[JPRT, 111th Congress]
[From the U.S. Government Publishing Office]


 
                     CONGRESSIONAL OVERSIGHT PANEL 

                      FEBRUARY OVERSIGHT REPORT * 

                               ----------                              

        COMMERCIAL REAL ESTATE LOSSES AND THE RISK TO FINANCIAL 
                               STABILITY

                  [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]


               February 10, 2010.--Ordered to be printed

    * Submitted under Section 125(b)(1) of Title 1 of the Emergency 
        Economic Stabilization Act of 2008, Pub. L. No. 110-343












        CONGRESSIONAL OVERSIGHT PANEL FEBRUARY OVERSIGHT REPORT












                     CONGRESSIONAL OVERSIGHT PANEL

                      FEBRUARY OVERSIGHT REPORT *

                               __________

        COMMERCIAL REAL ESTATE LOSSES AND THE RISK TO FINANCIAL 
                               STABILITY


                  [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

               February 10, 2010.--Ordered to be printed

    * Submitted under Section 125(b)(1) of Title 1 of the Emergency 
        Economic Stabilization Act of 2008, Pub. L. No. 110-343

                               ----------
                         U.S. GOVERNMENT PRINTING OFFICE 

54-785 PDF                       WASHINGTON : 2010 

For sale by the Superintendent of Documents, U.S. Government Printing 
Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; 
DC area (202) 512-1800 Fax: (202) 512-2104 Mail: Stop IDCC, 
Washington, DC 20402-0001 

















                     CONGRESSIONAL OVERSIGHT PANEL
                             Panel Members
                        Elizabeth Warren, Chair
                             Paul S. Atkins
                           Richard H. Neiman
                             Damon Silvers
                           J. Mark McWatters


















4                           C O N T E N T S

                               __________
                                                                   Page
Executive Summary................................................     1
Section One: February Report.....................................     4
    A. Introduction..............................................     4
    B. What is Commercial Real Estate?...........................     5
    C. History of Commercial Real Estate Concerns................    14
    D. Present Condition of Commercial Real Estate...............    23
    E. Scope of the Commercial Real Estate Markets...............    30
    F. Risks.....................................................    51
    G. Bank Capital; Financial and Regulatory Accounting Issues; 
      Counterparty Issues; and Workouts..........................    67
    H. Regulatory Guidance, the Stress Tests, and EESA...........    87
    I. The TARP..................................................   103
    J. Conclusion................................................   117
Annex I: The Commercial Real Estate Boom and Bust of the 1980s...   119
Section Two: Update on Warrants..................................   127
Section Three: Additional Views..................................   134
Section Four: Correspondence with Treasury Update................   138
Section Five: TARP Updates Since Last Report.....................   139
Section Six: Oversight Activities................................   152
Section Seven: About the Congressional Oversight Panel...........   153
Appendices:
    APPENDIX I: LETTER FROM SECRETARY TIMOTHY GEITHNER TO CHAIR 
      ELIZABETH WARREN, RE: PANEL QUESTIONS FOR CIT GROUP UNDER 
      CPP, DATED JANUARY 13, 2010................................   155
======================================================================


                       FEBRUARY OVERSIGHT REPORT

                                _______
                                

               February 10, 2010.--Ordered to be printed

                                _______
                                

                          EXECUTIVE SUMMARY *

---------------------------------------------------------------------------
    * The Panel adopted this report with a 5-0 vote on February 10, 
2010.
---------------------------------------------------------------------------
    Over the next few years, a wave of commercial real estate 
loan failures could threaten America's already-weakened 
financial system. The Congressional Oversight Panel is deeply 
concerned that commercial loan losses could jeopardize the 
stability of many banks, particularly the nation's mid-size and 
smaller banks, and that as the damage spreads beyond individual 
banks that it will contribute to prolonged weakness throughout 
the economy.
    Commercial real estate loans are taken out by developers to 
purchase, build, and maintain properties such as shopping 
centers, offices, hotels, and apartments. These loans have 
terms of three to ten years, but the monthly payments are not 
scheduled to repay the loan in that period. At the end of the 
initial term, the entire remaining balance of the loan comes 
due, and the borrower must take out a new loan to finance its 
continued ownership of the property. Banks and other commercial 
property lenders bear two primary risks: (1) a borrower may not 
be able to pay interest and principal during the loan's term, 
and (2) a borrower may not be able to get refinancing when the 
loan term ends. In either case, the loan will default and the 
property will face foreclosure.
    The problems facing commercial real estate have no single 
cause. The loans most likely to fail were made at the height of 
the real estate bubble when commercial real estate values had 
been driven above sustainable levels and loans; many were made 
carelessly in a rush for profit. Other loans were potentially 
sound when made but the severe recession has translated into 
fewer retail customers, less frequent vacations, decreased 
demand for office space, and a weaker apartment market, all 
increasing the likelihood of default on commercial real estate 
loans. Even borrowers who own profitable properties may be 
unable to refinance their loans as they face tightened 
underwriting standards, increased demands for additional 
investment by borrowers, and restricted credit.
    Between 2010 and 2014, about $1.4 trillion in commercial 
real estate loans will reach the end of their terms. Nearly 
half are at present ``underwater''--that is, the borrower owes 
more than the underlying property is currently worth. 
Commercial property values have fallen more than 40 percent 
since the beginning of 2007. Increased vacancy rates, which now 
range from eight percent for multifamily housing to 18 percent 
for office buildings, and falling rents, which have declined 40 
percent for office space and 33 percent for retail space, have 
exerted a powerful downward pressure on the value of commercial 
properties.
    The largest commercial real estate loan losses are 
projected for 2011 and beyond; losses at banks alone could 
range as high as $200-$300 billion. The stress tests conducted 
last year for 19 major financial institutions examined their 
capital reserves only through the end of 2010. Even more 
significantly, small and mid-sized banks were never subjected 
to any exercise comparable to the stress tests, despite the 
fact that small and mid-sized banks are proportionately even 
more exposed than their larger counterparts to commercial real 
estate loan losses.
    A significant wave of commercial mortgage defaults would 
trigger economic damage that could touch the lives of nearly 
every American. Empty office complexes, hotels, and retail 
stores could lead directly to lost jobs. Foreclosures on 
apartment complexes could push families out of their 
residences, even if they had never missed a rent payment. Banks 
that suffer, or are afraid of suffering, commercial mortgage 
losses could grow even more reluctant to lend, which could in 
turn further reduce access to credit for more businesses and 
families and accelerate a negative economic cycle.
    It is difficult to predict either the number of 
foreclosures to come or who will be most immediately affected. 
In the worst case scenario, hundreds more community and mid-
sized banks could face insolvency. Because these banks play a 
critical role in financing the small businesses that could help 
the American economy create new jobs, their widespread failure 
could disrupt local communities, undermine the economic 
recovery, and extend an already painful recession.
    There are no easy solutions to these problems. Although it 
endorses no specific proposals, the Panel identifies a number 
of possible interventions to contain the problem until the 
commercial real estate market can return to health. The Panel 
is clear that government cannot and should not keep every bank 
afloat. But neither should it turn a blind eye to the dangers 
of unnecessary bank failures and their impact on communities.
    The Panel believes that Treasury and bank supervisors must 
address forthrightly and transparently the threats facing the 
commercial real estate markets. The coming trouble in 
commercial real estate could pose painful problems for the 
communities, small businesses, and American families already 
struggling to make ends meet in today's exceptionally difficult 
economy.

           *         *         *         *         *

    This month's report also includes a brief summary of the 
status of the disposition of the warrants that Treasury has 
acquired in conjunction with its TARP investments in financial 
institutions. The Panel had conducted its own review of the 
initial results of Treasury's repurchases of warrants in its 
July Report (TARP Repayments, Including the Repurchase of Stock 
Warrants) and called for greater disclosure concerning 
Treasury's warrant disposition process and valuation 
methodology. In January, Treasury published its first report on 
the warrants. Treasury's warrant sales receipts up to this time 
total just over $4 billion, which is slightly more than 
Treasury's own internal model estimates their value, but 
slightly below (92 percent) the Panel's best estimate. The 
Panel now projects receipts from the sale or auction of TARP 
warrants--both those sold or auctioned to date and those yet to 
be disposed of--will total $9.3 billion.
                      SECTION ONE: FEBRUARY REPORT


                            A. Introduction

    Treasury is winding down the Troubled Asset Relief Program 
(TARP), although the Program has been extended until October 3, 
2010. The TARP financial assistance programs for banks and bank 
holding companies (BHCs) have ended, and all but six of the 
nation's largest BHCs have repaid the assistance they received; 
\1\ in total, 59 of the 708 institutions that participated in 
the financial assistance program have repaid fully.\2\ 
Simultaneously, however, federal financial supervisors and 
private analysts are expressing strong concern about the 
commercial real estate markets. Secretary Geithner's letter to 
Congressional leaders certifying his decision to extend the 
TARP cited as one of the reasons for the extension that 
``[c]ommercial real estate losses also weigh heavily on many 
small banks, impairing their ability to extend new loans.'' \3\
---------------------------------------------------------------------------
    \1\ Subject to the stress tests conducted by the federal bank 
supervisors in the first half of 2009.
    \2\  Although Citigroup repaid funds it had received under two TARP 
programs, Treasury owns $24.4 billion in common shares and therefore 
Citigroup is still participating in the CPP.
    \3\  Letter from Timothy F. Geithner, Secretary of the Treasury, to 
Nancy Pelosi, Speaker of the U.S. House of Representatives (Dec. 9, 
2009) (online at www.ustreas.gov/press/releases/reports/
pelosi%20letter.pdf).
---------------------------------------------------------------------------
    The financing of commercial real estate is not identical to 
that of residential real estate, nor is the way in which 
potential defaults can be avoided. Nonetheless, the two markets 
share core elements. Securitization of mortgage-backed loans is 
a major factor in both; securitization of loans is concentrated 
in large banks, while small banks generally hold whole loans on 
their books. The difficulties residential real estate has 
encountered and the difficulties commercial real estate has 
started to experience are a combination of the real estate 
bubble, the credit contraction, and the state of the economy. 
And of course, both types of loans play an essential role in 
financial institutions' operations, balance sheets, and capital 
adequacy.
    But the timing of the two sets of difficulties is 
different. Home mortgages started to default at unprecedented 
rates as the real estate bubble burst in 2007. Commercial real 
estate defaults are rising, but the consensus is that the full 
force of the problems in that sector and their impact on the 
nation's financial institutions will be felt over the next 
three years and beyond, after the TARP has expired.
    The relationship between the commercial real estate markets 
and the TARP has been a concern of the Panel for some time. The 
Panel began to study the issue in detail in May 2009 at a field 
hearing in New York City.\4\ Its August 2009 report on ``The 
Continued Risk of Troubled Assets'' \5\ contained a specific 
discussion of commercial real estate, and its June 2009 report 
on ``Stress Testing and Shoring Up Bank Capital'' \6\ noted the 
role of commercial real estate loss projections in the stress 
test computations. The Panel held its second field hearing on 
commercial real estate on January 27, 2010 in Atlanta, one of 
the nation's most depressed commercial real estate markets; 
this report reflects the testimony at that hearing.
---------------------------------------------------------------------------
    \4\ Congressional Oversight Panel, Field Hearing in New York City 
on Corporate and Commercial Real Estate Lending (May 28, 2009) (online 
at cop.senate.gov/hearings/library/hearing-052809-newyork.cfm).
    \5\ Congressional Oversight Panel, August Oversight Report: The 
Continued Risk of Troubled Assets, at 54-57 (Aug. 11, 2009) (online at 
cop.senate.gov/documents/cop-081109-report.pdf) (hereinafter ``COP 
August Oversight Report'').
    \6\ Congressional Oversight Panel, June Oversight Report: Stress 
Testing and Shoring Up Bank Capital, at 26, 41-43 (June 9, 2009) 
(online at cop.senate.gov/documents/cop-060909-report.pdf) (hereinafter 
``COP June Oversight Report'').
---------------------------------------------------------------------------
    The nation's bank supervisors expressed serious concern in 
2006 about the potential effect of the commercial real estate 
markets on the condition of the nation's banks. Congress 
specifically authorized Treasury to deal with commercial 
mortgages as part of the Emergency Economic Stabilization Act 
(EESA). But the direct attention paid to that subject by 
Treasury in its use, or planned use, of TARP funds has been 
relatively small.
    The most serious wave of commercial real estate 
difficulties is just now beginning; experts believe that the 
volume of bank write-downs and potential loan defaults may 
swell in the coming years, in the absence of a strong immediate 
improvement in the economy. This report examines the nature and 
potential impact of a second wave of property-based stress on 
the financial system--this time based on commercial rather than 
residential real estate. To do so, it begins by outlining the 
way commercial real estate is financed, explores the 
relationship between the state of commercial real estate today 
and the property bubble of 2005-2007, and highlights the all-
important impact of economic recovery on commercial real estate 
values and the health of commercial real estate loans. The 
report then details the nature, timing, and potential impact of 
the risks involved in commercial real estate and the ways banks 
and lenders can work to cushion the effect of temporary 
dislocations pending an economic recovery. It also briefly 
suggests ways in which the broader risks might be mitigated by 
a combination of government and private sector actions.
    These are not theoretical questions. The report examines 
the way these risks can directly affect ordinary citizens and 
businesses. A wave of foreclosures affecting multifamily 
housing, for example, can displace families or reduce the 
conditions in which they live. Mortgages on multifamily housing 
make up 26.5 percent of the nation's total stock of commercial 
real estate mortgages.\7\
---------------------------------------------------------------------------
    \7\ Board of Governors of the Federal Reserve System, Z.1 Flow of 
Funds Account of the United States (December 10, 2009) (online at 
www.federalreserve.gov/releases/Z1/Current/z1.pdf) (hereinafter 
``Federal Reserve Statistical Release Z.1'').
---------------------------------------------------------------------------
    Commercial real estate issues--most likely serious ones--
have been identified for several years, and the nation 
experienced a previous commercial real estate crisis during the 
1980s. How the financial system and the government deal now 
with a second wave of property-induced stress on the financial 
system will indicate what Treasury, the bank supervisors, and 
the private sector have learned from the last two years.

                   B. What is Commercial Real Estate?

    Although ``commercial real estate'' has a variety of 
definitions in academic and business literature, there are two 
general ways of thinking about it. Relevant guidance from the 
federal financial supervisors takes a straight-forward 
approach, defining commercial real estate as ``multifamily'' 
property, and ``nonfarm nonresidential'' property.\8\ This 
formulation reflects the division of the non-farm \9\ real 
estate markets into a single-family residential market 
(generally one to four family structures) and a largely 
separate commercial market, which includes practically all 
other property types.\10\
---------------------------------------------------------------------------
    \8\ See Board of Governors of the Federal Reserve System, Mortgage 
Debt Outstanding (Dec. 2009) (online at www.federalreserve.gov/
econresdata/releases/mortoutstand/current.htm).
    \9\ Id. As of the 3rd quarter of 2009, the total universe of real 
estate debt consisted of $10.85 trillion of residential mortgages, 
$3.43 trillion of commercial mortgages (including multifamily), and 
$132.28 billion of farm mortgages.
    \10\ See John P. Wiedemer, Real Estate Finance, Seventh Edition, at 
244 (1995) (hereinafter ``Real Estate Finance, Seventh Edition''). 
Following industry conventions, this report considers the 
``residential'' category to consist of single family homes and two- to 
four-unit multifamily properties. Although larger multifamily 
properties are considered by some definitions (and by the IRS) to be 
residential, they are more commonly included in the commercial category 
because of characteristics these properties share with other types of 
commercial property.
---------------------------------------------------------------------------
    That leads to the second defining characteristic, which 
goes to the core of any discussion of commercial real estate 
loans and financing. Commercial properties are generally 
income-producing assets, generating rental or other income and 
having a potential for capital appreciation.\11\ Unlike a 
residential property, the value of a commercial property 
depends largely on the amount of income that can be expected 
from the property.\12\
---------------------------------------------------------------------------
    \11\ Id., at 244-245. Some property types that do not produce 
traditional rental income are classified as commercial real estate. In 
the case of a property owned by the tenant (``corporate real estate''), 
such as a factory, the notional income generated by the structure is 
subsumed within the results of the broader enterprise. Institutional 
properties (e.g. museums, hospitals, schools, government buildings) are 
considered commercial property due to their many similarities to more 
traditional commercial property types, the fact that most of these 
properties produce cash flow of some type, and because the properties 
are financed in the commercial mortgage market. Land for development is 
a precursor for an income producing property. Land is also often held 
for appreciation as an investment. Conversely, some residential assets 
are income producing, such as single family houses that are rented, or 
small two- to four- unit apartment properties. Due to the methods of 
finance and other characteristics, these properties are rarely 
considered to be commercial real estate.
    \12\ There are four common methods of valuing a commercial 
property: capitalization rate, discounted cash flow, comparable sales, 
and replacement cost. The first two methods are purely functions of 
property income. The comparable sales method is implicitly based on 
property income, since comparable property sale prices depend on other 
buyers' assessments of value based on income. Replacement cost does not 
depend on income, but is mainly used as a check on the other methods.
---------------------------------------------------------------------------

1. Types of Commercial Real Estate

    The characteristics of different categories of commercial 
real estate are important when considering their respective 
value and ability to support bank and other loans.
            a. Retail Properties
    Retail properties range in size from regional malls, free-
standing ``big-box'' retailers, and strip malls to single, 
large or small buildings housing local businesses. To generate 
the cash flow necessary to service their loans, all retail 
properties depend, directly or indirectly, on the success of 
the businesses that occupy the property (which in turn depends 
on its own combination of financial, economic, and competitive 
factors). For this reason, retail properties (as well as hotel 
and tourist properties) are more directly affected by the 
health of the economy than most other property types. Retail is 
also the property type most sensitive to location.
            b. Hotel and Tourist Properties
    Hotel and tourist properties include resort, convention, 
airport, extended stay, and boutique hotels, as well as 
motels.\13\ The hotel sector is cyclical and volatile, in large 
part because the ``lease term'' for a hotel is usually a few 
days at most. Hotel income depends directly on the level of 
occupancy and the daily rate charged; those rental rates are 
sensitive to additional supply in the market and can change 
daily. These factors, plus changing trends in both tourism and 
business travel based on the economy or local conditions, make 
future hotel income difficult to predict. Hotels also tend to 
be highly leveraged, further increasing investment risk.\14\
---------------------------------------------------------------------------
    \13\ See William B. Brueggeman and Jeffery D. Fisher, Real Estate 
Finance and Investments, at 211 (2001) (hereinafter ``Brueggeman and 
Fisher'').
    \14\ Precept Corporation, The Handbook of First Mortgage Lending: A 
Standardized Method for the Commercial Real Estate Industry, at 253 
(2002).
---------------------------------------------------------------------------
            c. Office Buildings
    The office sector is a diverse grouping that includes all 
properties in which office occupancy is the dominant use.\15\ 
Office buildings are designated by class, from A to C, in 
descending order of quality and cost.\16\ Because office leases 
are relatively long term, usually for three to ten years, 
office properties can be more stable in their financial 
performance than other classes of commercial real estate, at 
least during the lease terms and assuming no defaults. Office 
space tends to have significant costs during re-leasing, 
including brokerage charges, downtime, and the considerable 
amount of fit-out work that needs to be done to accommodate new 
tenants.
---------------------------------------------------------------------------
    \15\ Again, some of the space is owner-occupied, e.g., by small 
services businesses.
    \16\ Urban Land Institute, Office Development Handbook, 2nd Edition 
(Dec. 1998) ``Class A space can be characterized as buildings that have 
excellent location and access, attract high quality tenants, and are 
managed professionally. Building materials are high quality and rents 
are competitive with other new buildings. Class B buildings have good 
locations, management, and construction, and tenant standards are high. 
Buildings should have very little functional obsolescence and 
deterioration. Class C buildings are typically 15 to 25 years old but 
are maintaining steady occupancy. Tenants filter from Class B to Class 
A and from Class C to Class B.''
    Other classification systems may set square footage standards for 
the classes, and may include an ``unclassified'' category for space 
below the standards of Class C or unusual property types that may be 
difficult to lease.
---------------------------------------------------------------------------
            d. Industrial Properties
    Industrial real estate traditionally consists of warehouse, 
manufacturing, light industry and related, e.g., research and 
development or laboratory, properties.\17\ Office and 
industrial properties are sometimes combined into a single 
``office/industrial'' category because some industrial 
properties contain a significant amount of office space. Light 
industrial and warehouse properties can often easily be 
converted from one use to another; a heavy industrial property, 
such as a mill, will be less amenable to conversion to other 
uses.\18\ Industrial properties tend to have more stable 
returns than office, hotel, or retail properties.\19\
---------------------------------------------------------------------------
    \17\ Johannson L. Yap and Rene M. Circ, Guide to Classifying 
Industrial Property, Second Edition, Urban Land Institute, at viii 
(2003) (hereinafter ``Guide to Classifying Industrial Property'').
    \18\ See Brueggeman and Fisher, supra note 13, at 211.
    \19\ Guide to Classifying Industrial Property, supra note 17, at 
vi.
---------------------------------------------------------------------------
            e. Multifamily Housing and Apartment Units
    Multifamily housing consists of buildings with multiple 
dwelling units for rent. Unlike most residential properties, 
multifamily properties are income generating, and generally use 
the commercial mortgage market for financing. The basic 
subtypes of multifamily are high rise, low rise, and garden 
apartments.\20\ A number of other types of properties are 
sometimes converted into apartments (such as loft units in 
converted industrial properties) and would then fall into this 
category.\21\
---------------------------------------------------------------------------
    \20\ Brueggeman and Fisher, supra note 13, at 211.
    \21\ Condominium and assisted living properties share many 
characteristics with multifamily rental properties, but are not 
considered part of the multifamily category, although they do use the 
commercial finance market. See Real Estate Finance, Seventh Edition, 
supra note 10, at 199-200.
---------------------------------------------------------------------------
    Multifamily properties usually have a greater number of 
tenants and shorter leases (six months to two years) than 
retail, office, and industrial spaces. Again, cash flow is 
relatively stable over the terms of any lease. Multifamily 
properties, however, are susceptible to competition, because 
the barriers to entry into the market are low.\22\
---------------------------------------------------------------------------
    \22\ Joseph F. DeMichele and William J. Adams, ``Introduction to 
Commercial Mortgage Backed Securities,'' in The Handbook of Non-Agency 
Mortgage-Backed Securities, at 335-336 (1997) (hereinafter ``DeMichele 
and Adams'').
---------------------------------------------------------------------------
    Unlike other commercial property types, a significant 
percentage of the multifamily sector is subsidized in some form 
through government programs such as the Section 8 Housing 
Choice Voucher Program or Low Income Housing Tax Credits 
(LIHTC). These units are often referred to as ``affordable'' or 
``assisted'' housing, as opposed to unsubsidized ``market 
rate'' housing.
    As of 2007 there were more than 17 million apartment units 
in the United States, most of which have one or two bedrooms. 
As can be seen in Figure 1, the South contained the largest 
number of apartment units followed by the West, the Northeast, 
and the Midwest.\23\ The highest median rents, however, were 
seen in the West, followed by the Northeast, the South, and the 
Midwest.\24\ Rents in certain markets, especially major 
metropolitan areas such as New York, are significantly more 
than the median.
---------------------------------------------------------------------------
    \23\ National Multi Housing Council, Quick Facts: Apartment Stock 
(2009) (online at www.nmhc.org/Content/
ServeContent.cfm?ContentItemID=141).
    \24\ Id.

