The residential real estate market is drowning in foreclosures as the crisis there continues to broaden and worsen. RealtyTrac this week announced that foreclosures were up in 65% of U.S. metro areas, although some of the hardest-hit areas are recovering.

Why isn't there a comparable flood of commercial foreclosures?

Lending during the peak bubble years of 2005 to 2007 made as little sense in commercial lending as it did in residential lending. For example, the infamous "liar's loans" in the residential market, which allowed mortgage originators and their clients to report mythical income streams to justify huge loans, were paralleled in the commercial market by loans based on inflated revenue projections, rather than actual income.

Sham Transactions

From September 2001 through October 2005, Walter Hackett was a vice president for California's PFF Bank & Trust and oversaw the Commercial Note Department, a position that gave him a clear window on some of the banking industry's bad practices. While he believes PFF Bank's practices were particularly egregious at the time, he believes it was nowhere near unique and as the bubble continued to inflate, its practices became relatively common.

Hackett put those practices in the context of lending decisions made to Empire Land, a real estate developer and speculator that was the bank's biggest client. Empire Land ultimately went belly up, a failure that was one of the causes of the bank's 2008 demise. Hackett explains that Empire created a number of subsidiaries and would "sell" a property from one to the other, inflating the price with each transaction.

These transactions were such shams that Empire didn't even transfer money among its entities. After Empire got the price of the property at the level it wanted, it asked PFF for a loan, seeking to use the parcel as collateral. Although Hackett uncovered the price inflating transactions, and although Empire was doing it with several properties, PFF decided to make the loan anyway, giving the client 65% of the inflated value.

"We were effectively making 'hard money' loans," says Hackett. "Those are loans made without regard to the borrower's ability to pay, you just look at what you could get if you took the collateral. The bank thought that since they were only lending 65% of the inflated property value there would be no problem." He added: "A local economist said housing prices in the area were 'bulletproof' and senior management believed him."

"Besieged by Lunatics"

The practices were a radical departure from traditional banking, Hackett noted:
"A lot of the stuff I saw over the years that made business sense was gone. I started to see bigger and bigger assumptions being made. It stopped being about the numbers and common sense. I heard people say things such as 'it's Bob doing the deal, so there's nothing to worry about. It's real estate, it's secured, there's no problem.' In 27 years I had never seen deals done that way. I started to feel like I was besieged by lunatics."
Proper paperwork became unimportant. On one deal involving Empire, the documents were so bad -- Hackett was concerned the contracts wouldn't be enforceable -- that he tried to stop the deal. He was overridden, and the loan was made. Hackett reported it to the Office of Thrift Supervision and his internal actions were deemed "whistleblowing" by the bank's internal attorneys.

One of the factors driving all the bad loan decisions, Hackett explains, was that the bank paid its loan officers commissions on each deal, which undermined loan quality just as much as the incentives given to residential mortgage brokers to steer clients into the most expensive loans did.

And even without assuming the worst of PFF Bank's practices were widespread, it's clear that bubble commercial real estate lending made no sense from a traditional banking perspective. Commercial real estate attorney Ed Mermelstein explains that in peak bubble markets such as New York, "where trillions of dollars were loaned out in a very short period of time -- 2005 to 2007 -- in both refinancing and acquisitions, that's when the lenders were lending on projections instead of actual revenue. That's where most of the equity has been lost. " He added: "Pretty much anything that traded hands in 2005 and 2007 is underwater or will be soon as expiring leases will be renewed at low rate."

Rather Than Foreclosure, "Extend and Pretend"

One spectacular deal failure has been the Stuyvesant Town housing complex in New York City, which is poised to go into foreclosure. But it's by no means the only deal done based on unrealistic revenue projections. New York City deals so "aggressively" priced that they had a hard time closing even at the peak of the bubble include the famous "lipstick building" on Third Avenue, 450 Park Avenue, and others. Most bubble properties, wherever they are in the country, aren't being foreclosed on. Instead lenders are engaging in what's derisively referred to as "extend and pretend."

Apparently, the banks don't dare foreclose, because it would devastate their balance sheets. As Mermelstein notes: "The way the value of the properties is determined plays a big part in the calculus [of whether or not to foreclose]. The residential market just has a lot more comparable sales. In the commercial real estate market there's a lot less volume, so there's a lot less ability to get a price point."

Or to put it another way, commercial real estate is a relatively illiquid asset, and if banks foreclose in any volume, "fire sale" prices will be set and determine how other assets are "marked to market" (that is, using an asset's actual market value on the bank's balance sheet), which would devastate bank balance sheets.

Sounds familiar. Remember when the banks worked so hard to eliminate "mark to market" accounting for the various collateralized debt obligations, mortgage backed securities and other "complex illiquid assets" on their books? And just as with those assets, regulators accommodated the banks on commercial real estate accounting, making it easier to "extend and pretend" in October 2009. Indeed, the FDIC's Shelia Bair defended the practice recently.

Bloomberg reports that some lenders may be getting a little more honest -- at least the lenders say they will next year -- and engage in "extend and amend." In some markets, such as hard-hit Las Vegas, it's possible that the foreclosures will start happening.

