Leaked Document Shows Fed Preparing For Next Mortgage Crisis

The rising defaults on commercial loans could lead to another banking crisis, although the Fed doesn’t seem to be ready to admit the problem. The significant risk is held by financial companies with large commercial loan portfolios and insufficient reserves. In the following post, Glenn Hall from The Street writes that the Fed should be dealing more openly with the threat.

Here we go again with all the regulatory silence and wishful thinking by banks that preceded the first mortgage meltdown. Meltdown part II could be in the making as defaults rise in the commercial real estate sector.

Behind closed doors, U.S. banking regulators appear to be “girding for a rerun” of the mortgage losses that nearly crippled the financial markets last year, according to a report in the Wall Street Journal citing an unpublished Federal Reserve report.

The Fed report concludes that U.S. banks are slow to take losses on their commercial real estate loans , the Journal reports, adding that the documents it obtained do not represent the Fed’s formal position. The point is ratified by a review of regulatory filings by the Journal, which found that banks with heavy exposure to commercial property loans set aside only 38 cents in reserves for every $1 in bad loans in the second quarter.

I don’t know what’s worse, the banks skimping on reserves and holding off on reporting losses in hope of a revival or the Fed for knowing about the problem and trying to keep it a secret. Someone at the Fed must feel the same way because the report somehow found its way to the media.

To illustrate the risk, Capmark Financial is singled out by the Journal as having only 11 cents in reserves for every $1 in bad loans in the second quarter. Capmark, you may recall, was previously part of General Motors’ GMAC lending arm before being taken over by an investor group that includes Kohlberg Kravis Roberts and Goldman Sachs (GS Quote).

Last month, Capmark acknowledged that it is teetering on bankruptcy and accepted a rescue deal from a group led by Warren Buffett. Capmark is a pretty good a barometer of the commercial property mortgage industry since it is among the top servicers of U.S. commercial real estate loans and the biggest for property in the rest of the world, according to the Mortgage Bankers Association.

The top servicer of commercial mortgages in the U.S. is Wells Fargo (WFC Quote), which was already in the top 5 before buying Wachovia, which is the biggest master and primary servicer of commercial bank and savings institution loans, according to the MBA. Wachovia also ranks at the top for warehouse facility mortgages.

GEMSA is the top credit company, pension funds, REITs, and investment funds servicer, PNC (PNC Quote) is the leading FHA and Ginnie Mae servicer and Capmark is first for other investor type loans, according to the MBA..

If you’re concerned about international exposure to commercial property loans, the leaders are Hatfield Philips, Deutsche Bank (DB Quote) and GEMSA, according to the MBA.

And those are just the servicers. Banks and thrifts hold roughly half of outstanding commercial property loans, representing $1.6 trillion of debt, according to Commercial Property Executive, which concluded that the highest default risk is for loans originated in 2006-2007 boom , when “commercial properties were valued far too highly in those days, and are now underwater.”

In case you’re wondering whether the commercial real estate sector is really at risk, consider that defaults on loans to the sector rose to 2.88% in the third quarter from 2.25% in the second quarter, which was already the highest level since 1994, according to an analysis of FDIC data by Real Estate Econometrics.

Real Estate Econometrics projects that the default rate will swell to 4.2% by the end of this year and peak in 2011 and the group warns that the largest losses will occur at regional and community banks.

All things considered, it seems like something the Fed should be talking about more openly and that banks should be addressing more quickly.

Nobody wants a rerun of the mortgage meltdown.

This post has been republished from The Street.