                             FIGURE 1: MULTIFAMILY UNITS AND MEDIAN RENTS BY REGION
----------------------------------------------------------------------------------------------------------------
                                                                        Multifamily Property Size by Number of
                                                Percent     Median              Units in Each Category
              Region                Number of   of Total   Monthly  --------------------------------------------
                                      Units      Units       Rent      5-9     10-24    25-49    50-99     100+
                                                                      Units    Units    Units    Units    Units
----------------------------------------------------------------------------------------------------------------
Northeast.........................      3,950        23%       $714      871    1,062      679      577      762
Midwest...........................      3,556        20%        550    1,110    1,299      404      357      386
South.............................      5,577        32%        640    1,840    2,510      435      260      532
West..............................      4,305        25%        800    1,317    1,603      586      373      427
                                   -----------------------------------------------------------------------------
    Total U.S.....................     17,389       100%        675    5,138    6,473    2,104    1,567    2,107
----------------------------------------------------------------------------------------------------------------

    The median household income of renters, as of 2007, was 
$25,500, well below the national median of $47,000. The median 
income of renters of unsubsidized market rate units was higher, 
at $30,000. The median age of renters was 39. Nearly half of 
apartments are occupied by only one person. Of renter 
households, 22 percent have at least one child.\25\
---------------------------------------------------------------------------
    \25\ Id.
---------------------------------------------------------------------------
            f. Homebuilders
    The development of residential properties is considered a 
commercial real estate activity, and loans to businesses that 
develop residential properties are also considered commercial 
real estate loans.

2. How Commercial Real Estate Is Financed

    The financing of commercial real estate reflects the prime 
characteristics of commercial property, namely that (1) they 
are built to generate income, (2) income is used to service the 
loans obtained by the property developer or operator, and (3) 
the value of the property depends largely on the amount of that 
income.
    The commercial and residential real estate industries share 
many similarities in basic structure and terminology. Location 
is a well-known factor influencing the property values of both 
categories. Both types of property experienced bubbles in the 
past decade. Loan underwriting and equity requirements were 
loosened for both types of real estate, although the commercial 
real estate bubble was smaller and less extreme; moreover, as 
discussed throughout the report, the full force of the 
commercial real estate bubble has yet to be felt.
    The bubble in residential property also did much to fuel 
directly the bubble in commercial property. Companies related 
to residential real estate, construction, and home furnishing 
grew rapidly as a result of the residential bubble and expanded 
the demand for office and industrial space. Many new retail 
properties were also built to serve new residential 
development; the force of the credit-driven consumer economy 
was even greater.
    Commercial and residential real estate finance, however, 
have significant differences. Unlike most residential 
borrowers, commercial borrowers tend to be real estate 
professionals. Commercial borrowers are also expected to pay 
debt service from property income rather than from personal 
income, unlike homeowners. Consequently, some of the loan 
structures that are used in the residential mortgage market, 
such as stated income loans or low introductory interest rates, 
are not available in the commercial market. In addition, the 
different tax treatment of commercial and residential 
properties (especially the allowance of depreciation of 
commercial properties) creates incentives for different types 
of ownership and financing structures.
    The two main categories of commercial real estate mortgages 
are discussed below.
            a. Construction and Development Financing
    Construction loans--often called ``ADC,'' for 
``acquisition, development, and construction'' or ``C&D'' for 
``construction and development''--allow the developer to do 
just what the name implies, that is, to obtain funds to build 
on the property. ADC financing is usually short-term and almost 
always supplied by a depository institution.
    These loans usually have an adjustable rate, priced at a 
spread over the prime rate or another benchmark.\26\ The bank 
typically plays an active role in monitoring these loans and 
approving ``draws'' as funds are needed for construction.\27\ 
Since a property under construction does not generate rental 
income to cover debt service, a construction loan more often 
than not includes an interest reserve which holds back enough 
of the loan proceeds to cover the interest payments due during 
the term of the loan. (Thus, the developer borrows the money to 
pay the interest on the construction loan, because the 
property, by definition, cannot generate cash flow to do so.) 
Underwriting a construction loan requires forecasting the time 
it will take the developer to lease up the property to a 
sufficient extent to enable the loan to be converted into 
permanent financing.
---------------------------------------------------------------------------
    \26\ Brueggeman and Fisher, supra note 13, at 445.
    \27\ Brueggeman and Fisher, supra note 13, at 481-485.
---------------------------------------------------------------------------
    Unlike later stages of financing, construction loans are 
usually recourse loans, that is, the lender has a right to 
recover directly from any available general assets of the 
developer if the loan is not repaid (a right that is meaningful 
only to the extent that the developer has those assets in the 
necessary amount).

               FIGURE 2: CONSTRUCTION LOAN FLOWCHART \28\

---------------------------------------------------------------------------
    \28\ In smaller and some other non-securitized loans, the 
relationship runs directly between the borrower and the lender, without 
the use of a servicer. 

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

            b. Permanent Financing
    After construction is completed and the building leased, 
the developer takes out a commercial mortgage as permanent 
financing and uses the proceeds to repay the construction loan; 
the need for permanent financing is built into the financing 
and economics of the project from the outset.
    The terms of the permanent financing and the attractiveness 
of the property to lenders depend, again, on the income the 
property is expected to generate, based on its initial leasing 
rate, general economic conditions, and demand for properties of 
that type. Translation of that income into a projected value 
for the property sets the loan-to-value (LTV) ratio (the 
principal balance divided by the property's value) backing the 
debt and also affects the loan's interest rate.
    Commercial mortgages may have a fixed or an adjustable rate 
and may also be interest-only and negative-amortization 
loans.\29\ The loan-to-value ratio is typically lower for 
commercial mortgages than for single-family residential 
mortgages, ranging from 50 to 80 percent. The remaining amount 
is usually equity supplied by the borrower (either singly or 
through a group of investors). The term for commercial 
mortgages is fairly short, usually three to ten years. The 
amortization schedule is often longer than the term of the 
loan, usually 30 years, with a balloon payment of the remaining 
outstanding principal due at loan maturity.
---------------------------------------------------------------------------
    \29\ In a negative amortization loan, the monthly payment is less 
than the interest due. The unpaid interest is added to the principal 
balance, which increases over the term of the loan, and both must be 
paid in a balloon at maturity.
---------------------------------------------------------------------------
    Commercial borrowers usually refinance their properties at 
the end of the loan term. During refinancing, the lender (often 
a different lender than the original one) reevaluates the 
property and bases the new loan terms on the current state of 
the property and prevailing market conditions. Similarly, many 
non-traditional or subprime residential loans were made with 
the assumption that the loan would need to be refinanced at the 
end of the introductory period when the rate reset. However, 
unlike the commercial sector in which refinancings were 
necessary three to ten years later, many non-traditional or 
subprime loans required refinancing in only one to three years. 
Thus, loose underwriting or other factors contributing to the 
inability to refinance loans arose much more quickly in the 
residential real estate sector than the commercial real estate 
sector.
    There are a number of other reasons why the commercial real 
estate cycle tends to lag the residential cycle. The multi-year 
leases common in commercial real estate lock in rental income 
for the duration of the lease, even if the tenant's actual 
space needs have decreased. In addition, it takes some time for 
either economic growth or contraction to work its way through 
the economy to the point where it influences commercial space 
demand. For example, a retail store may have poor sales for 
months or years before it closes and causes a loss of income to 
the property owner. Unemployment, itself a lagging indicator, 
greatly influences commercial real estate demand, since each 
lost job means an empty office or factory work station, as well 
as lower retail and hotel spending.
    Unlike construction loans, commercial mortgages are 
generally non-recourse loans; the borrower stands to lose only 
its own investment if the property is foreclosed.\30\ The 
lender may look only to the property itself to recover its 
funds if the borrower defaults, generally through a sale to a 
third party who wishes to take over the property. The 
nonrecourse nature of the financing, again, makes careful 
underwriting crucial.\31\
---------------------------------------------------------------------------
    \30\ See Brueggeman and Fisher, supra note 13, at 447.
    \31\ Commercial mortgages may have prepayment penalties to 
discourage refinancing before the maturity date. Most securitized 
mortgages incorporate a prepayment ``lock out'' that forbids prepayment 
altogether unless there is ``defeasance,'' where the prepaying mortgage 
is replaced in the pool with an equal amount of Treasury bonds.
---------------------------------------------------------------------------

              FIGURE 3: PERMANENT MORTGAGE FLOWCHART \32\

---------------------------------------------------------------------------
    \32\ Again, in smaller and some other, non-securitized, loans, the 
relationship runs directly between the borrower and the lender, without 
the use of a servicer. 

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    In a way, the term ``permanent financing'' is a misnomer. 
Commercial mortgages generally have a short term, and they 
require refinancing at the end of their original term, such as 
seven years. At that point, the income experience of the 
property, which largely sets its value, is re-examined, and the 
new loan is originated based on that re-examination (often by a 
lender different than the original one) plus then-prevailing 
interest rates; such a refinancing may benefit the borrower or 
the lender. Future refinancing is assumed during underwriting 
of the original loan because the underwriting computations 
assume a period far longer than the term of the loan; thus, a 
drop in the value of the property as an income-producing asset 
stiffens the loan terms and increases the economic costs to the 
borrower. Those costs may make further operation of the 
property by the developer untenable, transferring the loss of 
value to the lender.
    As discussed below, a number of different classes of 
financial institutions provide permanent financing and 
refinancing for commercial real estate projects. Depository 
institutions, especially in smaller communities, are likely to 
finance local projects and hold the loans on their books as 
whole loans. Pension funds and insurance companies are major 
whole loan investors, although they tend to originate their 
loans through a contracted mortgage bank or mortgage brokerage 
firm. And a large number of permanent loans are funded through 
the issuance of commercial mortgage-backed securities (CMBS), 
described below in Section E.2.
    In order to fund a large whole loan mortgage, a group of 
investors will often form a syndicate to invest in a project 
jointly and thereby spread risks or allow larger amounts to be 
funded. Smaller banks will often syndicate a large mortgage 
among a group of banks with similar investment needs.
    Real estate syndications are particularly common among 
equity investors, although permanent mortgages, construction 
loans, and various combinations of investment types are 
syndicated as well. A syndicator, often the general partner of 
a limited partnership, acts as the sponsor and organizer of the 
syndication. The syndicator usually does not invest much of its 
own capital; instead, it earns a fee for its management role.
    Aside from limited partnerships, real estate investors use 
numerous other types of syndication structures. These include 
``blind pools,'' in which the syndicator has great discretion 
over the properties or types of investments to be funded, and 
public syndicates, which are structured to allow the interests 
to be sold to investors in different states.\33\
---------------------------------------------------------------------------
    \33\ See generally Brueggeman and Fisher, supra note 13, at 368-
386.
---------------------------------------------------------------------------
    The patterns of commercial real estate financing--and loan 
administration through a network of servicers--are discussed in 
Section E.

3. Kinds of Difficulties Commercial Real Estate Can Encounter--An 
        Introduction

    There are two types of difficulties that commercial real 
estate financing arrangements encounter most frequently. The 
first is credit risk, where the property produces insufficient 
cash flow to service the mortgage. The second is term risk, 
which involves difficulty refinancing the current mortgage on 
the property at the end of the loan term. Term risk itself has 
two parts. The first involves difficulties faced by owners of 
relatively healthy properties, who cannot refinance because a 
credit contraction or severe economic downturn either limits 
the capital available or tightens underwriting standards. The 
second type of term risk involves difficulties faced by owners 
of projects that were originally financed based on faulty 
underwriting at a time when commercial real estate values were 
inflated. The problems posed by both credit risk and term risk 
are discussed in Section F.2.

             C. History of Commercial Real Estate Concerns

    Commercial real estate concerns are not new. The nation 
experienced a major commercial real estate crisis during the 
1980s that resulted in the failure of several thousand banks 
and cost the taxpayers $157 billion (nominal dollars). More 
than half a decade ago, the banking supervisors began to 
express worries about a new overconcentration in commercial 
real estate lending, especially at the smaller institutions, as 
discussed below, and in Section H.1.

1. Commercial Real Estate Crises of the 1980s and 1990s

    Commercial real estate crises have happened, and challenged 
the regulatory apparatus, before. Historically, the commercial 
real estate market has been cyclical, and some oscillation 
between booms and busts is natural.\34\ The last significant 
U.S. real estate-related financial crisis before the 1980s 
occurred in the late 1920s and early 1930s. The boom and bust 
that occurred during the 1980s was characterized by commercial 
property values that fell between 30 and 50 percent in a two-
year period--at the time the largest drop in property values in 
the United States since the Great Depression.\35\
---------------------------------------------------------------------------
    \34\ See C. Alan Garner, Is Commercial Real Estate Reliving the 
1980s and Early 1990s?, Federal Reserve Bank of Kansas City--Economic 
Review, at 91 (Fall 2008) (online at www.frbkc.org/Publicat/ECONREV/
PDF/3q08Garner.pdf) (hereinafter ``Garner Economic Review Article'').
    \35\ Jim Clayton, Cap Rates & Real Estate Cycles: A Historical 
Perspective with a Look to the Future, Cornerstone Real Estate Advisors 
(June 2009) (online at www.cornerstoneadvisers.com/research/
CREACapRates.pdf). A more detailed description of the causes of the 
1980s crisis appears in Annex I, infra.
---------------------------------------------------------------------------
    The initial boom was so great that between 1980 and 1990 
the total value of commercial real estate loans issued by U.S. 
banks tripled, representing an increase from 6.9 percent to 
12.0 percent of banks' total assets.\36\ Savings and loan 
institutions (S&Ls) also increased their commercial real estate 
loan portfolios as the proportion of their portfolios in 
residential mortgage lending declined.\37\
---------------------------------------------------------------------------
    \36\ This does not include the quantities being loaned by credit 
unions or thrift institutions. See Federal Deposit Insurance 
Corporation, History of the Eighties--Lessons for the Future, at 152 
(Dec. 1997) (online at www.fdic.gov/bank/historical/history/
137_165.pdf) (hereinafter ``History of the Eighties'').
    \37\ Id., at 26.
---------------------------------------------------------------------------
    From the late 1980s, however, the value of commercial real 
estate properties rapidly declined, and by 1991 a large 
proportion of banks' commercial real estate loans were either 
non-performing or foreclosed.\38\ Residential property values 
also fell nine percent from 1980 to 1985.\39\ Due to the more 
localized nature of banking during this period--the result of 
public policies at both the federal and state levels that 
discouraged or even prohibited interstate banking and 
branching--states such as Texas and Florida were affected more 
severely than other areas.\40\ Unable to recoup their losses, 
roughly 2,300 lending institutions failed, and the government 
was forced to expend $157.5 billion (approximately $280 billion 
in 2009 dollars) \41\ protecting depositors' funds and 
facilitating the closure or restructuring of these 
organizations.
---------------------------------------------------------------------------
    \38\ Id., at 153.
    \39\ Robert Shiller, Irrational Exuberance (online at 
www.econ.yale.edu/ centsshiller/data/Fig2-1.xls) (accessed Jan. 27, 
2010). Percentage change is inflation adjusted.
    \40\ See Frederic J. Mishkin, The Economics of Money, Banking, and 
Financial Markets (Addison-Wesley, 2003). See also Lawrence J. White, 
The S&L Debate: Public Policy Lessons for Bank and Thrift Regulation 
(Oxford University Press, 1991).
    \41\ Inflation-adjusted figures are calculated using the U.S. 
Bureau of Labor Statistics' Consumer Price Index Inflation Calculator. 
U.S. Bureau of Labor Statistics, CPI Inflation Calculator (online at 
data.bls.gov/cgi-bin/cpicalc.pl) (accessed Feb. 8, 2010).
---------------------------------------------------------------------------
    Between 1986 and 1994, 1,043 thrift institutions and 1,248 
banks failed, with total assets of approximately $726 billion 
(approximately $1.19 trillion in 2009 dollars).\42\ Although 
the commercial real estate market was not the only market 
suffering a downturn at this time and therefore cannot be 
labeled as the only cause of these failures, an analysis of 
bank assets indicates that those institutions that had invested 
heavily in commercial real estate during the preceding decade 
were substantially more likely to fail than those that had 
not.\43\
---------------------------------------------------------------------------
    \42\ $519 billion of these assets belonged to failed thrift 
institutions, and $207 billion to failed banks ($851.91 billion and 
$339.78 billion in 2009 dollars, respectively). See Timothy Curry and 
Lynn Shibut, The Cost of the Savings and Loan Crisis: Truth and 
Consequences, FDIC Banking Review, at 26 (Dec. 2000) (online at 
www.fdic.gov/bank/analytical/banking/2000dec/brv13n2_2.pdf). See also 
Federal Deposit Insurance Corporation, Number and Deposits of BIF-
Insured Banks Closed Because of Financial Difficulties, 1934 through 
1998 (online at www.fdic.gov/about/strategic/report/98Annual/119.html) 
(accessed at Jan. 15, 2010).
    \43\ See Rebel A. Cole and George W. Fenn, The Role of Commercial 
Real Estate Investments in the Banking Crisis of 1985-92, at 13 (Nov. 
1, 2008) (online at ssrn.com/abstract=1293473) (hereinafter ``Cole and 
Fenn'').
---------------------------------------------------------------------------
    Congress responded to the banking and thrift crisis of the 
1980s by passing the Financial Institutions Reform, Recovery 
and Enforcement Act (FIRREA) in 1989. This Act consolidated the 
major federal deposit insurance programs under the authority of 
the Federal Deposit Insurance Corporation (FDIC) and created 
the Resolution Trust Corporation (RTC), which was tasked with 
liquidating the assets of insolvent thrift institutions and 
using the revenue to recoup the government's outlays. The RTC 
is generally considered to have been a successful program.\44\
---------------------------------------------------------------------------
    \44\ COP August Oversight Report, supra note 5, at 40; 
Congressional Oversight Panel, April Oversight Report: Assessing 
Treasury's Strategy: Six Months of TARP, at 49-50 (Apr. 7, 2009) 
(online at cop.senate.gov/documents/cop-040709-report.pdf).
---------------------------------------------------------------------------
    One consequence of the thrift and banking crisis of the 
late 1980s and early 1990s was the sharp decline in the number 
of banks and thrifts: in 1980, there were 14,222 banks, but 
only 10,313 by 1994. The thrift industry contracted from 3,234 
savings and loans in 1986 to 1,645 institutions in 1995. The 
banking sector also had become more concentrated over this 
period, with the 25 largest institutions holding 29.3 percent 
of insured banking deposits in 1980, growing to 42.9 percent in 
1994.\45\
---------------------------------------------------------------------------
    \45\ See Stephen Rhoades, Bank Mergers and Industrywide Structure, 
1980-1994, at 25 (Jan. 1996) (online at www.federalreserve.gov/pubs/
StaffStudies/1990-99/ss169.pdf).
---------------------------------------------------------------------------
    From 1990 onward, the commercial real estate market 
gradually recovered, and by the end of the decade it was once 
again a popular investment option.\46\ There were three broad 
reasons. First, the basic factors necessary for market recovery 
were present: the economy was in a sustained upswing, which 
meant that the demand for office and retail space was still 
growing, and the monetary and regulatory problems that had 
allowed the market to run out of control had been resolved.\47\
---------------------------------------------------------------------------
    \46\ Roger Thompson, Rebuilding Commercial Real Estate, HBS Alumni 
Bulletin (Jan. 9, 2006) (online at hbswk.hbs.edu/item/5156.html) 
(hereinafter ``Rebuilding Commercial Real Estate'').
    \47\ See HighBeam Business, Operators of Nonresidential Buildings 
Market Report (online at business.highbeam.com/industry-reports/
finance/operators-of-nonresidential-buildings) (hereinafter 
``Nonresidential Buildings Market Report'') (accessed Jan. 19, 2010).
---------------------------------------------------------------------------
    Second, the collapse prompted a restructuring of how the 
commercial real estate market operated, which in turn brought 
new investments. Many commercial property owners viewed going 
public--moving from private ownership to the public real estate 
investment trust (REIT) model (rarely used before 1990)--as a 
way to recapitalize their holdings and operations, and thereby 
avoid bankruptcy. These proved remarkably popular, and between 
1992 and 1997, approximately 150 REITs were organized, with 
aggregate equity value escalating from $10 billion to over $175 
billion during that period.\48\ At the same time, Wall Street 
banks--hitherto largely uninvolved in commercial real estate--
saw the defaulted loans the RTC was selling as a good 
opportunity to move into the real estate market for a low entry 
cost.\49\ These banks also came up with a proposal for how the 
RTC could dispose of the billions of dollars in thrift loans 
that were not in default: create commercial mortgage-backed 
securities. These proved to be popular, too, and attracted 
considerable investment.\50\
---------------------------------------------------------------------------
    \48\ See Rebuilding Commercial Real Estate, supra note 46.
    \49\ See Rebuilding Commercial Real Estate, supra note 46.
    \50\ See Rebuilding Commercial Real Estate, supra note 46.
---------------------------------------------------------------------------
    In addition to the need for the government to dispose of 
these financial assets, the Tax Reform Act of 1986, which 
created the Real Estate Mortgage Investment Conduit (REMIC), 
facilitated the issuance of mortgage securitizations, including 
CMBS.
    Finally, although the bursting of the technology bubble of 
2001 had negative repercussions across all markets, it caused 
investors to become wary of new industries and move back toward 
more traditional investment opportunities like commercial real 
estate. It helped that most REITs were continuing to report 
double-digit rates of return.\51\ This extra investment shored 
up the commercial real estate market in a time when most other 
markets were suffering.\52\
---------------------------------------------------------------------------
    \51\ See Rebuilding Commercial Real Estate, supra note 46.
    \52\ See Nonresidential Buildings Market Report, supra note 47 
(accessed Jan. 19, 2010); see also Rebuilding Commercial Real Estate, 
supra note 46.
---------------------------------------------------------------------------