It's unlikely that many of the big banks will do mass foreclosures, however, because of the potential balance-sheet damage. Mermelstein notes that as things stand now, "In commercial real estate, banks can write loan losses down in smaller pieces over a longer period of time, you know, balance sheet window dressing, like the way the banks took debt off their books to report at quarter's end."

Why would they want to give that up?

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wbischo

The banks don't foreclose on the wealthy owners of Commercial Real Estate. In fact in some cities accross the country, the majority of owners of Commercial property are rich foreigners who are buying up our best properties. Look at the names of the owners of the businesses in your town and check which countries in which they claim their citizenship. Pretty soon, we won't have to worry about "sending jobs outside the country", WE will be supporing workers from other countries right here at home, with our own "low wages and no benefits". It is already happening. Who do you think is going to end up owning the "ghost cities" created by the Bush created recession? Our economy is coming back and getting stronger, but I doubt that it will ever be the economy of ten years ago.

November 01 2010 at 3:27 AM Report abuse -2 rate up rate down Reply
Lazarko

I was a Realtor for 12 years struggled in a bad market. Thought I'd become a writer and quite in 2002 just as prices rose. Now I never in my wildest dreams saw what was coming. "GREED," became the norm and many retired millionaires. At what cost to their "SOULS?" I can sleep well at night, poor yes but with no regrets or nightmares from sleezy business deals. I am appalled by the people who scamed and literally brought down our Nation. It started in DC with Fannie Mae-Freddie Mac (Barney Frank) etc. Unless Washington is cleaned up and these Bankers-Brokers-Lenders etc. are brought up on charges or made to explain before a real-genuine bi-partisan panel then we as Americans will get Screwed-Again...!

November 01 2010 at 2:21 AM Report abuse +3 rate up rate down Reply
dugandean

I'm in this business. There haven't been many foreclosures, but give it another six months.......

November 01 2010 at 1:32 AM Report abuse +3 rate up rate down Reply
Linda

there may not be a crisis YET in the Commercial Real Estate., BUT...where I live, there sure are A LOT of empty stores that were occupied last year.

October 31 2010 at 11:35 PM Report abuse +3 rate up rate down Reply
Richard

Odd, but in all the rant thrown at us by politicians from both parties - NOBODY has mentioned the words TERM LIMITS!! What "we the people" should demand above everything else is a method of QUICKLY getting rid of the political hacks and racketeers.

October 31 2010 at 9:53 PM Report abuse +4 rate up rate down Reply
2 replies to Richard's comment
sfamilyent

With periodic elections, we essentially have term limits as determined by the voters. If "we the people" happen to like what a particular politician does during their present term, "we the people" can choose to keep them in office for another term. If "we the people" don't like the actions of an elected official, "we the people" can replace them. My state has term limits, and the churning is proving to be counter productive. Newly elected representatives, senators and governors very rarely hit the ground running.

November 01 2010 at 6:25 AM Report abuse -2 rate up rate down Reply
PAULA

Yes I agree, Richard term limits are the way to go . It not for us to ask for it is for us to demand, we are the employer, they are the employee's, and short term limits, we have entirly to many politians at the trough for 20-30-40- yr's. This is not a career they are supposed to be there to make the people's voices heard not to find some where to retirer.

November 01 2010 at 11:21 AM Report abuse +1 rate up rate down Reply
foolmeonce

This is only half of the story. The commerical crash has not come because banks are manipulating their books and not foreclosing because if they did the commerical properties would far devalue compared to residential real estate. So these banks are still not getting their mortgage payments and the FEDs are probably giving free monies to these big banks so they can hold on to these dead assets longer then usual. Manipulation, manipulation and manipulation... Sad, but we thought that communism, dictators and or terrorism was going to bring down our nation - but we managed to do it all by ourselves without anyone's help.

October 31 2010 at 8:52 PM Report abuse +4 rate up rate down Reply
rpic436842

the days of reckoning will soon be upon us all!

October 31 2010 at 7:35 PM Report abuse +3 rate up rate down Reply
Vince

I blame these economic problems on 3 groups, Realtors who should know the people they sell to cant afford what they are buying. Loan officers who should know who can afford it and who cant if they are not cheats. And the idiot buyer making $9 to $15 / hr should know they cant afford to buy a $250K house or higher especially with an adjustable rate.What were these people thinking?

October 31 2010 at 7:10 PM Report abuse +5 rate up rate down Reply
ginotortelli

Basically, the rich keep on getting richer and the middle class pays for it. The banks are protecting themselves by protecting their rich friends. They couldn't care less about those of us in the middle class. They are foreclosing on our homes and their rich friends are buying them up in droves. Then they rent them back to us for a profit. When the dust finally starts to clear, we will all be paying inflated prices for these former foreclosures so the rich can get even richer. I am glad that I am as old as I am. I am hoping to die long before the revolution between the "haves" and "have nots" begins. I just feel sorry for my children and grandchildren. At least this can't be blamed on President Obama. This whole mess was started AND fell apart during the Bush administration. Even the bailouts for the big banks and Wall Street were put in motion by Bush and his cronies.

October 31 2010 at 6:49 PM Report abuse -5 rate up rate down Reply
tr

ALL I CAN SAY IS THANK GOD THE RECESSION ENDED IN JUNE 09.YEAH RIGHT.

October 31 2010 at 6:03 PM Report abuse +9 rate up rate down Reply