The $400 Billion Time Bomb In Commercial MortgagesBrian Kellyupdated Jan 11, 2009TweetAt GET.com we maintain complete editorial integrity on our content & provide transparent & unbiased information. Companies don't pay us to include their products although we receive a compensation when you successfully apply to products from our partners. See how we make money here.At GET.com we maintain complete editorial integrity.The sub-prime mess could pale in comparison to the calamity that rising commercial mortgage delinquencies are threatening. Since the S&L crisis, commercial banks have increased their holdings of commercial mortgages at an accelerating rate. The Commercial Mortgage Security Association (CMSA) estimates that in 1991 commercial banks held $410 billion in mortgages and by 2006 banks held $1.28 trillion.The primary driver for banks holding so many commercial mortgages was the securitization market. Mortgage backed securities allowed banks to liquidate holdings via a commercial mortgage backed security (CMBS) or a collateralized debt obligation (CDO). In fact, bank holdings of commercial mortgages correlated with the growth in issuance of both CMBS and CDOs.This chart illustrates that CDO issuance was at its peak from 2005 to 2007, similar to the housing market. It is also easy to see that in 2008, CDO issuance has dropped precipitously. According to the CMSA, there have not been any CDO's issued since June 2008. A similar pattern is found with CMBS issuance.A reasonable person would look at the data and conclude that banks probably decreased holdings in commercial mortgages as the securitization market dried up...by now, we all know that the people running the banks are neither reasonable or rational.The irrational behavior is glaring, from Q1 2007 to Q3 2008 banks increased commercial loan holdings by 15% while the securitization market collapsed. It is now estimated that commercial banks hold 43% of the $3.4 trillion commercial mortgage loan market. In a previous post I discussed the rising delinquency rates in the commercial mortgage loan market. Deutsche Bank (DB) estimates that delinquencies will rise to 3% by the end of 2009. Interestingly, during the S&L crisis the delinquency rate rose to 30% and currently many CMBS are pricing in that scenario.A back of the envelope stress test for banks under various delinquency rates is presented below. The table was constructed using CMSA data for bank holdings of commercial mortgages totaling $1.493 trillion.The low end of the stress test is the 3% delinquency rate estimated by Deutsche Bank, while the upper bound is the delinquency rate being priced in to some CMBS. The billion dollar question is who is right? If the low end prevails then the banks are facing $44 billion of additional write-offs, and if the CMBS market is correct then losses soar to $447.9 billion. Recall that banks received $250 billion + to fill the hole caused by the residential mortgage market. And the 90+ day delinquency rate rate on sub-prime mortgages is running about 30%.According to the FDIC, 18% or $2.1 trillion of the $11.4 trillion residential mortgage loans outstanding are held by commercial banks. The commercial real estate market is smaller, but the banks hold a larger portion. The CMSA reports that 43% or $1.49 trillion of the $3.4 trillion commercial mortgage market is held by banks.Given that the current economic environment is much worse than during the S&L crisis, it is not hard to understand why the CMBS market is pricing for a 30% default rate. Since the banks own a higher percentage of commercial mortgages the resulting losses could be larger than the so called "sub-prime" losses. So while Congress debates whether or not the TARP was put to good use, the $400 billion commercial mortgage time bomb is ticking.Disclosure: I am long SKF and SRSEditorial Disclosure: Any personal views and opinions expressed by the author in this article are the author's own and do not necessarily reflect the viewpoint of GET.com. The editorial content on this page is not provided by any of the companies mentioned, and has not been reviewed, approved or otherwise endorsed by any of these entities. Opinions expressed here are author's alone, not those of the companies mentioned, and have not been reviewed, approved or otherwise endorsed by any of these entities.