2. Recognition of Commercial Real Estate Problems Before the Crisis 
        Broke 

    During the boom in residential real estate in the early to 
mid-2000s, larger institutions and less regulated players came 
to dominate most credit offerings to individual consumers, such 
as home mortgages and credit cards.\53\ In response to this 
increased competition in other areas, smaller and community 
banks increased their focus on commercial real estate 
lending.\54\ Commercial real estate lending, which typically 
requires greater investigation into individual loans and 
borrowers, also caters to the strengths of smaller and 
community financial institutions.\55\ As a result, these 
smaller institutions could generate superior returns in 
commercial real estate, and many institutions grew to have high 
commercial real estate concentrations on their balance sheets.
---------------------------------------------------------------------------
    \53\ Federal Deposit Insurance Corporation, The Future of Banking 
in America: Community Banks: Their Recent Past, Current Performance, 
and Future Prospects (Jan. 2005) (online at www.fdic.gov/bank/
analytical/banking/2005jan/article1.html); Senate Committee on Banking, 
Housing, and Urban Affairs, Testimony of John Dugan, Comptroller of the 
Currency, The State of the Banking Industry, 110th Cong. (Mar. 4, 2008) 
(online at banking.senate.gov/public/
index.cfm?FuseAction=Files.View&FileStore_id=44b0e0bc-10ee-447b-a1e8-
8211ea4c70dc) (hereinafter ``Dugan Testimony, March 4, 2008 Senate 
Banking Hearing'').
    \54\ Dugan Testimony, Dugan Testimony, March 4, 2008 Senate Banking 
Hearing, supra note 53. See also Board of Governors of the Federal 
Reserve System, Speech of Chairman Ben S. Bernanke to the Independent 
Community Bankers of America National Convention and Techworld (Mar. 8, 
2006) (online at www.federalreserve.gov/newsevents/speech/
Bernanke20060308a.htm) (hereinafter ``Bernanke Community Bankers 
Speech'') (discussing the evolution of unsecured personal lending from 
a relationship lending paradigm to a highly quantitative paradigm more 
suitable for larger financial institutions).
    \55\ Bernanke Community Bankers Speech, supra note 54. See also 
Dugan Testimony, Dugan Testimony, March 4, 2008 Senate Banking Hearing, 
supra note 53.
---------------------------------------------------------------------------
    At the same time, commercial real estate secured by large 
properties with steady income streams, the highest quality 
borrowers in the space, gravitated towards origination by 
larger institutions with subsequent distribution to the CMBS 
market.\56\ These properties typically require larger loans 
than smaller and community banks can provide, and the greater 
resources of larger institutions and the secondary market can 
better satisfy these needs.\57\ The CMBS market therefore 
captured many of the most secure commercial real estate 
investments.
---------------------------------------------------------------------------
    \56\ Dugan Testimony, Dugan Testimony, March 4, 2008 Senate Banking 
Hearing, supra note 53; Richard Parkus, The Outlook for Commercial Real 
Estate and Its Impact on Banks, at 17 (Jul. 30, 2009) (online at 
www.cre.db.com/sites/default/files/docs/research/cre_20090730.pdf). The 
CMBS market is discussed below, in Section E.2.
    \57\ Dugan Testimony, Dugan Testimony, March 4, 2008 Senate Banking 
Hearing, supra note 53.
---------------------------------------------------------------------------
    In combination, these two trends meant that, even absent a 
commercial real estate bubble or weak economic conditions, 
smaller and community banks would have greater exposure to a 
riskier set of commercial real estate loans. Alongside 
substantial asset price corrections and deteriorating market 
fundamentals, these conditions put smaller and community banks 
at much greater risk than the collapse in residential real 
estate did.
    By early 2006, bank supervisors had reason to be concerned 
about the state of the commercial real estate sector. As was 
happening in the residential market, a confluence of low 
interest rates, high liquidity in the credit markets, a drop in 
underwriting standards, and rapidly rising ``bubble'' values 
produced a boom in ``bubble-induced'' construction and real 
estate sales based on a combination of unrealistic projections 
and relaxed underwriting standards.\58\ In 2005 and 2006, a 
survey of the 73 largest national banks found that their loan 
standards were weakening, as Figure 4 shows.\59\ The banks' 
commercial real estate lending portfolios were also becoming 
riskier, as shown in Figure 5, and the outlook over the next 12 
months was for the risks to continue to grow.\60\
---------------------------------------------------------------------------
    \58\ Federal Deposit Insurance Corporation, Financial Institution 
Letters: Managing Commercial Real Estate Concentrations in a 
Challenging Environment (March 17, 2008) (online at www.fdic.gov/news/
news/financial/2008/fil08022.html) (hereinafter ``Financial Institution 
Letters'').
    \59\ Office of the Comptroller of the Currency, Survey of Credit 
Underwriting Practices 2006, at 25-27 (Oct. 2006) (online at 
www.occ.treas.gov/2006Underwriting/2006UnderwritingSurvey.pdf) 
(hereinafter ``Survey of Credit Underwriting Practices'').
    \60\ Id., at 25-27.
---------------------------------------------------------------------------

   FIGURE 4: CHANGES IN UNDERWRITING STANDARDS FOR NON-CONSTRUCTION 
                   COMMERCIAL REAL ESTATE LOANS \61\


---------------------------------------------------------------------------
    \61\ Id., at 25-27.

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
    
 FIGURE 5: CHANGES IN THE LEVEL OF CREDIT RISK IN BANK PORTFOLIOS FOR 
           NON-CONSTRUCTION COMMERCIAL REAL ESTATE LOANS \62\


---------------------------------------------------------------------------
    \62\ Id., at 25-27. 

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
    
    Lax underwriting was also evident in CMBS deals from 2005 
to 2007. In the late 1990s, only six to nine percent of the 
loans in CMBS transactions were interest-only loans, during the 
term of which the borrower was not responsible for paying down 
principal, as Figure 6 shows. By 2005, that figure had climbed 
to 48 percent, and by 2006, it was 59 percent.\63\ The 
Government Accountability Office (GAO) found in a report this 
month that CMBS underwriting standards were at their worst in 
2006-2007.\64\
---------------------------------------------------------------------------
    \63\ Bloomberg data (accessed Jan. 12, 2010).
    \64\ Government Accountability Office, Troubled Asset Relief 
Program: Treasury Needs to Strengthen its Decision-Making Process on 
the Term Asset-Backed Securities Liquidity Facility at 29 (Feb. 2010) 
(online at www.gao.gov/new.items/d1025.pdf) (hereinafter ``GAO TALF 
Report'') (also noting that commercial real estate prices have been 
falling since early 2008, and CMBS delinquencies have been rising, and 
stating: ``The Federal Reserve and Treasury have continued to note 
their ongoing concerns about this segment of the market'').
---------------------------------------------------------------------------

   FIGURE 6: PERCENTAGE OF CMBS THAT WERE INTEREST-ONLY AND PARTIAL 
               INTEREST-ONLY AT ORIGINATION, BY YEAR \65\

---------------------------------------------------------------------------
    \65\ Bloomberg data (accessed Jan. 12, 2010). ``Interest only'' 
refers to the original percentage of the loans comprising the 
collateral that are fully interest only, meaning that they do not 
amortize. ``Partial interest only'' refers to the original percentage 
of the loans comprising the collateral that are partially interest 
only, meaning that they do not amortize over part of the term. 

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]


    But weakened underwriting was not the only reason for 
supervisors to be concerned. In fact, beginning in 2003, the 
Office of the Comptroller of the Currency (OCC) conducted an 
examination of commercial real estate lending across multiple 
institutions and found increasing policy exceptions, 
lengthening maturities, and a lack of quality control and 
independence in the appraisal process.\66\ At the same time 
that loans were growing riskier, many banks' portfolios were 
becoming less diversified generally and more concentrated in 
commercial real estate lending. In 2003, banks with assets of 
$100 million to $1 billion had commercial real estate 
portfolios equal to 156 percent of their total risk-based 
capital. That figure had risen to 318 percent by the third 
quarter of 2006.\67\ The concentrations were particularly 
worrisome in the West and the Southeast. By June 2005, in the 
FDIC's San Francisco region, which covers 11 states including 
California, Arizona, and Nevada, commercial real estate lending 
at 60 percent of banks amounted to
---------------------------------------------------------------------------
    \66\ Office of the Comptroller of the Currency, Remarks by John C. 
Dugan, Comptroller of the Currency, Before the New York Bankers 
Association, New York, New York (Apr. 6, 2006) (online at 
www.occ.treas.gov/ftp/release/2006-45a.pdf) (hereinafter ``Dugan 
Remarks Before the New York Bankers Association'').
    \67\ Office of the Comptroller of the Currency, Board of Governors 
of the Federal Reserve System, Federal Deposit Insurance Corporation, 
Office of Thrift Supervision, Concentrations in Commercial Real Estate, 
Sound Risk Management Practices (Jan. 9, 2006) (online at 
www.occ.treas.gov/ftp/release/2006-2a.pdf) (hereinafter ``Agencies 
Proposed Guidance'').
---------------------------------------------------------------------------
more than three times their capital levels.\68\ The picture was 
only slightly less worrisome in the Atlanta region, which 
covers seven states; the percentage of banks in the region that 
exceeded the 300 percent threshold was 48 percent.\69\ The 
broader market environment exacerbated the problem because when 
mortgage markets froze, builders could not find buyers, and the 
need for developed lots decreased dramatically, causing many 
developers to leave behind unfinished projects with loans that 
could not be serviced.\70\
---------------------------------------------------------------------------
    \68\ Federal Deposit Insurance Program, Office of the Inspector 
General, FDIC's Consideration of Commercial Real Estate Concentration 
Risk in FDIC-Supervised Institutions, at 2 (Feb. 2008) (Audit Report 
No. 08-005) (online at www.fdicig.gov/reports08/08-005.pdf) 
(hereinafter ``FDIC's Audit Report'').
    \69\ Id., at 2.
    \70\ Congressional Oversight Panel, Testimony of Chris Burnett, 
chief executive officer, Cornerstone Bank, Atlanta Field Hearing on 
Commercial Real Estate (Jan. 27, 2009) (online at cop.senate.gov/
hearings/library/hearing-012710-atlanta.cfm) (hereinafter ``COP Field 
Hearing in Atlanta Testimony of Chris Burnett'').
---------------------------------------------------------------------------

3. During the Late 2000s

    Revelations about deteriorating loan performance in 
subprime residential mortgages and resulting declines in the 
value of residential mortgage backed securities (RMBS), 
collateralized debt obligations (CDOs), and other instruments 
began in the spring of 2007.\71\ The problems continued to 
worsen through the summer of 2007.\72\ As the extent of this 
crisis became apparent, analysts began warning of a potential 
follow-on crisis in commercial real estate.
---------------------------------------------------------------------------
    \71\ See, e.g., Senate Committee on Banking, Housing & Urban 
Affairs, Subcommittee on Securities, Insurance and Investment, Written 
Testimony of Warren Kornfeld, Managing Director, Moody's Investors 
Service, Subprime Mortgage Market Turmoil: Examining the Role of 
Securitization, 110th Cong., at 14 (Apr. 17, 2007) (online at 
banking.senate.gov/public/
index.cfm?FuseAction=Hearings.List&Month=0&Year=2007) (``Pools of 
securitized 2006 mortgages have experienced rising delinquencies and 
loans in foreclosure, but due to the typically long time to foreclose 
and liquidate the underlying property, actual losses are only now 
beginning to be realized''); New Century Financial Corporation, New 
Century Financial Corporation Files for Chapter 11; Announces Agreement 
to Sell Servicing Operations (Apr. 2, 2007) (online at 
www.prnewswire.com/news-releases/new-century-financial-corporation-
files-for-chapter-11-announces-agreement-to-sell-servicing-operations-
57759932.html).
    \72\ G.M. Filisko, Subprime Lending Fallout, National Real Estate 
Investor (July 1, 2007) (online at nreionline.com/finance/reit/
real_estate_subprime_lending_fallout/).
---------------------------------------------------------------------------
    In November 2007, a Moody's report and a Citigroup 
analyst's note both predicted falling asset prices and trouble 
for commercial real estate similar to the crisis in the 
residential real estate market.\73\ Other experts sounded an 
alarm about commercial real estate as part of a broader alarm 
about the worsening of the financial crisis. In testimony 
before the House Financial Services Committee, Professor 
Nouriel Roubini predicted that ``the commercial real estate 
loan market will soon enter into a meltdown similar to the 
subprime one.'' \74\
---------------------------------------------------------------------------
    \73\ See, e.g., John Glover and Jody Shen, Deadbeat Developers 
Signaled by Property Derivatives, Bloomberg (Nov. 28, 2007) (online at 
www.bloomberg.com/apps/news?pid=newsarchive&sid=au2XBiCyWeME); Peter 
Grant, Commercial Property Now Under Pressure, Wall Street Journal 
(Nov. 19, 2007); Moody's Investor Service, Moody's/REAL Commercial 
Property Price Indices, November 2007, at 1 (Nov. 16, 2007) (online at 
www.realindices.com/pdf/CPPI_1107.pdf).
    \74\ See, e.g., House Committee on Financial Services, Written 
Testimony of Nouriel Roubini, Professor of Economics, New York 
University Stern School of Business, Monetary Policy and the State of 
the Economy, 110th Cong. (Feb. 26, 2008) (online at 
financialservices.house.gov/hearing110/roubini022608.pdf).
---------------------------------------------------------------------------
    This view was by no means unanimous. During late 2007 and 
early 2008, a number of commentators challenged the assertion 
that the commercial real estate market was in crisis, and 
anticipated no collapse.\75\
---------------------------------------------------------------------------
    \75\ While these analysts noted the downturn in commercial real 
estate, they expressed the opinion that market fundamentals were sound. 
See, e.g., Mortgage Bankers Association, Commercial Real Estate/
Multifamily Finance Quarterly Data Book: Q4 2007, at 55 (Mar. 26, 2008) 
(online at www.mortgagebankers.org/files/Research/DataBooks/
2007fourthquarterdatabook.pdf); Keefe, Bruyette & Woods, KRX Monthly: 
Is Commercial Real Estate Next?, at 1 (Mar. 4, 2008) (online at 
www2.snl.com/InteractiveX/ResearchRpts/
ResearchReportDetails.aspx?KF=5701364&persp=rr&KD=7424418); Lew 
Sichelman, Major Fall in CRE Deals Since End of Summer, National 
Mortgage News (Nov. 5, 2007) (online at nationalmortgagenews.com/
premium/archive/?id=157677).
---------------------------------------------------------------------------
    FDIC senior management also identified commercial real 
estate as a potential problem during early 2008. Chairman 
Sheila Bair testified before the Senate Banking Committee in 
March and June 2008, both times emphasizing smaller banks' 
concentrated holdings of problematic commercial real estate 
investments.\76\ This position represented a shift in emphasis 
from her position in December 2007, when she distinguished the 
current market difficulties from the S&L crisis because of the 
earlier crisis' roots in commercial real estate problems.\77\
---------------------------------------------------------------------------
    \76\ Senate Committee on Banking, Housing, and Urban Affairs, 
Written Testimony of Sheila Bair, Chair, Federal Deposit Insurance 
Corporation, The State of the Banking Industry: Part II, 110th Cong., 
at 4-5 (June 5, 2008) (online at banking.senate.gov/public/
index.cfm?FuseAction=Files.View&FileStore_id=9708bf58-20ac-4aa9-9240-
f0d772a1be25) (hereinafter ``June 5, 2008 Written Testimony of Sheila 
Bair''); Senate Committee on Banking, Housing, and Urban Affairs, 
Testimony of Sheila Bair, Chair, Federal Deposit Insurance Corporation, 
The State of the Banking Industry, 110th Cong., at 11-12 (Mar. 4, 2008) 
(online at banking.senate.gov/public/
index.cfm?FuseAction=Files.View&FileStore_id=093111d0-c4fe-47f30-a87a-
b103f0513f7a) (hereinafter ``March 4, 2008 Written Testimony of Sheila 
Bair'').
    In responding to comments received on their proposed guidance on 
commercial real estate lending in 2006, the supervisors noted the 
concerns that smaller institutions expressed about the fact that real 
estate lending had become their ``bread and butter'' business in part 
because other lending opportunities for these smaller banks have 
dwindled over time. Many observers have noted that small and medium 
sized banks have lost market share in credit card lending and mortgage 
financing, for example, leaving them less diversified and with 
portfolios concentrated on riskier loans such as commercial real 
estate. This, in turn, reflects the larger trends in financial 
intermediation, particularly the growth in securitization of mortgages 
and consumer and credit card loans as well as the economies of scale 
that allow the largest banks to originate such loans in large volumes 
either for their own portfolios or for inclusion in asset backed or 
mortgage backed securities. See Agencies Proposed Guidance, supra note 
67. See, e.g., Timothy Clark et al., The Role of Retail Banking in the 
U.S. Banking Industry: Risk, Return, and Industry Structure, FRBNY 
Economic Policy Review, at 39, 45-46 (Dec. 2007) (online at 
www.newyorkfed.org/research/epr/07v13n3/0712hirt.pdf); Joseph Nichols, 
How Has the Growth of the CMBS Market Impacted Commercial Real Estate 
Lending at Banks?, CMBS World, at 18, 19-20 (Summer 2007) (online at 
www.cmsaglobal.org/cmbsworld/cmbsworld_toc.aspx?folderid=1386).
    \77\ House Committee on Financial Services, Testimony of Sheila 
Bair, Chairman, Federal Deposit Insurance Corporation, Hearing on 
Foreclosure Prevention, at 37, 110th Cong. (Dec. 6, 2007) (online at 
frwebgate.access.gpo.gov/cgi-bin/
getdoc.cgi?dbname=110_house_hearings&docid=f:40435.pdf).
---------------------------------------------------------------------------
    In June 2008, the FDIC indicated that its examiners were 
aware of the potential for a crisis and continued to press 
banks that were not in compliance with 2006 interagency 
guidance on concentrations in commercial real estate.\78\ 
However, the FDIC Inspector General's Material Loss Review 
found cases in which examiners did not call for action by the 
FDIC in resolving the troubled bank involved soon enough.\79\
---------------------------------------------------------------------------
    \78\ See, e.g., June 5, 2008 Written Testimony of Sheila Bair, 
supra note 76, at 13.
    \79\ Federal Deposit Insurance Corporation, Office of Inspector 
General, Semiannual Report to the Congress, at 13 (Oct. 30, 2009) 
(online at www.fdicoig.gov/semi-reports/SAROCT09/OIGSemi_FDIC_09-9-
09.pdf). See Section H.1, below.
---------------------------------------------------------------------------
    The OCC and the Federal Reserve Board (Federal Reserve), 
like the FDIC, also noted that many of their regulatory charges 
were potentially overexposed in commercial real estate.\80\ 
Similarly, both agencies focused on ensuring that their 
examiners who supervised smaller and community banks with large 
commercial real estate exposures acted within the boundaries of 
the 2006 interagency guidance.\81\
---------------------------------------------------------------------------
    \80\ Senate Committee on Banking, Housing, and Urban Affairs, 
Written Testimony of Donald L. Kohn, Vice Chairman, Board of Governors 
of the Federal Reserve System, The State of the Banking Industry, 110th 
Cong. (Mar. 4, 2008) (online at banking.senate.gov/public/
index.cfm?FuseAction=Files.View&FileStore_id=5496f28d-b49b-4a58-befa-
8bb3708de3cb) (hereinafter ``Written Testimony of Donald Kohn''); Dugan 
Testimony, March 4, 2008 Senate Banking Hearing, supra note 53.
    \81\ Written Testimony of Donald Kohn, supra note 80.
---------------------------------------------------------------------------
    In contrast to the FDIC, Federal Reserve, and OCC, 
Treasury's public statements and initiatives during late 2007 
and early 2008 concentrated mostly on the residential real 
estate sector. To the extent that Treasury discussed commercial 
real estate, it did so in the context of a broader real estate 
market contraction or in the context of write-downs on 
CMBS.\82\
---------------------------------------------------------------------------
    \82\ Senate Committee on Banking, Housing, and Urban Affairs, 
Testimony of Henry M. Paulson, Jr., Secretary of the Treasury, Recent 
Developments in U.S. Financial Markets and Regulatory Responses to 
Them, 110th Cong. (July 15, 2008) (online at banking.senate.gov/public/
index.cfm?FuseAction=Hearings.Hearing&Hearing_ID=8f6a9350-3d39-43a0-
bbfb-953403ab19cc).
---------------------------------------------------------------------------
    In the months leading up to the financial crisis and the 
panic atmosphere that surrounded the consideration of EESA, the 
Act giving the Treasury Secretary the authority to establish 
the TARP, both private analysts and bank supervisors began 
noticing warning signs that a commercial real estate collapse 
could endanger the health of the financial system. But, again, 
these warnings typically took place alongside more dire 
warnings about the crisis in the residential real estate 
market.\83\
---------------------------------------------------------------------------
    \83\ John McCune, First-half 2008: far from a pretty picture, ABA 
Banking Journal, at 7 (Sept. 1, 2008) (``The impact of the [residential 
real estate] collapse also appeared to be percolating down into the 
commercial real estate lending segment. . . . It remains to be seen if 
this is the start of a larger trend, but is certainly something worth 
paying attention to''); Mark Vitner, Senior Economist, Wachovia, and 
Anika R. Khan, Economist, Wachovia, Could housing tremors shake 
commercial real estate?, ABA Banking Journal, at 56 (May 1, 2008) 
(``The abrupt collapse of the subprime mortgage market and severe 
correction in home construction and prices has raised concerns the same 
thing could happen to commercial real estate'').
---------------------------------------------------------------------------

