A year after the collapse of Lehman Brothers and the impending threat of global economic meltdown, the Dow is back over 10,000 and economists optimistically say that the worst is behind us. Everyone now knows that last fall’s stock market crash stemmed from the bursting of the real estate bubble: excess lending led to a wave of foreclosures, triggering a catastrophic domino effect throughout the economy. Expert economists and bank regulators are now worried that a similar incident may be imminent in the commercial real estate sector.

“While there have been some positive signals of late, the financial system remains fragile and key trouble spots remain,” such as commercial real estate, U.S. Federal Reserve Board Governor Daniel Tarullo said.

With the US unemployment rate nearing 10% and more then seven million jobs lost during the current recession, the demand for office space has been minimal. Businesses are closing and downsizing, which in turn is creating an abundance of vacant commercial real estate properties. This has left leasers scrambling to fill empty offices and many developers defaulting on their loans. In the past year, the amount of delinquent commercial loans has more than doubled to over 9 percent.

Unlike the seemingly instantaneous effect that was felt from the residential real estate bubble, experts predict a “slow-motion car crash” scenario when it comes to commercial real estate. The effect is expected to be felt over a several year period, when many current commercial loans are due to reach maturity. From 2005-2007 there was a surge in five-year commercial real estate loans, meaning that the trouble is expected to be spaced out between 2010 and 2012.

According to an article from Reuters, at the end of September banks had roughly $1.7 trillion in commercial real estate loans on their books, accounting for about 15 percent of their assets. During their stress tests of 19 major banks in the spring, the government neglected to include the majority of regional and local lenders; these banks hold a considerable portion of the nation’s commercial property loans.

While many experts predict that large banks on the coasts have the capital required to be able to weather the storm, defaulted commercial loans could spell disaster for smaller regional banks in the middle of the country. Earlier this month the FDIC was forced to close Warren Bank in Michigan, who had 40 percent of its total loans—roughly $395 million—in commercial real estate. Similar closings are occurring in other Midwest states and are expected to increase in the coming year. Due to their small size, these banks shouldn’t holdout for the same type of government aid that the “too-big-to-fail” institutions received through the TARP.

Early this year the government launched the Term-Asset-Backed Securities Loan Facility to promote lending to consumers and small businesses, but opened the program to commercial real estate loans in June to help the problem. These measures will aid banks in managing the losses on their books, but won’t be enough to save a failing institution.

Just like in the residential real estate market, commercial real estate prices have been hit hard in the last year. Banks have been hesitant to recognize commercial real estate losses on their books, instead altering the terms in loans with the hope that the economy will improve. Giving delinquent borrowers leeway is a risky proposition, as banks may simply be delaying the inevitable. Currently the Fed and other federal bank regulators are devising a plan that will outline methods to help banks to account for their losses due to commercial real estate loans.

“We view it as a very key risk … and we have put a lot of emphasis on it,” said Jon Greenlee, associate director of the Fed’s division of banking supervision.

There are some beacons of hope in this otherwise bleak situation. Unlike the housing market, there wasn’t drastic overbuilding in commercial real estate, so it should be easier to stabilize prices. The commercial real estate market is only about the third of the size as its residential counterpart, and unlike families, commercial property owners are still able to collect rent. Therefore, it is in both parties interest—the banks and the property owners—to keep the buildings from going into default foreclosure. This should pave the way for negotiations and compromise between these parties.

The commercial real estate threat is further evidence of the interconnectedness of all sectors of the economy. Hopefully people will begin to learn from the mistakes of the past several years, but so far that doesn’t appear to be the case. Now financial institutions are beginning to employ the same fancy derivatives that led to the real estate meltdown, such as collateralized debt obligations and credit default swaps, to the healthcare sector: it sure didn’t take long for people to forget their past failures and indiscretions. Maybe more federal regulation, like an agency that regulates financial products and services, isn’t such a bad idea.

Although economists are claiming that the worst is over, the decisions that lenders, regulators and financial institutions make in the coming months will shape the fate of our economy for years to come.

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