Mulholland in New York at smulholland3@bloomberg.net.

To contact the editor responsible for this story: Chris Anstey at canstey@bloomberg.net; Robert Burgess at bburgess@bloomberg.net.