4. Emergency Economic Stabilization Act and the TARP

    During consideration of EESA, concerns about the commercial 
real estate market occasionally surfaced as part of the floor 
debate in both houses of Congress, especially in the context of 
critiquing the bill for not doing more to protect the interests 
of commercial real estate borrowers and lenders. For example, 
Representative Steven LaTourette criticized the practice of 
bank examiners insisting that banks write down commercial real 
estate assets that had declined in value, resulting in 
decreased credit capacity for community needs like additional 
commercial real estate development.\84\ Senator Orrin Hatch 
similarly highlighted the need to preserve commercial real 
estate expansion and construction as part of broader economic 
needs not addressed in EESA.\85\
---------------------------------------------------------------------------
    \84\ Statement of Congressman Steven LaTourette, Congressional 
Record, H10386-87 (Sept. 29, 2008) (``[I]f you are a bank and you have 
a million dollar building in your portfolio but because the real estate 
market isn't doing so well, the bank examiners have come in and they 
have said your building is only worth $400,000 today. You haven't sold 
it. Nothing has happened to it. You are still collecting rent on it, 
but you have taken a $600,000 hit on your balance sheet. That has a 
double-edged effect in that now that you have a reduced balance sheet, 
you have to squirrel more cash so you can't make loans to people 
wanting to engage in business, people wanting to buy homes'').
    \85\ Statement of Senator Orrin Hatch, Congressional Record, S10263 
(Oct. 1, 2008) (``The rest of the economy is in urgent need of 
attention too. . . . We need to keep business fixed investment in new 
plant and equipment and commercial construction moving forward. That 
would help keep employment, productivity, and wages growing, and keep 
the rest of the economy healthy'').
---------------------------------------------------------------------------
    This legislative concern about commercial real estate 
assets translated into specific authority in the final 
legislation to address commercial real estate problems. EESA 
signals that troubled commercial real estate assets, like 
residential assets, are important to financial stability. The 
statute itself identifies commercial mortgages, as well as 
securities based on, or derivatives of, commercial mortgages, 
as troubled assets, that Treasury may purchase without a 
written determination that such a purchase is necessary for 
financial stability.\86\ In contrast, other financial 
instruments require that Treasury deliver such a written 
determination to Congress prior to making a purchase.\87\
---------------------------------------------------------------------------
    \86\ The mortgage must have been originated, or the security or 
derivative must have been issued, prior to March 14, 2008. Residential 
mortgages, securities, or derivatives also fall into this category of 
Treasury's purchasing authority. 12 U.S.C. Sec. 5202(9)(A).
    \87\ 12 U.S.C. Sec. 5202(9)(B).
---------------------------------------------------------------------------
    Given congressional concerns regarding commercial real 
estate, the Panel has conducted previous work on the potential 
problems in the commercial real estate market. The Panel held a 
field hearing in New York about commercial real estate credit, 
hearing from analysts, market participants, and 
supervisors.\88\ In its June Report, the Panel addressed the 
failure to capture the risk posed by commercial real estate 
loans as a major shortcoming of the stress tests conducted 
under the Supervisory Capital Assistance Program in May 
2009.\89\ The Panel further addressed the risks posed by 
commercial real estate assets in its August Report on the 
continuing presence of troubled assets on bank balance 
sheets.\90\ This report, as well as its January 27, 2010 field 
hearing in Atlanta, followed and amplified these efforts.
---------------------------------------------------------------------------
    \88\ Congressional Oversight Panel, The Impact of Economic Recovery 
Efforts on Corporate and Commercial Real Estate Lending (May 28, 2009) 
(online at cop.senate.gov/documents/transcript-052809-newyork.pdf).
    \89\ COP June Oversight Report, supra note 6.
    \90\ COP August Oversight Report, supra note 5.
---------------------------------------------------------------------------

             D. Present Condition of Commercial Real Estate

    The commercial real estate market is currently experiencing 
considerable difficulty for two distinct reasons. First, the 
current economic downturn has resulted in a dramatic 
deterioration of commercial real estate fundamentals. 
Increasing vacancy rates and falling rental prices present 
problems for all commercial real estate loans. Decreased cash 
flows will affect the ability of borrowers to make required 
loan payments. Falling commercial property values result in 
higher LTV ratios, making it harder for borrowers to refinance 
under current terms regardless of the soundness of the original 
financing, the quality of the property, and whether the loan is 
performing.
    Second, the development of the commercial real estate 
bubble, as discussed above, resulted in the origination of a 
significant amount of commercial real estate loans based on 
dramatically weakened underwriting standards. These loans were 
based on overly aggressive rental or cash flow projections (or 
projections that were only sustainable under bubble 
conditions), had higher levels of allowable leverage, and were 
not soundly underwritten. Loans of this sort (somewhat 
analogous to ``Alt-A'' residential loans) will encounter far 
greater difficulty as projections fail to materialize on 
already excessively leveraged commercial properties.
    In both cases, inherently risky construction loans and the 
non-recourse nature of permanent commercial real estate 
financing increase the pressures that both lenders and 
borrowers face. Construction loans are experiencing the biggest 
problems with vacancy or cash flow issues, have the highest 
likelihood of default, and have higher loss severity rates than 
other commercial real estate loans. (For example, the 25 
institutions from the Atlanta area that failed since 2008 
reported weighted average ADC loans of 384 percent of total 
capital a year before their failure.\91\ Because a lender's 
recovery is typically limited to the value of the underlying 
property, commercial real estate investments are increasingly 
at risk as LTV ratios rise or the value of the collateral is no 
longer sufficient to cover the outstanding loan amount.
---------------------------------------------------------------------------
    \91\ Congressional Oversight Panel, Written Testimony of Doreen 
Eberley, acting regional director, Atlanta Regional Office of the 
Federal Deposit Insurance Corporation, Atlanta Field Hearing on 
Commercial Real Estate, at 4, (Jan. 27, 2010) (online at 
cop.senate.gov/documents/testimony-012710-eberley.pdf) (hereinafter 
``Written Testimony of Doreen Eberley'').
---------------------------------------------------------------------------
    The following three sections further analyze the current 
state of the commercial real estate market and the risks posed 
to financial institutions by commercial real estate loans. This 
section, Section D, discusses the overall condition of the 
economy and how negative economic growth, rising unemployment 
rates, and decreased consumer spending have impacted commercial 
real estate fundamentals. Section E discusses the current 
landscape of the commercial real estate market, including 
current levels of commercial real estate whole loans and CMBS 
by holding institution, property type, and geographic region. 
Section F discusses the risks posed by the current state of the 
commercial real estate market, such as credit risk (the risk 
that loans will default prior to maturity), term risk (the risk 
that loans will default at maturity or will be unable to 
refinance), the risk that borrowers will be unable to obtain 
financing for commercial real estate purchases or developments, 
and interest rate risk (the risk that rising interest rates 
will make it harder for borrowers to finance or refinance 
loans).
    Again, no single factor is as important to the state of the 
commercial real estate markets as a steady, and indeed swift, 
economic recovery. It is questionable whether loans financing 
properties on the basis of unrealistic projections, inflated 
values, and faulty underwriting during 2005-2007 can survive in 
any event, as discussed more fully below. But it is more 
important to recognize that the continuing deep recession that 
the economy is experiencing is putting at risk many sound 
commercial real estate investments that were soundly conceived 
and reasonably underwritten.
    Economic growth and low unemployment rates lead to greater 
demand for, and occupancy of, commercial office space, more 
retail tenants and retail sales, and greater utilization of 
travel and hospitality space.\92\ Without more people in 
stores, more people at hotels, more people able to afford new 
or larger apartments, and more businesses seeking new or larger 
office space and other commercial property, the markets cannot 
recover and the credit and term risk created by commercial real 
estate loans cannot abate without the potential imposition of 
substantial costs on lenders. Each of these factors has its own 
impact on the broader commercial real estate problem. Thus, 
retail and hotel-tourist property problems likely reflect 
reduced cash flows not only from unemployment but also from 
household deleveraging, i.e., higher family savings rates. 
Perhaps even more important, the problem property owners and 
lenders face derives both from an undersupply of tenants and 
purchasers, and economic pressures that reduce incentives for 
the flow of new sources of equity into the commercial real 
estate markets.
---------------------------------------------------------------------------
    \92\ See Congressional Oversight Panel, Written Testimony of Chris 
Burnett, chief executive officer, Cornerstone Bank, Atlanta Field 
Hearing on Commercial Real Estate, at 3-6 (Jan. 27, 2010) (online 
atcop.senate.gov/documents/testimony-012710-burnett.pdf) (hereinafter 
``Written Testimony of Chris Burnett'').
---------------------------------------------------------------------------

1. Economic Conditions and Deteriorating Market Fundamentals

    The health of the commercial real estate market depends on 
the health of the overall economy. Consequently, the market 
fundamentals will likely stay weak for the foreseeable 
future.\93\ This means that even soundly financed projects will 
encounter difficulties. Those projects that were not soundly 
underwritten will likely encounter far greater difficulty as 
aggressive rental growth or cash flow projections fail to 
materialize, property values drop, and LTV ratios rise on 
already excessively leveraged properties. New and partially 
constructed properties are experiencing the biggest problems 
with vacancy and cash flow issues (leading to a higher number 
of loan defaults and higher loss severity rates than other 
commercial property loans).\94\ Falling commercial property 
prices are increasing debt-to-equity ratios, decreasing the 
amount of equity the borrower holds in the property (putting 
pressure on the borrowers) and removing the cushion that 
lenders built into non- recourse loans to protect their 
original investments (putting pressure on the lenders).
---------------------------------------------------------------------------
    \93\ See, e.g., Congressional Oversight Panel, Written Testimony of 
Jon D. Greenlee, associate director, Division of Bank Supervision and 
Regulation, Board of Governors of the Federal Reserve System, Atlanta 
Field Hearing on Commercial Real Estate, at 5-6 (Jan. 27, 2010) (online 
at cop.senate.gov/documents/testimony-012710-greenlee.pdf) (hereinafter 
``Written Testimony of Jon Greenlee'').
    \94\ Id., at 7 (``As job losses continue, demand for commercial 
property has declined, vacancy rates increased, and property values 
fallen. The higher vacancy levels and significant decline in the value 
of existing properties have placed particularly heavy pressure on 
construction and development projects that do not generate income until 
after completion'').
---------------------------------------------------------------------------
    Since the summer of 2007, the ongoing economic crisis has 
spread from credit markets, through the financial sector, and 
into the broader economy. Economic indicators are sending mixed 
signals as to whether the worst is over or whether the nation 
should expect further weakening in the economy. Economic growth 
has only recently returned after several quarters of decline, 
suggesting that a recovery is beginning. However, despite 
recent positive Gross Domestic Product (GDP) numbers, 
unemployment has risen to levels not seen in decades. Figures 7 
and 8 illustrate the evolution of the current economic 
downturn.

       FIGURE 7: SEASONALLY ADJUSTED ANNUAL GDP GROWTH RATES \95\

---------------------------------------------------------------------------
    \95\ U.S. Department of Commerce, Bureau of Economic Analysis, 
Gross Domestic Product: Third Quarter 2009 (Dec. 22, 2009) (online at 
www.bea.gov/ newsreleases/ national/gdp/2009/xls/gdp3q09_3rd.xls). The 
Bureau of Economic Analysis provides that the acceleration in real GDP 
growth in Q4 2009, based on their advance estimate, primarily reflected 
an acceleration in private inventory replenishment (adding 3.4 
percentage points to the fourth quarter change of 5.7 percent), a 
deceleration in imports (increasing 10.5 percent in Q4, as compared to 
a 21.3 percent increase in Q3), and an upturn in nonresidential fixed 
investment (increasing 2.9 percent in Q4, as compared to a 5.9 percent 
decrease in Q3) that was partly offset by decelerations in federal 
government spending (increasing 0.1 percent in Q4, as compared to an 
8.0 percent increase in Q3) and in personal consumption expenditures 
(increasing 2.0 percent in Q4, as compared to a 2.8 percent increase in 
Q3). U.S. Department of Commerce, Bureau of Economic Analysis, Gross 
Domestic Product: Fourth Quarter 2009 (Advance Estimate), at 1-2 (Jan. 
29, 2010) (online at www.bea.gov/ newsrelease/national/gdp/ 
gdpnewsrelease.htm) (hereinafter ``BEA Fourth Quarter GDP Estimate''). 
It is yet to be seen whether this growth, driven in part by inventory 
replenishment, is sustainable. Sustainability of economic growth will 
depend, to some extent, on how (or whether) inventory replenishment 
translates into final sales to domestic purchasers. 

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              FIGURE 8: UNEMPLOYMENT RATES SINCE 2000 \96\

---------------------------------------------------------------------------
    \96\ Bureau of Labor Statistics, Employment Status of the Civilian 
Noninstitutional Population 16 Years and Over, 1970 to Date (online at 
ftp.bls.gov/pub/suppl/empsit.cpseea1.txt) (accessed Feb. 9, 2010). 
Underemployment, an alternative measure of the status of employment, 
includes a larger percentage of the population and directly follows the 
trend of unemployment. Both measures illustrate the continuing 
deterioration of employment conditions since January 2008. As of 
December 2009, underemployment was 17.3 percent and unemployment was 10 
percent. Underemployment, as measured by the Bureau of Labor 
Statistics, is comprised of the total number of unemployed as well as 
marginally attached workers, discouraged workers, and individuals 
employed part-time due to economic factors who would otherwise seek 
full-time work. For further discussion of the measure, see Bureau of 
Labor Statistics, Alternative Measures of Labor Utilization (Dec. 2009) 
(online at www.bls.gov/ news.release/ empsit.t12.htm). In January 2010, 
unemployment rates decreased from 10.0 to 9.7 percent and 
underemployment decreased from 17.3 to 16.5 percent. Bureau of Labor 
Statistics, Employment Situation Summary (Feb. 5, 2010) (online at 
bls.gov/ news.release/ empsit.nr0.htm); Bureau of Labor Statistics, 
Alternative Measures of Labor Utilization (Jan. 2010) (online at 
www.bls.gov/ news.release/ empsit.t15.htm). However, for the week 
ending January 30, 2010, the advance figure for initial jobless claims 
for unemployment insurance rose to 480,000, an increase of 8,000 from 
the previous week's revised figure. This was the fourth rise in initial 
jobless claims in the last five weeks. See U.S. Department of Labor, 
Unemployment Insurance Weekly Claims Reports, Feb. 4, 2010 (increase of 
8,000), Jan. 28, 2010 (decrease of 8,000), Jan. 21, 2010 (increase of 
36,000), Jan. 14, 2010 (increase of 11,000), and Jan. 7, 2010 (increase 
of 1,000).

