When General Growth, the big mall owner, declared bankruptcy last week, experts speculated that large banks were about to face another string of losses from commercial real estate. Bank stocks have been down over the last trading week and the Chapter 11 filing of the mall company has done little to support them. But, the size of the trouble did not get much press until Morgan Stanley (MS) announced earnings. It took a $1 billion net loss on its commercial real estate holdings. Investors should appropriately fear that the Morgan Stanley problem is only the beginning of what will be a long series of similar charges at the money center banks.

It is odd that it has not been a greater investor concern. Commercial real estate suffers from the same issues that have done such damage to the home mortgage industry. Many properties were bought near the top of the market. Banks were willing lenders, assuming that the inflation in lease values would rise in malls and office buildings. Vacancy rates were low. How could anyone pass up such an outstanding investment?

Commercial real estate could be hit harder than residential in some areas. Buildings and shopping centers opened in the last year or two, or those in the process of being finished, may find it nearly impossible to attract tenants.  Buyers for an office complex will be hard to find even in a foreclosure. Maintenance costs are high. Tenants will most likely avoid empty buildings. Visitors find it unnerving to park in an empty lot and walk through a lobby with no security.

The Treasury keeps insisting that the $110 billion it has left in the TARP money is adequate for any bank funding problems that arise out of the credit crisis. If commercial real estate values drop at an accelerating rate and bank write-offs jump into the billions of dollars, the money to repair the balance sheet damage is going to have to come from somewhere.  The American banking industry is not staging the kind of recovery that would guarantee that losses have hit their worst levels, since there are increasing consumer credit card default rates and failing corporate loans on which many companies can no longer make interest payments.

The Financial Times recently reported on data about commercial real estate from Fitch, one of the three large credit ratings agencies. The paper wrote that “Fitch said properties were increasingly financed with no money down or even with loans for more than 100 per cent of a property’s value as owners borrowed greater amounts upfront to pay interest costs, betting that cash flows would improve quickly enough for the property to be self-sustaining.”

This means that what people did on a small scale with home mortgages they did on a larger scale with buildings and malls. General Growth has about $27 billion in debt. It is too early to say how much of that can be recouped though asset sales, but with commercial real estate defaults growing, all of the excess inventory will cause prices to drop, perhaps precipitously.

Since Wall St. loved, up until recently, to package financial products into intricate bundles of derivatives, it is not likely that commercial mortgages were left out of that process. While the problems of exotic commercial paper instruments are not going to be as large as mortgage-backed securities, they will still be significant.

Wall St. Keeps looking for an end to the deleveraging process, the pot at the end of the rainbow where all of the debt in the world is covered by assets with conservative valuations. There are a bunch of leprechauns searching for the same thing. They can send up a smoke signal when they find it.

Douglas A. McIntyre

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