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]


    Other economic indicators that are vital to the health of 
commercial real estate, such as consumer spending, have 
experienced overall declines from pre-recession levels but do 
not provide a clear message of recovery. For example, personal 
consumption has declined from its peak in the fourth quarter of 
2007, but quarterly changes have oscillated between positive 
and negative.\97\ The extent and timing of the economic 
recovery is important in assessing the magnitude of the 
commercial real estate problem because, as a general rule, 
commercial real estate metrics tend to lag overall economic 
performance,\98\ and commercial real estate market fundamentals 
have already deteriorated significantly.
---------------------------------------------------------------------------
    \97\ U.S. Department of Commerce, Bureau of Economic Analysis, 
National Income and Product Accounts Table (Table 2.3.3: Real Personal 
Consumption Expenditures by Major Type of Product, Quantity Indexes) 
(aggregate numbers, indexed to 2005) (online at www.bea.gov/ National/
nipaweb/ TableView.asp? SelectedTable=63&ViewSeries= 
NO&Java=no&Request3 Place=N&3Place=N&FromView= YES&Freq= 
Qtr&FirstYear=2007&LastYear= 2009&3Place=N&AllYearsChk= 
YES&Update=Update &JavaBox=no#Mid) (accessed Feb. 8, 2010) (showing 
increases in Q2 2008, Q1 2009, and Q3 2009).
    \98\ Written Testimony of Doreen Eberley, supra note 91, at 7-8 
(``Performance of loans that have commercial real estate properties as 
collateral typically lags behind economic cycles. Going into an 
economic downturn, property owners may have cash reserves available to 
continue making loan payments as the market slows, and tenants may be 
locked into leases that provide continuing cash flow well into a 
recession. However, toward the end of an economic downturn, vacant 
space may be slow to fill, and concessionary rental rates may lead to 
reduced cash flow for some time after economic recovery begins''). For 
example, although the economic recession in the early 2000s officially 
lasted only from March 2001 to November 2001, commercial real estate 
vacancies did not peak until September 2003 and did not begin to 
decline until March 2004. See National Bureau of Economic Research, 
Business Cycle Expansions and Contractions (online at www.nber.org/
cycles.html) (accessed Feb. 8, 2010); Mortgage Bankers Association, 
Commercial Real Estate/Multifamily Finance Quarterly Data Book: Q3 
2009, at 26-27 (Nov. 2009) (hereinafter ``MBA Data Book: Q3 2009'').
    Commercial real estate fundamentals tend to track unemployment 
rates, another lagging economic indicator, more closely than GDP 
growth. The current economic crisis has so far followed this trend, 
with vacancy rates continuing to rise even after the return of positive 
economic growth. Similar to unemployment rates, vacancy rates began to 
fall in 2003, began rising in 2007, and are still rising.
---------------------------------------------------------------------------
    For the last several quarters, average vacancy rates have 
been rising and average rental prices have been falling for all 
major commercial property types.\99\ The following charts 
present these changes in average vacancy rates and average 
rental prices from 2003 to 2009.
---------------------------------------------------------------------------
    \99\ MBA Data Book: Q3 2009, supra note 98, at 26-27.
---------------------------------------------------------------------------

FIGURE 9: COMMERCIAL REAL ESTATE AVERAGE VACANCY RATES BY PROPERTY TYPE 
                                 \100\

---------------------------------------------------------------------------
    \100\ MBA Data Book: Q3 2009, supra note 98, at 27. Although 
average vacancy rates are commensurate with 2003 levels, it should be 
noted that the levels in 2003 were also the result of recessionary 
conditions of the early 2000s, vacancy rates have been buffered by the 
presence of long-term leases on some commercial properties, and the 
increase in available commercial space has translated into an 
increasing number of properties with vacancy issues. 

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

  FIGURE 10: COMMERCIAL REAL ESTATE AVERAGE RENTAL PRICES BY PROPERTY 
                               TYPE \101\

---------------------------------------------------------------------------
    \101\ MBA Data Book: Q3 2009, supra note 98, at 27. See also 
Written Testimony of Doreen Eberley, supra note 91, at 4-5 (``As of 
third quarter 2009, quarterly rent growth has been negative across all 
major commercial real estate property types nationally for at least the 
last four quarters. Asking rents for all major commercial real estate 
property types nationally were lower on both a year-over-year and 
quarter-over quarter basis''). 

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    Current average vacancy rates and rental prices have been 
buffered by the long-term leases held by many commercial 
properties (e.g., office and industrial).\102\ The combination 
of negative net absorption rates \103\ and additional space 
that will become available from projects started during the 
boom years \104\ will cause vacancy rates to remain high, and 
will continue putting downward pressure on rental prices for 
all major commercial property types. Taken together, this 
falling demand and already excessive supply of commercial 
property will cause many projects to be viable no longer, as 
properties lose, or are unable to obtain, tenants and as cash 
flows (actual or projected) fall.
---------------------------------------------------------------------------
    \102\ See Richard Parkus and Harris Trifon, The Outlook for 
Commercial Real Estate and its Implications for Banks, at 10 (Dec. 
2009) (hereinafter ``Parkus and Trifon''). See additional discussion of 
commercial properties at Section B.1.
    \103\ Net absorption rates are a measure of the change in occupancy 
levels or vacancy rates. Negative net absorption occurs when the amount 
of available commercial space (e.g., through lease terminations and new 
construction) exceeds the amount of space being taken off the market 
(e.g., through new leases and renewals).
    \104\ MBA Data Book: Q3 2009, supra note 98, at 28-29 (as shown by 
the number of net completions).
---------------------------------------------------------------------------
    In addition to deteriorating market fundamentals, the price 
of commercial property has plummeted. As seen in the following 
chart, commercial property values have fallen over 40 percent 
since the beginning of 2007.\105\
---------------------------------------------------------------------------
    \105\ Moody's Investors Service, Moody's/REAL Commercial Property 
Price Indices, December 2009, at 1 (Dec. 21, 2009) (hereinafter ``Dec. 
2009 Moody's/REAL Commercial Property Price Indices'') (``The peak in 
prices was reached two years ago in October 2007, and prices have since 
fallen 43.7%''). However, it should be noted that there was a small 
uptick in commercial property prices in November. See Moody's Investors 
Service, Moody's/REAL Commercial Property Price Indices, January 2010, 
at 1 (Jan. 15, 2010) (``After 13 consecutive months of declining 
property values, the Moody's/REAL Commercial Property Price Index 
(CPPI) measured a 1.0% increase in prices in November. . . . The 1.0% 
growth in prices seen in November is a small bright spot for the 
commercial real estate sector, which has seen values fall over 43% from 
the peak'').
---------------------------------------------------------------------------

     FIGURE 11: COMMERCIAL REAL ESTATE PROPERTY PRICE INDICES \106\

---------------------------------------------------------------------------
    \106\ See Massachusetts Institute of Technology Center for Real 
Estate, Commercial RE Data Laboratory, Transactions-Based Index (TBI) 
(accessed February 9, 2010) (measuring price movements and total 
returns based on transaction prices of commercial properties 
(apartment, industrial, office, and retail) sold from the National 
Council of Real Estate Investment Fiduciaries (NCREIF) Index database); 
Dec. 2009 Dec. 2009 Moody's/REAL Commercial Property Price Indices, 
supra note 105, at 1, 3 (measuring ``the change in actual transaction 
prices for commercial real estate assets based on the repeat sales of 
the same assets at different points in time''). See also Massachusetts 
Institute of Technology Center for Real Estate, Commercial RE Data 
Laboratory, Moody's/REAL Commercial Property Price Index (CPPI) 
(accessed February 9, 2010) (discussing the difference in Moody's/REAL 
CPPI and NCREIF TBI); MBA Data Book: Q3 2009, supra note 98, at 34-35. 

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    The decline in property value is largely driven by 
declining cash flows that have resulted from increased vacancy 
rates and decreased rental income.\107\ Contracting cash flows 
(actual and projected) result in lower net present value 
calculations. Tightened underwriting standards also decrease 
the ability of borrowers to qualify for commercial real estate 
loans, thus decreasing the demand for commercial property.\108\ 
Sharp decreases in the number of sales of commercial and 
multifamily properties reflect such a decrease in demand.\109\
---------------------------------------------------------------------------
    \107\ See, e.g., Written Testimony of Doreen Eberley, supra note 
91, at 4; Parkus and Trifon, supra note 102, at 32.
    \108\ Parkus and Trifon, supra note 102, at 32; see also Written 
Testimony of Doreen Eberley, supra note 91, at 6-97 (providing that 
tightened underwriting standards and a more risk-averse posture on the 
part of lenders has resulted in reduced credit availability and that 
reduced credit availability ``reduces the pool of possible buyers, 
increases the amount of equity that buyers must bring to transactions, 
and causes downward pressure on values'').
    \109\ See MBA Data Book: Q3 2009, supra note 98, at 30-31; see also 
Congressional Oversight Panel, Written Testimony of Mark Elliott, 
partner and head, Office and Industrial Real Estate Group, Troutman 
Sanders, Atlanta Field Hearing on Commercial Real Estate, at 1 (Jan. 
27, 2010) (online at cop.senate.gov/documents/testimony-012710-
elliott.pdf) (hereinafter ``Written Testimony of Mark Elliott'') (``The 
distress [in commercial loan markets in Atlanta] arises out of the 
nearly complete shut down of new loans into the market, and a 
corresponding and nearly as dramatic shut down of the replacement of 
existing loans on commercial properties. . . . This shutdown of the 
finance side has had an equally dramatic effect on the buy-side of 
commercial real estate assets; without the means to finance an 
acquisition, almost nothing is being bought or sold'').
---------------------------------------------------------------------------
    It should be noted that pricing is in a state of adjustment 
due to the decrease in the number of sales transactions. In the 
absence of market comparables, it is difficult to establish 
property values with any certainty. The few transactions that 
are occurring are generally focused on distressed borrowers or 
troubled loans \110\ and are being underwritten with higher cap 
rates, lower initial rents, declining rent growth or cash flow 
projections, and higher required internal rates of return.\111\ 
When fundamentals stabilize and lending resumes, the number of 
sales transactions should increase, thereby decreasing the 
spread between mortgage interest rates and the rate on 
comparable Treasury securities.\112\
---------------------------------------------------------------------------
    \110\ Written Testimony of Jon Greenlee, supra note 93, at 11 
(``Given the lack of sales in many real estate markets and the 
predominant number of distressed sales in the current environment, 
regulated institutions face significant challenges today in assessing 
the value of real estate'').
    \111\ See Written Testimony of Doreen Eberley, supra note 91, at 5 
(providing that in the current environment, investors are demanding 
higher required rates of return on their investments, as reflected in 
higher property capitalization rates and explaining that rising 
capitalization rates cause property values to fall); RREEF Research, 
Global Commercial Real Estate Debt: Deleveraging into Distress, at 3 
(June 2009) (hereinafter ``Deleveraging into Distress'').
    \112\ Deleveraging into Distress, supra note 111, at 3.
---------------------------------------------------------------------------
    Overall, the general economic downturn, uncertainty about 
the pace of any recovery, and low expectations for improving 
commercial real estate market fundamentals mean that prospects 
for a commercial real estate recovery in the near future are 
dim.

             E. Scope of the Commercial Real Estate Markets

    Commercial real estate markets currently absorb $3.4 
trillion in debt, which represents 6.5 percent of total 
outstanding credit market debt.\113\ The commercial real estate 
market grew exponentially from 2004 to its peak in Q4 2008, 
with a 52 percent growth in debt; however, commercial real 
estate debt growth appears to be winding back, decreasing 1.3 
percent from its peak 2008 levels to Q4 2009.\114\ Although 
peak commercial real estate debt outstanding was only one-third 
that of residential mortgage debt at its peak in Q1 2008,\115\ 
the size of the commercial real estate market means that its 
disruption could also have ripple effects throughout the 
broader economy, prolonging the financial crisis.
---------------------------------------------------------------------------
    \113\ Federal Reserve Statistical Release Z.1, supra note 7.
    \114\ Federal Reserve Statistical Release Z.1, supra note 7.
    \115\ Federal Reserve Statistical Release Z.1, supra note 7.
---------------------------------------------------------------------------
    For financial institutions, the ultimate impact of the 
commercial real estate whole loan problem will fall 
disproportionately on smaller regional and community banks that 
have higher concentrations of, and exposure to, such loans than 
larger national or money center banks. The impact of commercial 
real estate problems on the various holders of CMBS and other 
participants in the CMBS markets is more difficult to predict. 
The experience of the last two years, however, indicates that 
both risks can be serious threats to the institutions and 
borrowers involved.

   FIGURE 12: CRE DEBT OUTSTANDING BY FINANCIAL SECTORS (billions of 
                             dollars) \116\

---------------------------------------------------------------------------
    \116\ Federal Reserve Statistical Release Z.1, supra note 7. 

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    As the figure above shows, commercial banks hold $1.5 
trillion in commercial real estate debt outstanding, which is 
the largest share of the market at 45 percent.\117\ The next 
largest commercial real estate debt holders are asset-backed 
security (ABS) issuers with 21 percent of the total 
market.\118\ The remaining holders of commercial real estate 
debt share a fairly equal slice of the pie, ranging from four 
to nine percent. The total commercial real estate
---------------------------------------------------------------------------
    \117\ Federal Reserve Statistical Release Z.1, supra note 7.
    \118\ While the Federal Reserve uses the classification ``ABS 
issuers'' when disaggregating credit market debt by sector, for the 
purposes of this report, ABS issuers are equivalent to CMBS issuers.
---------------------------------------------------------------------------
debt outstanding includes both commercial real estate whole 
loans and related securities (i.e., CMBS).
    Banks are generally much more exposed to commercial real 
estate than CMBS investors because of the quality of the 
properties serving as collateral. Unlike the residential real 
estate market where banks generally kept the best residential 
mortgages and securitized the riskier loans into RMBS, CMBS 
loans were generally made to higher quality, stable properties 
with more reliable cash flow streams (e.g., a fully leased 
office building).\119\ The CMBS market was able to siphon off 
the highest quality commercial properties through lower 
interest rates and more allowable leverage.\120\ Banks, 
particularly mid-size and small banks, were left lending to 
transitional properties or construction projects with more 
uncertain cash flows or to less sought-after properties in 
secondary or tertiary markets.\121\ CMBS losses will 
potentially trigger capital consequences, as discussed in 
greater detail in Section G.
---------------------------------------------------------------------------
    \119\ See Parkus and Trifon, supra note 102, at 36.
    \120\ See Parkus and Trifon, supra note 102, at 36; see also 
Richard Parkus and Jing An, The Future Refinancing Crisis in Commercial 
Real Estate Part II: Extensions and Refinements, at 25 (July 15, 2009) 
(hereinafter ``The Future Refinancing Crisis, Part II'') (``[T]he CMBS 
market grew dramatically over the past few years, from $93 billion in 
issuance in 2004, to $169 billion in 2005, to $207 billion in 2006 to 
$230 billion in 2007. Much of the growth in market share came at the 
expense of banks, as CMBS siphoned off many of the desirable loans on 
stabilized properties with extremely competitive rates. Banks, funding 
themselves at L-5bp simply couldn't compete on price terms given the 
execution that was available in CMBS at the time. This forced banks, 
particularly regional and community banks, into riskier lines of 
commercial real estate lending'').
    \121\ Parkus and Trifon, supra note 102, at 26 (``Because of their 
liability structure, bank commercial lending has always tended to focus 
more on shorter term lending on properties with some transitional 
aspect to them--properties with a business plan. Such transitional 
properties typically suffer more in a downturn as the projected cash 
flow growth fails to materialize''). These loans typically have three 
to five year terms, are expected to mature at the trough of the 
downturn (2011-2012), and have consistently had significantly higher 
delinquency rates than CMBS loans. See also Richard Parkus and Harris 
Trifon, The Outlook for Commercial Real Estate and Its Implications for 
Banks, at 48 (Dec. 2009).
---------------------------------------------------------------------------

         FIGURE 13: COMMERCIAL REAL ESTATE PRIVATE EQUITY \122\

---------------------------------------------------------------------------
    \122\ Gail Lee, U.S. CRE Debt Markets: What's Next?, PREA 
Quarterly, at 68-70 (Fall 2009) (hereinafter ``US CRE Debt Markets''). 
Data excludes corporate, nonprofit, and government equity real estate 
holdings as well as single-family and owner-occupied residences. 

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

         FIGURE 14: COMMERCIAL REAL ESTATE PUBLIC EQUITY \123\

---------------------------------------------------------------------------
    \123\ U.S. CRE Debt Markets, supra note 122. Data excludes 
corporate, nonprofit, and government equity real estate holdings as 
well as single-family and owner-occupied residences. 

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

                                 FIGURE 15: BANK EXPOSURE TO COMMERCIAL REAL ESTATE, CMBS, AND CDS (AS OF 9/30/09) \124\
                                                                  [Dollars in millions]
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                   Notional
                                                             Total CRE    Total      Notional     Amount of     Tier 1   CRE Whole    CMBS/
  Commercial Banks (classified by asset size)      Total       Whole       CMBS      Amount of      Credit      Risk-      Loans/     Tier 1   CDS/ Tier
                                                   Assets       Loan     Exposure     Credit     Derivatives    based      Tier 1    Capital   1 Capital
                                                              Exposure              Derivatives  (Guarantor)   Capital    Capital
--------------------------------------------------------------------------------------------------------------------------------------------------------
> $10 billion (85 banks)......................   $9,460,306   $842,794    $47,304   $12,985,697   $6,273,213   $749,303     112.5%       6.3%    1733.0%
$1 billion to $10 billion (440 banks).........    1,158,908    364,533      1,943            60           31    104,897     347.5%       1.9%       0.1%
$100 million to $1 billion (3,798 banks)......    1,104,244    353,651        708           132           24    102,542     344.9%       0.7%       0.1%
< $100 million125 (2,588 banks)...............      142,938     26,955         58             0            0     16,315     165.2%       0.4%      0.1%
--------------------------------------------------------------------------------------------------------------------------------------------------------
124 Federal Deposit Insurance Corporation, Statistics on Depository Institutions (online at www2.fdic.gov/sdi/main.asp) (hereinafter ``Statistics on
  Depository Institutions'') (accessed Jan. 22, 2010). Notional amount of credit derivatives is total credit derivative exposure of which credit default
  swaps for CMBS are a portion.
125 Per SNL Financial, the weighted average of commercial real estate to tier 1 risk-based capital is 276 percent for banks with less than $25 million
  in total assets.

    Commercial real estate whole loans are spread among the 
four commercial bank asset categories, with the mid-size banks' 
commercial real estate to Tier 1 capital ratios reaching the 
range considered ``CRE concentrated'' and the largest and 
smallest banks' ratios being one-third of that.\126\ Tier 1 
capital is the supervisors' preferred measurement of capital 
adequacy. Although banks with over $10 billion in assets hold 
over half of commercial banks' total commercial real estate 
whole loans, the mid-size and smaller banks face the greatest 
exposure. Thus, mid-size and smaller banks are less well-
capitalized against the risks of substantial commercial real 
estate loan write-downs. In terms of securitized and structured 
products, however, the largest banks dominate in market share. 
CMBS exposure to Tier 1 capital is six percent at the largest 
banks, two percent at mid-size banks, and negligible at the 
smaller banks. Credit derivatives are virtually nonexistent on 
all other banks' books but those of larger commercial 
banks.\127\
---------------------------------------------------------------------------
    \126\ Per the Final Guidance on Concentrations in Commercial Real 
Estate Lending, Sound Risk Management Practices published by the OCC, 
the Federal Reserve, and the FDIC, a bank is considered to be ``CRE 
concentrated'' if loans for construction, land development, and other 
land and loans secured by multifamily and nonfarm, nonresidential 
property (excluding loans secured by owner-occupied properties) are 300 
percent or more of total capital or if construction and land loans are 
more than 100 percent of total capital.
    \127\ Statistics on Depository Institutions, supra note 124 
(accessed Jan. 22, 2010).
---------------------------------------------------------------------------
    The current distribution of commercial real estate loans 
may be particularly problematic for the small business 
community because smaller regional and community banks with 
substantial commercial real estate exposure account for almost 
half of small business loans. For example, smaller banks with 
the highest exposure--commercial real estate loans in excess of 
three times Tier 1 capital--provide around 40 percent of all 
small business loans.\128\
---------------------------------------------------------------------------
    \128\ Dennis P. Lockhart, Economic Recovery, Small Businesses, and 
the Challenge of Commercial Real Estate, Federal Reserve Bank of 
Atlanta Speech (Nov. 10, 2009) (hereinafter ``Lockhart Speech before 
the Atlanta Fed'').
---------------------------------------------------------------------------

   FIGURE 16: CRE WHOLE LOAN EXPOSURE AND SMALL BUSINESS LENDING BY 
                         INSTITUTION SIZE \129\

---------------------------------------------------------------------------
    \129\ Statistics on Depository Institutions, supra note 124 
(accessed Jan. 22, 2010). 

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    The withdrawal of small business loans because of a 
disproportionate exposure to commercial real estate capital 
creates a ``negative feedback loop'' that suppresses economic 
recovery: fewer loans to small businesses hamper employment 
growth, which could prolong commercial real estate problems by 
contributing to higher vacancy rates and lower cash flows. This 
loop has a considerable impact on the overall economy 
considering that small businesses have accounted for around 45 
percent of net job losses in this recession (through 2008) and 
have contributed to around one-third of net job growth in the 
past two economic expansions.\130\ Federal Reserve Chairman Ben 
Bernanke and Treasury Secretary Timothy Geithner have noted the 
particular problems that small businesses are facing in the 
current, challenging credit environment.\131\ In his January 
27, 2010 State of the Union address, President Obama announced 
a proposal to take ``$30 billion of the money Wall Street banks 
have repaid and use it to help community banks give small 
businesses the credit they need to stay afloat.'' \132\ For 
further discussion of President Obama's proposal and its TARP 
ramifications, see Section I.4.
---------------------------------------------------------------------------
    \130\ Lockhart Speech before the Atlanta Fed, supra note 128. See 
also Secretary of the Treasury Timothy F. Geithner and Small Business 
Administration Administrator Karen G. Mills, Report to the President: 
Small Business Financing Forum, at 18-20 (Dec. 3, 2009) (hereinafter 
``Small Business Financing Forum'').
    \131\ See Economic Club of Washington, D.C., Statement of Federal 
Reserve Chairman Ben S. Bernanke (Dec. 7, 2009); Small Business 
Financing Forum, supra note 130, at 18-19.
    \132\ See Remarks by the President in State of the Union Address, 
The White House Office of the Press Secretary (Jan. 27, 2010) (online 
at www.whitehouse.gov/the-press-office/remarks-president-state-union-
address) (hereinafter ``State of the Union Remarks''). As discussed in 
Section I.4 below, the Administration's proposal involves transferring 
the necessary amount from the TARP to a separate fund.
---------------------------------------------------------------------------
    In addition to the impact on the small business community, 
the geographic areas serviced by the more exposed regional and 
com-
munity banks may suffer as a result of tightened credit terms, 
a contraction in bank lending, and possibly bank failures. To 
the extent that smaller communities have fewer options for 
available credit, these developments could have severe short-
term consequences. As far as individual commercial properties 
or borrowers are concerned, the impact will depend on the type 
of commercial property involved and local developments related 
to commercial real estate fundamentals as well as the overall 
economy. For example, apartment buildings in the South are 
greatly underperforming the national statistics, while 
apartment buildings in the East continue to perform 
better.\133\ On the other hand, the Southern retail sector has 
greatly outperformed the nation while the Eastern retail sector 
was the worst performer nationally.\134\
---------------------------------------------------------------------------
    \133\ See Dec. 2009 Dec. 2009 Moody's/REAL Commercial Property 
Price Indices, supra note 105, at 7-8 (providing that the eastern 
apartment index has fallen 13.2 percent, the national apartment index 
has fallen nearly 40 percent, and the broader southern apartment index 
has fallen 51.8 percent in the past year).
    \134\ See Dec. 2009 Dec. 2009 Moody's/REAL Commercial Property 
Price Indices, supra note 105 (providing that eastern retail prices 
fell 31.9 percent, national retail prices fell 19.4 percent, and 
southern retail prices fell 8 percent in the past year).
---------------------------------------------------------------------------

1. Whole Loans 

    A whole loan is simply the original mortgage loan made by a 
lender for a series of principal and interest payments over 
time. As indicated in Figures 12 and 15 above, 46 percent of 
outstanding commercial real estate debt exists in the form of 
whole loans, as it is the original source of funding.\135\ 
Through whole loans, investors provide capital to the 
commercial mortgage market in exchange for the undiluted risks 
and income associated with those loans. The securitization of 
commercial real estate through CMBS began in the 1990s and 
entered a stage of innovation in the 2000s; so, structured 
commercial real estate products are relatively young.\136\ As 
noted in Figure 15 above, commercial real estate loans 
outstanding are split fairly evenly between larger banks and 
mid-size banks. For the two mid-size classes of banks (i.e., 
assets from $100 million to $10 billion), however, the total 
commercial real estate loans outstanding is between 347 and 345 
percent of Tier 1 capital, compared to only 112 percent of Tier 
1 capital at commercial banks with over $10 billion in 
assets.\137\
---------------------------------------------------------------------------
    \135\ The calculation is based upon the ``Total CRE Whole Loan 
Exposure'' column of $1.587 trillion (Figure 15) divided by $3.434 
trillion of ``Total CRE Debt Exposure By Financial Sector'' (totaling 
all sectors) (Figure 12).
    \136\ James R. Woodwell, The Perfect Calm, Mortgage Banking (Jan. 
2007) (online at www.mbaa.org/files/Research/IndustryArticles/
Woodwell.pdf).
    \137\ Statistics on Depository Institutions, supra note 124 
(accessed Jan. 22, 2010).
---------------------------------------------------------------------------
    Foresight Analytics, a California-based firm specializing 
in real estate market research and analysis, calculates banks' 
exposure to commercial real estate to be even higher than that 
estimated by the Federal Reserve. Drawing on bank regulatory 
filings, including call reports and thrift financial reports, 
Foresight estimates that the total commercial real estate loan 
exposure of commercial banks is $1.9 trillion compared to the 
$1.5 trillion Federal Reserve estimate. The 20 largest banks, 
those with assets greater than $100 billion, hold $600.5 
billion in commercial real estate loans.\138\ The following 
table shows the breakdown of commercial real estate loans 
across banks by type.
---------------------------------------------------------------------------
    \138\ Foresight Analytics, LLC, Commercial Real Estate Exposure by 
Size of Bank as of 3Q 2009 (Jan. 13, 2009) (provided at the request of 
the Congressional Oversight Panel) (hereinafter ``CRE Exposure by Size 
of Bank''). The FDIC does not disaggregate data in public form beyond 
the total assets ``greater than $10 billion'' category. The use of 
Foresight Analytics data allows for a further disaggregation of FDIC 
categories, although the number of banks reporting, and thus total 
exposure across banks, are slightly different.

             FIGURE 17: COMMERCIAL REAL ESTATE LOANS BY TYPE (BANKS AND THRIFTS AS OF Q3 2009) \139\
----------------------------------------------------------------------------------------------------------------
                                      Bank   Total CRE   Commercial    Multifamily    Construction    Unsecured
 Institution Size by Total Assets    Count     Loans     Mortgages      Mortgages       and Land         CRE
----------------------------------------------------------------------------------------------------------------
> $100 Bn.........................       20      600.5        318.3            79.7           160.5         42.0
$10 Bn to $100 Bn.................       92      373.4        209.6            57.0            93.8         13.0
$1 Bn to $10 Bn...................      584      447.8        272.9            45.9           123.3          5.7
$100 Mn to $1 Bn..................    4,499      412.5        269.0            32.0           108.0          3.5
$0 to $100 Mn.....................    2,913       29.7         20.7             1.9             6.7          0.4
                                   -----------------------------------------------------------------------------
    Total.........................   8,108    1,864.0      1,090.6           216.5           492.3          64.6
----------------------------------------------------------------------------------------------------------------
\139\ Id.

    The OCC, the Federal Reserve, and the FDIC have published a 
Final Guidance on Concentrations in Commercial Real Estate 
Lending, Sound Risk Management Practices.\140\ Although the 
Guidance does not place any explicit limits on the ratio of 
commercial real estate loans to total assets, it states that 
``if loans for construction, land development, and other land 
and loans secured by multifamily and nonfarm, nonresidential 
property (excluding loans secured by owner-occupied properties) 
were 300 percent or more of total capital, the institution 
would also be considered to have a [commercial real estate] 
concentration and should employ heightened risk management 
practices.'' \141\ The supervisors also classify a bank as 
having a ``CRE Concentration'' if construction and land loans 
are more than 100 percent of total capital.\142\
---------------------------------------------------------------------------
    \140\ Concentrations in Commercial Real Estate Lending, Sound Risk 
Management Practices, 71 Fed. Reg. 74580 (Dec. 12, 2006). This guidance 
is discussed in more detail at pages 108-113 below.
    \141\ Concentrations in Commercial Real Estate Lending, Sound Risk 
Management Practices, 71 Fed. Reg. 74580, 74581 (Dec. 12, 2006).
    \142\ Id.
FIGURE 18: COMMERCIAL REAL ESTATE EXPOSURE VS. RISK-BASED CAPITAL\ 143\

---------------------------------------------------------------------------
    \143\ CRE Exposure by Size of Bank, supra note 138.

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

                      FIGURE 19: BANKS CATEGORIZED AS HAVING ``CRE CONCENTRATIONS'' \ 144\
----------------------------------------------------------------------------------------------------------------
                                                                                Bank Count
                                                        --------------------------------------------------------
                                                                                              Banks with CRE
                       Size Group                                            CRE           Concentrations/Total
                                                            Total       Concentrations      Banks within Asset
                                                                                                  Class
----------------------------------------------------------------------------------------------------------------
> $100 Bn..............................................           20                  1                       5%
$10 Bn to $100 Bn......................................           92                 27                      29%
$1 Bn to $10 Bn........................................          584                358                      61%
$100 Mn to $1 Bn.......................................        4,499              2,115                      47%
$0 to $100 Mn..........................................        2,913                487                      17%
                                                        --------------------------------
    Total..............................................       8,108               2,988
----------------------------------------------------------------------------------------------------------------
\144\ CRE Exposure by Size of Bank, supra note 138.

    As seen in the Foresight Analytics data above, the mid-size 
and smaller institutions have the largest percentage of ``CRE 
Concentration'' banks compared to total banks within their 
respective asset class. This percentage is especially high in 
banks with $1 billion to $10 billion in assets. The table above 
emphasizes the heightened commercial real estate exposure 
compared to total capital in banks with $100 million to $10 
billion in assets. Equally troubling, at least six of the 
nineteen stress-tested bank-holding companies have whole loan 
exposures in excess of 100 percent of Tier 1 risk-based 
capital. See additional discussion of banks that have received 
TARP assistance in Section H.

2. Commercial Mortgage Backed Securities (CMBS) 

                       FIGURE 20: CMBS FLOWCHART 


[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    CMBS are asset-backed bonds based on a group, or pool, of 
commercial real estate permanent mortgages. A single CMBS issue 
usually represents several hundred commercial mortgages, and 
the pool is diversified in many cases by including different 
types of properties. For example, a given CMBS may pool 50 
office buildings, 50 retail properties, 50 hotels, and 50 
multifamily housing developments. (In residential mortgage 
markets, loan terms are more standardized, and the overall 
impact of an individual loan in the performance of the MBS is 
minimal. In commercial mortgage markets, however, the 
individual commercial real estate loan can significantly impact 
the performance of the CMBS).\145\
---------------------------------------------------------------------------
    \145\ Commercial Mortgage Securities Association, Chapter Four: 
Issuing CMBS, CMSA E-Primer (www.cmsaglobal.org/assetlibrary/E0B68548-
4965-488A-8154-30691CB0F880/8be06679b07c4a5d93777548733482534.pdf).
---------------------------------------------------------------------------
    As can be seen in Figure 21 below, the use of CMBS to 
finance commercial real estate has grown very rapidly in recent 
years, peaking near the height of the commercial real estate 
bubble.

        FIGURE 21: TOTAL COMMERCIAL REAL ESTATE SECURITIZED \146\
------------------------------------------------------------------------
                                                              Percent
                          Year                              Securitized
------------------------------------------------------------------------
1970....................................................              .1
1980....................................................             1.5
1990....................................................             3.8
2000....................................................            18.9
2007--3rd Q (peak of securitization)....................            27.9
2009--3rd Q.............................................           25.4
------------------------------------------------------------------------
\146\ Commercial Mortgage Securities Association, Compendium of
  Statistics: Exhibit 19: Holders of Commercial & Multifamily Mortgage
  Loans (Dec. 10, 2009) (online at www.cmsaglobal.org/uploadedFiles/
  CMSA_Site_Home/Industry_Resources/Research/Industry_Statistics/
  CMSA_Compendium.pdf) (hereinafter ``Commercial Real Estate Securities
  Association, Exhibit 19'') (updated Jan. 12, 2010). Exhibit 21,
  Mortgage Securitization Levels.

    Both original permanent and refinanced loans may be 
securitized. The current lack of investor appetite for CMBS 
greatly constrains the ability of commercial property owners to 
obtain permanent loans to pay off construction loans or to 
refinance existing permanent loans. And without the ability to 
do so, outstanding commercial real estate loans have a reduced 
chance of repayment, unless the original lender provides funds 
for refinancing.
    A CMBS pool is usually set up to be eligible for tax 
treatment as a REMIC to allow taxation of income and capital 
gains only at the investor level. This structure makes the tax 
treatment of ownership of any particular tranche of a CMBS 
comparable to the ownership of whole loans, which are only 
taxed at the investor level.\147\ This issue is discussed 
further in Section G.3.
---------------------------------------------------------------------------
    \147\ See Brueggeman and Fisher, supra note 13, at 558-559.
---------------------------------------------------------------------------
    CMBS structures stratify a pool of commercial real estate 
mortgages into tranches (classes).\148\ This both enhances and 
complicates the structure in comparison to typical single-class 
residential MBS. The creation of tranches allows investors to 
choose from varying risk/reward ratios. Most CMBS use a senior/
subordinate structure, sometimes referred to as a 
``waterfall.'' In this arrangement, interest and principal due 
to the most senior tranche is paid first, in full, from the 
cash flow coming from the underlying mortgages. If the pool has 
cash left over, the next tranche is paid. This process 
continues down to the most junior or subordinate ``first loss'' 
tranche.\149\ If there is insufficient cash to pay all 
tranches, the most subordinate tranche is not paid. Further 
losses then flow up the subordination chain. Each class, 
therefore, receives protection from the class below it, while 
at the same time providing protection for the class directly 
above it. These relationships are illustrated in Figure 20, 
above.
---------------------------------------------------------------------------
    \148\ Commercial Mortgage Securities Association, Chapter One: An 
Overview of CMBS, CMSA E-Primer (www.cmsaglobal.org/assetlibrary/
CDACA8B2-5348-497A-A5AC-13A85661BF2E/
6baf4dcc38f14cefa99d85803fd283905.pdf).
    \149\ DeMichele and Adams, supra note 22, at 329-330.
---------------------------------------------------------------------------
    Senior tranches earn a better credit rating and yield a 
lower interest rate than more subordinate tranches due to their 
lower risk. Tranches are often referred to as either 
``investment grade'' or ``B-piece.'' Investment grade tranches 
have credit ratings from AAA to BBB- (to use S&P ratings) and 
are bought by the more safety-conscious investors. The 
investment grade category can be further divided into the AAA 
rated senior tranche and lower rated ``mezzanine'' tranches. B-
pieces, which are rated BB and below or are unrated, are risky 
and are purchased by specialized investors who thoroughly 
scrutinize the deal and the underlying properties.\150\ Thus, 
the stratification creates a CMBS structure in which risk is 
theoretically concentrated in the lower-rated tranches, so the 
credit enhancement of a tranche is provided through the 
subordination of other tranches.\151\
---------------------------------------------------------------------------
    \150\ DeMichele and Adams, supra note 22, at 329-330.
    \151\ Nomura Fixed Income Research, Synthetic CMBS Primer, at 6 
(Sept. 5, 2006) (online at www.securitization.net/pdf/Nomura/
SyntheticCMBS_5Sept06.pdf).
---------------------------------------------------------------------------
    The B-piece buyer assumes a greater level of risk by taking 
the most junior class yet receives in return a potentially 
higher yield. CMBS structures often make the B-piece buyer the 
``controlling class,'' which has special rights to monitor the 
performance of each loan.\152\
---------------------------------------------------------------------------
    \152\ Commercial Mortgage Securities Association and Mortgage 
Bankers Association, Borrower's Guide to CMBS, at 6 (2004) (online at 
www.cmsaglobal.org/CMSA_Resources/Borrowers_Page/Borrower_s_Page/) 
(hereinafter ``Borrower's Guide to CMBS'').
---------------------------------------------------------------------------
    A typical CMBS structure--and the risks that come with it--
can be illustrated by reviewing a specific CMBS deal and 
tracing it from loan origination to securitization. For Trust 
ML-CFC, Series 2007-5, Merrill Lynch served as depositor and 
joined Countrywide, Keybank, and IXIS Real Estate Capital as 
sponsors of a CMBS issue consisting of a pool of 333 
commercial, multifamily, and manufactured housing community 
mortgage loans with an aggregate initial mortgage balance of 
$4.4 billion.\153\ The largest loan backing the CMBS pool is an 
$800 million Peter Cooper Village and Stuyvesant Town loan 
(PCV/ST), which represents 18 percent of the pool.\154\ Tishman 
Speyer Properties, LP and BlackRock Realty acquired the New 
York-based PCV/ST 56 building apartment complex through a $3 
billion interest-only loan in 2006 and recently stopped 
scheduled debt payment, triggering default.\155\ Trust ML-CFC, 
Series 2007-5 securitizes an $800 million piece of the total 
PCV/ST loan, while other CMBS trusts securitize the remaining 
balance. The loan's LTV ratio at origination was 55.6 
percent.\156\
---------------------------------------------------------------------------
    \153\ SEC EDGAR Free Writing Prospectus, ML-CFC Commercial Mortgage 
Trust 2007-5 (Feb. 26, 2007) (online at www.secinfo.com/dsvrn.u13t.htm) 
(hereinafter ``ML-CFC Commercial Mortgage Trust 2007-5'').
    \154\ Fitch Ratings, ML-CFC Commercial Mortgage Trust Series 2007-
5-U.S. CMBS Focus Performance Report (Dec. 7, 2009) (online at 
www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=490406) 
(hereinafter ``CMBS Focus Performance Report'').
    \155\ ML-CFC Commercial Mortgage Trust 2007-5, supra note 153. See 
also Dawn Wotapka, Tishman, Blackrock Default on Stuyvesant Town, WSJ 
(Jan. 8, 2010) (online at online.wsj.com/article/
SB10001424052748703535104574646611615302076.html).
    \156\ ML-CFC Commercial Mortgage Trust 2007-5, supra note 153.
---------------------------------------------------------------------------
    As of November 2009, the loan was transferred to special 
servicing (see explanation below) to facilitate debt 
restructuring due to financial challenges from failed attempts 
to deregulate rent-stabilized units and insufficient cash flow 
to cover the debt service. While the PCV/ST loan is certainly 
the most stressed loan within the pool, specially serviced 
loans comprise 21 percent of the pool, and an additional 48 
loans are classified by Fitch Ratings as ``loans of concern.'' 
\157\ Furthermore, approximately 46.9 percent of the pool had a 
weighted average debt service coverage ratio less than 1.20 as 
of year-end 2008.\158\
---------------------------------------------------------------------------
    \157\ CMBS Focus Performance Report, supra note 154.
    \158\ CMBS Focus Performance Report, supra note 154. The debt 
service coverage ratio (DSCR) is the ratio between the annual debt 
service and the annual net operating income of the property. This ratio 
is a key underwriting criterion for lenders, as it refers to a 
property's ability to pay debt service after paying other regular 
expenses. A debt service coverage ratio of 1.1 to 1.0 means that the 
property's cash flow exceeds debt service for a given period of 10 
percent. Typically, lenders require a ratio greater than 1.0.
---------------------------------------------------------------------------
    As with most CMBS, the securities issued by the sponsors 
were organized into tranches. Fitch downgraded seven of these 
tranches and maintained a negative rating outlook on 15 of the 
24 rated tranches within the ML-CFC, 2006-1 trust pool on 
October 30, 2009, driven by the projected losses and current 
foreclosures and delinquencies on underlying loans.\159\ The 
losses for this CMBS deal are higher than the Fitch-modeled 
average recognized and have potential losses of 6.9 and 9.7 
percent, respectively, for all CMBS 2007 vintages.\160\ As 
losses increase, the relative loss protection from the upper 
tranches decreases.
---------------------------------------------------------------------------
    \159\ CMBS Focus Performance Report, supra note 154.
    \160\ CMBS Focus Performance Report, supra note 154.
---------------------------------------------------------------------------
            a. Servicing 
    After a commercial mortgage is originated, the borrower's 
main contact with creditors is through the loan servicer. Loan 
servicing consists of collecting and processing mortgage 
payments; remitting funds either to the whole loan owner or the 
CMBS trustee; monitoring the property; handling delinquencies, 
workouts, and foreclosures; and performing other duties related 
to loan administration.\161\ Servicers earn a servicing fee 
(usually from 1 to 25 basis points) based on the outstanding 
principal balance of the loan. Whole loans, which are held on a 
bank's balance sheet, are typically serviced by the originating 
lender.
---------------------------------------------------------------------------
    \161\ See Real Estate Finance, Seventh Edition, supra note 10, at 
303.
---------------------------------------------------------------------------
    For CMBS pools, a Pooling and Servicing Agreement (PSA) 
sets out the duties of the servicer and includes a ``servicing 
standard'' that describes the roles of each servicer and 
specific instructions for dealing with delinquencies, defaults, 
and other eventualities.\162\ A CMBS structure provides for a 
master and special servicers, and may or may not include 
primary servicers as well.
---------------------------------------------------------------------------
    \162\ Borrower's Guide to CMBS, supra note 152, at 3.
---------------------------------------------------------------------------
    The master servicer is responsible for servicing all 
performing loans in the pool through maturity. It also decides 
when loans that are delinquent or in default are transferred to 
the special servicer. For a delinquent loan where the late 
payments are considered recoverable by the master servicer, the 
latter will advance the missing principal and interest payments 
to pay the CMBS bondholders. When the funds are recovered, the 
master servicer will be refunded first, ahead of payments to 
the senior tranche. If the master servicer deems the loan to be 
unrecoverable, it will stop these advances.
    In many cases, the master servicer handles all contact with 
the borrower, including collecting payments, correspondence, 
and site visits. However, in some cases, these contact duties 
are subcontracted to one or more primary servicers.\163\ In 
these cases, the primary servicer has responsibility for 
contact with the borrower, leaving the master servicer to 
handle higher-level administrative duties. The primary servicer 
will often be the firm that originated the mortgage. This 
arrangement can be advantageous because the primary servicer 
maintains its personal relationship with the borrower, and the 
CMBS investors gain the services of a person or firm very 
familiar with the loan and property.\164\
---------------------------------------------------------------------------
    \163\ Borrower's Guide to CMBS, supra note 152, at 5.
    \164\ Borrower's Guide to CMBS, supra note 152, at 3.
---------------------------------------------------------------------------
    The third class of servicer is the ``special servicer,'' 
which is responsible for dealing with defaulted or other 
seriously troubled loans. The master servicer, following the 
servicing provisions in the PSA, transfers servicing for these 
loans to the special servicer. This usually occurs after the 
loan is 60 days delinquent.\165\ The special servicer then 
determines the appropriate course of action to take in keeping 
with the servicing standard in the PSA. The controlling class 
of the CMBS, usually the buyer of the first loss position, 
often has the right to appoint a special servicer and direct 
its course of action.\166\ The special servicer typically earns 
a management fee of 25 to 50 basis points on the outstanding 
principal balance of a loan in default as well as 75 basis 
points to one percent of the net recovery of funds at the end 
of the process.
---------------------------------------------------------------------------
    \165\ John N. Dunlevy, Structural Considerations Impacting CMBS, in 
The Handbook of Non-Agency Mortgage-Backed Securities, at 398 (1997).
    \166\ Borrower's Guide to CMBS, supra note 152, at 6.

                          FIGURE 22: TOP 10 COMMERCIAL MORTGAGE MASTER SERVICERS \167\
                                              [Dollars in millions]
----------------------------------------------------------------------------------------------------------------
                                              Parent Company/        TARP                 Number of    Average
      Rank          Servicing Company            Ownership        Recipient     Amount      Loans     Loan Size
----------------------------------------------------------------------------------------------------------------
1                 Wells Fargo N.A./       Wells Fargo...........         X      $476,209     42,829        $11.1
                   Wachovia Bank N.A.
2                 PNC Real Estate/        The PNC Financial              X       308,483     32,087          9.6
                   Midland Loan Services.  Services Group, Inc.
3                 Capmark Finance Inc...  Berkshire Hathaway,        \168\       248,739     32,357          7.7
                                           Inc./Leucadia
                                           National Corp.
4                 KeyBank Real Estate     Keycorp...............         X       133,138     12,501         10.7
                   Capital.
5                 Bank of America N.A...  Bank of America.......         X       132,152      9,953         13.3
6                 GEMSA Loan Services LP  GE Capital/CB Richard   .........      104,755      7,144         14.7
                                           Ellis.
7                 Deutsche Bank.........  Deutsche Bank Group...  .........       63,812      2,446         26.1
8                 Prudential Asset        Prudential Financial..  .........       62,826      6,004         10.5
                   Resources.
9                 JP Morgan Chase Bank..  JPMorgan Chase & Co...         X        50,410     42,914          1.2
10                NorthMarq Capital.....  NorthMarq Capital.....  .........       37,903      5,387         7.0
----------------------------------------------------------------------------------------------------------------
\167\ Mortgage Bankers Association, Survey of Commercial/Multifamily Mortgage Servicing Volumes, Mid Year 09
  (2009). This table includes multifamily properties of 2-4 units.
\168\ Capmark was formerly a subsidiary of GMAC, a TARP recipient. It was sold in September 2009 to Berkadia
  III, LLC, a joint venture between Berkshire Hathaway, Inc. and Leucadia National Corporation. Neither of these
  firms are TARP recipients.

            b. Underlying Property and Location 
    The current outstanding CMBS market is valued at $709 
billion. The CMBS market was virtually frozen from July 2008 to 
May 2009, with no CMBS issued during this period, but $2.329 
billion in issuances have occurred since June 2009.\169\ The 
freeze in the CMBS market was primarily due to problems in the 
broader mortgage security market. Decreased AAA-rated CMBS 
yield spreads over 5- and 10-year Treasury yields and the 
Federal Reserve's May 19, 2009 announcement of extending TALF 
to high-quality legacy CMBS provided the cushion of credit 
needed to begin the CMBS market thaw.\170\ Slowly, the 
securitized commercial real estate market is coming to life 
again. Using the data provided in Figure 15 [CRE, CMBS, CDS] 
and the Commercial Mortgage Securities Association (CMSA) 
statistic of $709 billion in CMBS outstanding, commercial banks 
hold a mere seven percent of the CMBS market.\171\
---------------------------------------------------------------------------
    \169\ Commercial Real Estate Securities Association, Exhibit 19, 
supra note 146 (updated Jan. 12, 2010).
    \170\ Federal Reserve Bank of Atlanta, Financial Highlights (July 
22, 2009) (online at www.frbatlanta.org/filelegacydocs/FH_072209.pdf).
    \171\ Statistics on Depository Institutions, supra note 124 
(accessed Jan. 22, 2010).
---------------------------------------------------------------------------
    Whereas commercial real estate whole loan exposure is 
spread across the four size categories of banks, CMBS exposure 
is concentrated in large commercial banks. According to 
Foresight Analytics, the 20 largest banks (those with assets 
over $100 billion) hold approximately 89.4 percent of total 
bank exposure to CMBS.\172\ The FDIC data further confirms 
this, as banks in the ``greater than $10 billion'' asset class 
hold 94.5 percent of total bank exposure to CMBS. CMBS is a 
negligible percentage of Tier 1 capital across commercial banks 
compared to the same ratio for whole loans, as seen earlier in 
Table 15.\173\
---------------------------------------------------------------------------
    \172\ CRE Exposure by Size of Bank, supra note 138.
    \173\ Statistics on Depository Institutions, supra note 124 
(accessed Jan. 22, 2010).
---------------------------------------------------------------------------

  FIGURE 23: CMBS OUTSTANDING BY PROPERTY TYPE (millions of dollars) 
                                 \174\

---------------------------------------------------------------------------
    \174\ Commercial Real Estate Securities Association, Exhibit 19, 
supra note 146. 

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    Office and retail commercial property comprise 59 percent 
of all CMBS underlying loans. Multifamily and lodging (hotel) 
properties, though a more moderate property presence, comprise 
15 and 10
percent, respectively. The remaining 16 percent of CMBS 
property types are industrial, mixed use, and other.\175\
---------------------------------------------------------------------------
    \175\ Commercial Real Estate Securities Association, Exhibit 19, 
supra note 146.

               FIGURE 24: CMBS BY PROPERTY LOCATION \176\
                          [Dollars in millions]
------------------------------------------------------------------------
                                                  Current     Allocation
                     State                        Balance      Percent
------------------------------------------------------------------------
California....................................     $104,965         16.9
New York......................................       95,824         15.4
Texas.........................................       49,840          8.0
Florida.......................................       42,400          6.8
Illinois......................................       24,740          4.0
Pennsylvania..................................       19,910          3.2
Georgia.......................................       19,838          3.2
New Jersey....................................       19,691          3.2
Maryland......................................       18,585          3.0
All Other States (less than 3.0% of total          $231,000          36
 each)........................................
------------------------------------------------------------------------
\176\ Commercial Mortgage Securities Association, Compendium of
  Statistics, at Exhibit 10: CMBS by Regions--Detail (Aug. 2008).

    The loans securing CMBS deals are generally concentrated in 
more populated states and do not include less sought after 
properties in secondary or tertiary markets (or properties 
associated with less populated areas).\177\ California and New 
York commercial real estate loans represent nearly one-third of 
all securitized loans. CMBS exposure to loans originated in 
Texas, Florida, and Illinois is notable to a smaller degree, 
and the remaining geographic CMBS loan exposure is spread among 
all other states.\178\ As foreclosure rates vary widely across 
states, knowing the state of origination for loans bundled in a 
CMBS structure provides greater insight into potential CMBS 
valuation issues.\179\
---------------------------------------------------------------------------
    \177\ Id. For example, the ten states with the smallest CMBS market 
share in December 2009 (from smallest to largest) were Wyoming, 
Montana, South Dakota, North Dakota, Vermont, Alaska, West Virginia, 
Idaho, Maine, and Rhode Island, with a combined total of 0.99 percent. 
See U.S. CMBS: Moody's CMBS Delinquency Tracker, January 2010, at 16 
(Jan. 15, 2010) (hereinafter ``CMBS Delinquency Tracker''). These 
states were among the 13 least populated states according to U.S. 
Census Bureau rankings. See U.S. Census Bureau, The 2010 Statistical 
Abstract: State Rankings, Resident Population, July 2008 (available 
online at www.census.gov/compendia/statab/2010/ranks/rank01.html) (last 
accessed Jan. 22, 2010). The four most populated states (California, 
Texas, New York, and Florida) also had the largest CMBS market share in 
2009, with a combined total of 40 percent.
    \178\ Commercial Mortgage Securities Association, Compendium of 
Statistics, at Exhibit 10: CMBS by Regions--Detail (Aug. 2008); see 
also CMBS Delinquency Tracker, supra note 177, at 16.
    \179\ The potential impact of commercial real estate problems on 
CMBS is magnified by so-called ``synthetic CMBS.'' Based on available 
transaction data, DTTC reported 2,065 derivative contracts referencing 
CMBS with a gross notional value of $24 billion as of January 8, 2010. 
A synthetic product is simply a derivative instrument designed to mimic 
the cash flows of a reference entity or asset. Synthetic CMBS allow an 
investor to gain exposure to either a specific CMBS pool or a CMBS 
index without actually taking ownership of the assets. The synthetic 
CMBS market lacks transparency; thus, determination of its scope 
relative to the commercial real estate market is difficult. The 
Depository Trust and Clearing Corporation, Trade Information Data 
Warehouse (Section I), at Table 3 (online at www.dtcc.com/products/
derivserv/data_table_i.php?id=table3_current) (hereinafter ``Trade 
Information Data Warehouse'') (accessed Jan. 12, 2010).
---------------------------------------------------------------------------
    The following chart, Figure 25, provides information on 
CMBS delinquency rates for the top 10 metropolitan statistical 
areas.

 FIGURE 25: CMBS DELINQUENCY RATES BY TOP 10 METROPOLITAN STATISTICAL 
                              AREAS \180\

---------------------------------------------------------------------------
    \180\ Bloomberg data (accessed Jan. 12, 2010). 

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    This chart illustrates the variation in problems that more 
populated areas are experiencing with commercial real estate 
loans collateralizing CMBS deals.

3. CMBS Credit Default Swaps 

    Credit defaults swaps (CDS) are over-the-counter (OTC) 
derivative \181\ instruments predicated on a contract between 
two counterparties: a protection buyer and a protection seller. 
CDS contracts
---------------------------------------------------------------------------
    \181\ The Financial Accounting Standards Board defines a derivative 
as an instrument that has one or more underlying assets and one or more 
notional amounts or payment provisions which determine settlement, 
requires no initial net investment, and whose terms permit net 
settlement.
---------------------------------------------------------------------------
function in a similar manner to insurance contracts. A 
protection buyer pays a periodic or up-front fee to a 
protection seller, who must then pay the protection buyer a fee 
in the occurrence of a ``credit event'' (e.g., bankruptcy or 
credit rating downgrade), effectively transferring credit risk 
from the buyer to the seller.\182\ An added layer of the CDS 
structure is its inherent ``risk circularity,'' replacing 
credit risk with counterparty risk.\183\ By safeguarding 
against the risk of credit default through a CDS, the 
protection buyer faces the risk that its counterparty will 
default on the contract, leaving it exposed to the original 
credit risk. This risk circularity was at the crux of American 
International Group's (AIG) ``too big to fail'' status and 
ultimate government bailout and payment to its CDS 
counterparties.\184\
---------------------------------------------------------------------------
    \182\ David Mengle, Credit Derivatives: An Overview, Federal 
Reserve Bank of Atlanta Economic Review (Fourth Quarter 2007) (online 
at www.frbatlanta.org/filelegacydocs/erq407_mengle.pdf).
    \183\ European Central Bank, Credit Default Swaps and Counterparty 
Risk (Aug. 2009) (online at www.ecb.int/pub/pdf/other/
creditdefaultswapsandcounterpartyrisk2009en.pdf) (hereinafter 
``European Central Bank CDS Report'').
    \184\ Dean Baker, The AIG Saga: A Brief Primer, The Center for 
Economic and Policy Research (Mar. 2009) (online at www.cepr.net/
documents/publications/AIG-2009-03.pdf) (hereinafter ``The AIG Saga: A 
Brief Primer'').
---------------------------------------------------------------------------
    The intent of a credit default swap is generally either to 
hedge or to speculate. An institution can hedge the credit risk 
of assets by acquiring CDS protection on those assets and can 
hedge the risk of counterparty default by acquiring CDS 
exposure to another institution.\185\ For example, if an 
investor held the CMBS pool MLCFC, Series 2007-5, he could 
hedge exposure through CMBX.3, which references this CMBS pool. 
CDS also allow an institution to gain exposure without any 
possession of the underlying referenced entities or assets 
through trading or speculative activities. An institution can 
acquire long exposure to the credit assets by selling CDS 
protection or acquire short exposure to the credit assets by 
buying CDS protection.\186\ Either way, the investor is 
speculating on the likelihood of a future credit event in 
regards to the reference entity or assets in which the investor 
possesses only exposure without actual ownership. Speculative 
trading is commonly referred to as a ``naked'' swap, since the 
investor has no cash position in the reference entity or 
assets.\187\
---------------------------------------------------------------------------
    \185\ European Central Bank CDS Report, supra note 183.
    \186\ European Central Bank CDS Report, supra note 183. Long 
exposure is speculation on the future upside potential and short 
exposure is speculation on the future downside potential, meaning a 
seller with long exposure is speculating on the unlikelihood of default 
and a buyer with short exposure is speculating on the reverse.
    \187\ European Central Bank CDS Report, supra note 183. 
Congressional Oversight Panel, Special Report on Regulatory Reform, at 
13-15 (Jan. 2009) (online at cop.senate.gov/reports/library/report-
012909-cop.cfm). As noted, a swap is a form of insurance, but the 
holder of a ``naked'' swap owns nothing to insure. A common state 
insurance rule bars purchasing insurance in the absence of an insurable 
interest, e.g., in the purchaser's home or car, or for members of the 
purchaser's family, precisely because buying insurance without such an 
interest is a form of speculation. As noted in the Panel's Special 
Report on Regulatory Reform, however, Congress prohibited the 
regulation of most derivatives in 2000. That action barred, for 
example, attempts to apply state insurance rules to ``naked swaps.''
---------------------------------------------------------------------------
    The meltdown in the residential mortgage market and sub-
prime loan-backed RMBS caused a massive capital drain on the 
major sellers of RMBS CDS in 2008 and heightened the 
counterparty risk exposure of buyers. The gross notional seller 
exposure to CDS backed by RMBS was $135.9 billion as of January 
8, 2010, compared to CDS backed by CMBS exposure of $24.1 
billion.\188\ However, net notional exposure for CMBS is $5.0 
billion, compared to only $67.7 million for RMBS. (Net notional 
exposure provides a more accurate view of actual exposure as it 
represents the maximum amount of credit exposure or payout in a 
credit default event.) \189\ Furthermore, this exposure is 
concentrated in 2,067 CDS contracts, while the RMBS exposure is 
spread throughout 27,908 contracts.\190\ Thus, the maximum 
credit exposure for CMBS-backed CDS is not only bigger than 
that of RMBS-backed CDS, but it is concentrated in a smaller 
number of contracts. As noted in the European Central Bank's 
report on Credit Default Swaps and Counterparty Risk, ``[i]n 
practice, the transfer of risk through CDS trades has proven to 
be limited, as the major players in the CDS market trade among 
themselves and increasingly guarantee risks for financial 
reference entities.'' \191\ The fact that RMBS credit default 
exposure played a significant role in the 2008 collapse and 
that the concentration of CMBS-backed CDS appears to be greater 
than that in RMBS CDS must be carefully considered in assessing 
the impact such swaps could have if the volume, nature, and 
pace of foreclosures of securitized properties continue to 
increase. Any attempt to gauge the potential impact--as was the 
case of RMBS swaps and swaps written on other securities--is 
difficult if not impossible owing to the opacity of the credit 
default swaps' market. (Although that issue is generally beyond 
the scope of this report, it should be noted that the Panel's 
Reform Report called direct attention to the need for 
transparency in the CDS markets.) \192\
---------------------------------------------------------------------------
    \188\ Trade Information Data Warehouse, supra note 179, at Table 3.
    \189\ Trade Information Data Warehouse, supra note 179, at Table 3.
    \190\ The Depository Trust and Clearing Corporation, Trade 
Information Warehouse, at Table 6 (online at www.dtcc.com/products/
derivserv/data_table--i.php?id=table6_current) (accessed Jan. 12, 
2010).
    \191\ European Central Bank CDS Report, supra note 183.
    \192\ Congressional Oversight Panel, Special Report on Regulatory 
Reform, at 13-15 (Jan. 2009) (online at cop.senate.gov/reports/library/
report-012909-cop.cfm).
---------------------------------------------------------------------------
    The impact of commercial real estate losses on CMBS and 
CMBS CDS markets ultimately affects the institutions that 
invest in them. The extent of the impact is largely dependent 
on the institution's size. As noted in section E.2(b), CMBS 
exposure is concentrated in the 20 largest financial 
institutions with assets over $100 billion.\193\ According to 
discussions with market experts, the largest banks issued 
higher quality commercial real estate loans for the purpose of 
securitizing, packaging, and distributing them, which left mid-
size and smaller banks to do the remaining lending for 
construction and local commercial real estate loans.\194\ Thus, 
in terms of risk and exposure relative to assets and Tier 1 
capital, the larger financial institutions are exposed to CMBS, 
and the smaller and mid-size financial institutions are more 
exposed to the whole loans. Given the size of notional CMBS 
holdings, that risk and exposure require extremely careful 
attention, in light of the experience of the last three years.
---------------------------------------------------------------------------
    \193\ Commercial Mortgage Securities Association, Investors of CMBS 
in 2008 (online at www.cmsaglobal.org/uploadedFiles/CMSAlSitelHome/
IndustrylResources/Research/IndustrylStatistics/Investors.pdf) 
(accessed Jan. 20, 2010).
    \194\ Staff conversation with The Real Estate Roundtable (Jan. 6, 
2010).
---------------------------------------------------------------------------

4. Financing of Multifamily Housing

    Multifamily housing is a subsection of commercial real 
estate that overlaps the commercial and residential mortgage 
markets in terms of structure and use. Although income-
producing and bearing commercial loan characteristics, 
multifamily housing also serves as a residence for tenants. 
Before delving deeper into the ramifications of commercial real 
estate losses on communities and tenants, it is important to 
understand the scope of multifamily housing. Multifamily 
mortgage debt outstanding has shown steady growth for several 
years, except for a $1.2 billion decrease from Q3 to Q4 2009, 
ending the year at $912 billion. In comparison, both 
residential mortgage and all other commercial mortgage debt 
outstanding peaked in 2008 and has steadily decreased 
since.\195\ Multifamily mortgage originations decreased 40 
percent from Q3 2008 to Q3 2009, compared to an overall 
decrease of 54 percent for all commercial property over the 
same time period.\196\ Thus, while the market for residential 
and other commercial mortgages experienced a ``boom and bust,'' 
multifamily has exhibited a steadier growth over time with less 
substantial decrease in recent quarters.
---------------------------------------------------------------------------
    \195\ Federal Reserve Flow of Funds Z.1, Dec. 10, 2009.
    \196\ MBA Data Book: Q3 2009, supra note 98.
---------------------------------------------------------------------------
    Government sponsored entities Fannie Mae and Freddie Mac 
(the GSEs) hold the largest amount of multifamily mortgage debt 
outstanding--39 percent. Commercial banks and CMBS/ABS issuers 
follow in stair-step succession with 24 and 12 percent, 
respectively, of total multifamily mortgage debt outstanding. 
The remaining 25 percent is divided fairly evenly among 
governments, savings institutions, life insurance companies, 
and financing institutions.\197\ Only in recent years have the 
GSEs come to hold such a large share of multifamily mortgage 
debt, as private sources of funding supplied the market in the 
past.\198\ As the CMBS market supports only 12 percent of the 
$912 billion of multifamily debt outstanding, the bulk of 
multifamily financing remains in whole loans.\199\
---------------------------------------------------------------------------
    \197\ MBA Data Book: Q3 2009, supra note 98.
    \198\ Donald S. Bradley, Frank E. Nothaft, and James L. Freund, 
Financing Multifamily Properties: A Play with New Actors and New Lines, 
Cityscape: A Journal of Policy Development and Research (Vol. 4, Num. 
1, 1998) (online at www.huduser.org/Periodicals/CITYSCPE/VOL4NUM1/
article1.pdf).
    \199\ Federal Reserve Flow of Funds Z.1, Dec. 10, 2009.
---------------------------------------------------------------------------
    According to the National Multi Housing Council, nearly 
one-third of American households rent and over 14 percent live 
in multifamily apartment complexes.\200\ Multifamily rental 
housing provides an alternative to home ownership for people in 
recent geographic transition, in search of convenience, or in 
need of a lower cost option. It also provides a more economic 
option than single family structures in terms of social 
services delivery, such as assisted living and physical 
infrastructure.\201\ When looking at the default possibilities 
of mortgages, the discussion often centers on the exposure to 
the borrower, lender, and investors. Devaluations of and 
defaults in multifamily mortgage loans indeed impact these 
individuals through lower cash flows, difficulty in 
refinancing, and potential loss of property. But this impact 
also extends to the residents of multifamily housing who 
potentially face deteriorating buildings, neglected 
maintenance, and increased rent.
---------------------------------------------------------------------------
    \200\ National Multi Housing Council, About NMHC (online at 
www.nmhc.org/Content/ServeContent.cfm?ContentItemID=4493) (accessed 
Jan. 21, 2010).
    \201\ Harvard University Joint Center for Housing Studies, Meeting 
Multifamily Housing Finance Needs During and After the Credit Crisis: A 
Policy Brief (Jan. 2009) (online at www.jchs.harvard.edu/publications/
finance/multifamily_housing_finance_needs.pdf) (hereinafter ``Meeting 
Multifamily Housing Finance Needs'').
---------------------------------------------------------------------------
    Both the total commercial mortgage and multifamily mortgage 
default rates have increased in recent quarters to 8.74 and 
3.58 percent, respectively.\202\ Although multifamily loan 
performance has remained strong compared to the overall 
commercial mortgage market, as evidenced in the significantly 
lower default rate, tightened credit, and broader challenges 
for commercial real estate mortgages could hinder apartment 
owners' ability to refinance and thus could cause increased 
defaults.\203\ If financing is tight and capital costs 
increase, owners may neglect property improvements or may 
attempt to pass along costs to tenants through increased rent 
and fees. Neglected property impacts the surrounding 
neighborhood's condition and, ultimately, value.\204\
---------------------------------------------------------------------------
    \202\ Federal Reserve Statistical Release, Charge-off and 
Delinquency Rates (online at www.federalreserve.gov/Releases/ChargeOff/
delallsa.htm) (accessed Jan. 20, 2010). Sibley Fleming, Bank Default 
Rates on CRE Loans Projected to Hit 4% in Fourth Quarter, National Real 
Estate Investor (online at nreionline.com/news/CRE_bank_default_rates).
    \203\ Meeting Multifamily Housing Finance Needs, supra note 201.
    \204\ Meeting Multifamily Housing Finance Needs, supra note 201.
---------------------------------------------------------------------------
    Currently, 79 percent of multifamily renters in the lowest 
income quartile and 45 percent in the lower-middle income 
quartile spend over half of their income on housing.\205\ 
Affordable, government-subsidized, multifamily units play a key 
role in the multifamily mortgage market, as they answer the 
low-income barrier to entry of home ownership. Low-income 
housing tax credits and tax-exempt multifamily bonds buttress 
the affordable housing market, but the credit crisis has 
undermined their ability to do so. Tax credit prices have 
fallen from 90 to 70 cents on the dollar, so more credits are 
now required to deliver the same amount of equity. Tax-exempt 
multifamily bond issuances have sharply decreased, cutting off 
another equity source for development and rehabilitation.\206\ 
Renters in need of affordable housing cannot move to a new 
complex in the face of increased rent or deteriorating 
maintenance as easily as other renters can, so the need for 
viable and prolific equity options is especially relevant in 
this subsector of the commercial mortgage market.
---------------------------------------------------------------------------
    \205\ Meeting Multifamily Housing Finance Needs, supra note 201.
    \206\ Meeting Multifamily Housing Finance Needs, supra note 201.
---------------------------------------------------------------------------
    While the multifamily mortgage market default rates are 
lower than those of the commercial mortgage market as a whole, 
multifamily default rates are still increasing. Furthermore, 
vacancy rates as of Q3 2009 were 13.1 percent, up from 11 
percent in Q3 2008. Some multifamily lenders used aggressive 
estimates in their underwriting practices that have heightened 
refinancing hurdles for those loans in the current market.\207\ 
Thus, the risks associated with property devaluation and 
tightened credit are the same for multifamily as they are for 
other commercial properties, but unlike other types of 
commercial real estate, those risks have the potential to 
translate into destabilized families and loss of affordable 
housing.
---------------------------------------------------------------------------
    \207\ Department of Housing and Urban Development, Eye on 
Multifamily Housing Finance (online at www.huduser.org/portal/
periodicals/ushmc/fall09/ch1.pdf).
---------------------------------------------------------------------------

                                F. Risks

    In the years preceding the current crisis, a series of 
trends pushed smaller and community banks toward greater 
concentration of their lending activities in commercial real 
estate. Simultaneously, higher quality commercial real estate 
projects tended to secure their financing in the CMBS market. 
As a result, if and when a crisis in commercial real estate 
develops, smaller and community banks will have greater 
exposure to lower quality investments, making them uniquely 
vulnerable.\208\
---------------------------------------------------------------------------
    \208\ See additional discussion of smaller regional and community 
bank exposure in Section E.
---------------------------------------------------------------------------
    As discussed above, the combination of deteriorating market 
conditions and looser underwriting standards, especially for 
loans originating in the bubble years of 2005-2007, has 
presented financial institutions holding commercial real estate 
loans and CMBS with significant risks.\209\ These institutions 
face large, potentially devastating losses as a result of loans 
that become non-performing or go into default.\210\ The values 
of the underlying collateral for these loans have plummeted, 
cash flows and operating income have fallen, and the number of 
sales transactions has been drastically reduced.\211\ One 
measure of the risks associated with CMBS is the fact that the 
Federal Reserve Bank of New York requires the largest haircuts 
(15 per cent) for CMBS financings compared to other asset 
classes in the Term Asset-Backed Securities Liquidity Program 
(TALF), as the GAO report noted in a report issued this 
month.\212\
---------------------------------------------------------------------------
    \209\ See generally Parkus and Trifon, supra note 102; COP August 
Oversight Report, supra note 5, at 54-57. GAO TALF Report, supra note 
64, at 13 (showing that private investors must provide a 15 percent 
``haircut,'' or equity contribution, on government-backed loans for 
CMBS, compared with 5-10 percent for credit card loans, and 5-9 percent 
for equipment loans).
    In addition, other factors could affect leasing incentives. For 
example, the Financial Accounting Standards Board has a current project 
on its agenda which could affect lease accounting for all public and 
private companies who lease property (the lessee). Currently lessees 
who recognize their lease payments as an expense may be required under 
certain circumstances to recognize their entire lease obligation as a 
liability on their balance sheet. If adopted, lessess may not renew 
their lease or terminate their lease obligation early. As a result, 
this could further provide additional lending risks in the real estate 
sector, since a borrower's cash flw could significantly cecrease due to 
empty tenant space which could result in further delinquencies or 
defaults in commercial real estate loans.
    \210\ See Richard Parkus and Harris Trifon, Q4 2009 Commercial Real 
Estate Outlook: Searching for a Bottom, at 3, 65-67 (Dec. 1, 2009) 
(hereinafter ``Parkus and Trifon: Searching for a Bottom'').
    \211\ See generally MBA Data Book: Q3 2009, supra note 98. For 
example, values of commercial real estate fell around 40 percent from 
Q3 2007 to Q3 2009. See id. at 34. In Q3 2009, for all major property 
types, average vacancy rates increased (to 8.4 percent for apartments, 
13 percent for industrial, 19.4 percent for office, and 18.6 percent 
for retail) and average rental rates decreased (by 6 percent for 
apartments, 9 percent for industrial, 9 percent for office, and 8 
percent for retail) causing cash flows and operating income to fall. 
Id. at 9. Sales transactions were 72 percent lower year-to date Q3 in 
2009 than in 2008, which were 66 percent lower than 2007. Id. Note that 
none of these numbers include construction or ADC loans. For an 
additional discussion of commercial real estate fundamentals, see 
Section B of this report.
    \212\ GAO TALF Report, supra note 64, at 13.
---------------------------------------------------------------------------
    As loan delinquency rates rise, many commercial real estate 
loans are expected to default prior to maturity.\213\ For loans 
that reach maturity, borrowers may face difficulty refinancing 
either because credit markets are too tight or because the 
loans do not qualify under new, stricter underwriting 
standards.\214\ If the borrowers cannot refinance, financial 
institutions may face the unenviable task of determining how 
best to recover their investments or minimize their losses: 
restructuring or extending the term of existing loans or 
foreclosure or liquidation.\215\ On the other hand, borrowers 
may decide to walk away from projects or properties if they are 
unwilling to accept terms that are unfavorable or fear the 
properties will not generate sufficient cash flows or operating 
income either to service new debt or to generate a future 
profit.\216\ Finally, financing may not be available for new 
loans because of a scarcity of credit, rising interest rates, 
or the withdrawal of special Federal Reserve liquidity 
programs. This section will provide a more detailed analysis of 
each of these problems and then turn to broader social and 
economic consequences and the consequences for financial 
institutions.
---------------------------------------------------------------------------
    \213\ See The Future Refinancing Crisis, Part II, supra note 120, 
at 4, 11; see also Goldman Sachs, U.S. Commercial Real Estate Take III: 
Reconstructing Estimates for Losses, Timing, at 16-20 (Sept. 29, 2009) 
(hereinafter ``Commercial Real Estate Take III'').
    \214\ See Richard Parkus and Jing An, The Future Refinancing Crisis 
in Commercial Real Estate, at 3 (Apr. 23, 2009) (hereinafter ``The 
Future Refinancing Crisis in CRE'').
    \215\ See Parkus and Trifon: Searching for a Bottom, supra note 
210, at 3. For further discussion of the alternatives available, see 
Section G of this report.
    \216\ See, e.g., Realpoint Research, Monthly Delinquency Report--
Commentary, December 2009, at 5-6 (Dec. 30, 2009) (hereinafter 
``Realpoint Report--December 2009''); Commercial Real Estate Take III, 
supra note 213, at 18-20.
---------------------------------------------------------------------------

1. Loans Become Delinquent

    The problem begins when commercial real estate loans become 
delinquent (or past due) and worsens as new (or total) 
delinquent loans increase and delinquent balances continue to 
age.\217\
---------------------------------------------------------------------------
    \217\ See, e.g., Parkus and Trifon Searching for a Bottom, supra 
note 210, at 3, 67.
---------------------------------------------------------------------------
    Although many analysts and Treasury officials believe that 
the commercial real estate problem is one that the economy can 
manage through, and analysts believe that the current condition 
of commercial real estate, in isolation, does not pose a 
systemic risk to the banking system, rising delinquency rates 
foreshadow continuing deterioration in the commercial real 
estate market.\218\ For the last several quarters, delinquency 
rates have been rising significantly.
---------------------------------------------------------------------------
    \218\ See, e.g., Parkus and Trifon Searching for a Bottom, supra 
note 210, at 67; U.S. Department of the Treasury, Statement of 
Secretary of the Treasury Timothy F. Geithner to the Economic Club of 
Chicago, at 7 (Oct. 29, 2009) (providing that the commercial real 
estate problem is ``a problem the economy can manage through, even 
though it's going to be still exceptionally difficult''); see also 
Written Testimony of Jon Greenlee, supra note 93, at 4, 9 (explaining 
that banks face significant challenges and significant further 
deterioration in their commercial real estate loans but that the 
stability of the banking system has improved in the past year).
---------------------------------------------------------------------------

   FIGURE 26: COMMERCIAL REAL ESTATE DELINQUENCIES FOR ALL DOMESTIC 
                         COMMERCIAL BANKS \219\

---------------------------------------------------------------------------
    \219\ Board of Governors of the Federal Reserve System, Data 
Download Program: Charge-off and Delinquency Rates (Instrument: 
Delinquencies/ All banks) (online at www.federalreserve.gov/
datadownload/Choose.aspx?rel=CHGDEL) (accessed Feb. 9, 2010). The 
Federal Reserve defines delinquent loans as those loans that are past 
due thirty days or more and still accruing interest as well as those in 
nonaccrual status. See also Citibank, CMBS Collateral Update: CMBS 
Delinquencies as of December 31, 2009, at 4-7 (Jan. 4, 2010) (providing 
analysis on CMBS delinquency by property type, origination year, 
region, and state); Realpoint Report--December 2009, supra note 216, at 
1 (providing that ``the overall delinquent unpaid balance is up an 
astounding 440% from one-year ago . . . and is now over 17 times the 
low point . . . in March 2007''); MBA Data Book: Q3 2009, supra note 
98, at 63-65 (providing that between the second and third quarters of 
2009, the 30+ day delinquency rate on loans held in CMBS increased 0.17 
percentage points to 4.06 percent and the 90+ day delinquency rate on 
loans held by FDIC insured banks and thrifts increased 0.51 percentage 
points to 3.43 percent); Parkus and Trifon, supra note 102, at 5-21; 
GAO TALF Report, supra note 64, at 29. 

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    The extent of ultimate commercial real estate losses is yet 
to be determined; however, large loan losses and the failure of 
some small and regional banks appear to some experienced 
analysts to be inevitable.\220\ New 30-day delinquency rates 
across commercial property types continue to rise, suggesting 
that commercial real estate loan performance will continue to 
deteriorate.\221\ However, there is some indication that the 
rate of growth, or pace of deterioration, is slowing.\222\ 
Unsurprisingly, the increase in delinquency rates has 
translated into rapidly rising default rates.\223\
---------------------------------------------------------------------------
    \220\ See, e.g., Parkus and Trifon: Searching for a Bottom, supra 
note 210, at 3, 67.
    \221\ See generally Parkus and Trifon, supra note 102, at 12 
(hotel, increasing), 15 (industrial, increasing), 17 (multifamily, 
increasing), 19 (office, stable but expected to increase), 20-21 
(retail, high but stable) (Dec. 2009).
    \222\ See Federal Deposit Insurance Corporation, Quarterly Banking 
Profile Third Quarter 2009, at 1-2 (Sept. 2009) (online at 
www2.fdic.gov/qbp/2009sep/qbp.pdf) (providing that the amount of 
noncurrent loans continued to increase but that the increase ``was the 
smallest in the past four quarters, as the rate of growth in noncurrent 
loans slowed for the second quarter in a row''); Parkus and Trifon, 
supra note 102, at 9.
    \223\ See, e.g., Parkus and Trifon: Searching for a Bottom, supra 
note 210, at 27-30.
---------------------------------------------------------------------------

2. Loans Go Into Default or Become Non-Performing 

    A loan will technically be in default when a borrower first 
fails to fulfill a loan obligation or promise, such as failure 
to make timely loan payments or violation of a debt covenant 
(for example, the requirement to maintain certain levels of 
capital or financial ratios).\224\ However, for the purposes of 
this report, a loan will be con-
sidered in default when it becomes over 90 days delinquent. 
Thus, default rates will reflect the number of new loans that 
are over 90 days delinquent.\225\ If a loan is over 90 days 
delinquent, or is in nonaccrual status because of deterioration 
in the financial condition of the borrower or because the 
lender can no longer expect the loan to be repaid in full,\226\ 
the loan will become non-performing \227\ or noncurrent.\228\ 
The increasing number of loans that are delinquent by 90 days 
or less, in default or delinquent by over 90 days, and in 
nonaccrual status, shown in Figure 27, indicates problems with 
the collectability of outstanding amounts and draws into 
question the proper valuation of these assets on financial 
institution balance sheets.\229\
---------------------------------------------------------------------------
    \224\ See Barron's Real Estate Handbook, Sixth Edition at 228 
(2005).
    \225\ See The Future Refinancing Crisis, Part II, supra note 120, 
at 15.
    \226\ A loan is to be reported to the FDIC as being in nonaccrual 
status if ``(1) it is maintained on a cash basis because of 
deterioration in the financial condition of the borrower, (2) payment 
in full of principal or interest is not expected, or (3) principal or 
interest has been in default for a period of 90 days or more unless the 
asset is both well secured and in the process of collection.'' See 
Federal Deposit Insurance Corporation, Schedule RC-N--Past Due and 
Nonaccrual Loans, Leases, and Other Assets: Definitions (online at 
www.fdic.gov/regulations/resources/call/crinst/897rc-n.pdf) (accessed 
Feb. 9, 2010).
    \227\ A loan is non-performing when it is not earning income, 
cannot be expected to be repaid in full, has payments of interest or 
principal over 90 days late, or was not repaid after its maturity date. 
See Barron's Real Estate Handbook, Sixth Edition, at 388 (2005).
    \228\ See Written Testimony of Doreen Eberley, supra note 91, at 4 
fn. 6.
    \229\ Valuation issues will be discussed further in Section G.2.
---------------------------------------------------------------------------

 FIGURE 27: DELINQUENT, DEFAULTED, AND NON-PERFORMING COMMERCIAL REAL 
          ESTATE LOANS FOR ALL DOMESTIC COMMERCIAL BANKS \230\

---------------------------------------------------------------------------
    \230\ Statistics on Depository Institutions, supra note 124. 

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    The increasing number of delinquent, defaulted, and non-
performing commercial real estate loans also reflects 
increasing levels of loan risks. Loan risks for borrowers and 
lenders fall into two categories: credit risk and term 
risk.\231\ Credit risk can lead to loan defaults prior to 
maturity; such defaults generally occur when a loan has 
negative equity and cash flows from the property are 
insufficient to service the debt, as measured by the debt 
service coverage ratio (DSCR).\232\ If the DSCR falls below 
one, and stays below one for a sufficiently long period of 
time, the borrower may decide to default rather than continue 
to invest time, money, or energy in the property. The borrower 
will have little incentive to keep a property that is without 
equity and is not generating enough income to service the debt, 
especially if he does not expect the cash flow situation to 
improve because of increasing vacancy rates and falling rental 
prices.\233\ The number of term defaults, and accompanying 
losses, has been steadily increasing for the last several 
quarters, as exemplified by the following chart on CMBS loan 
default rates.
---------------------------------------------------------------------------
    \231\ See additional discussion of these risks in Section B.3.
    \232\ The Debt Service Coverage Ratio (DSCR) is the metric for 
determining when a property is earning sufficient income to meet its 
debt obligations. DSCR is calculated by taking net operating income 
(cash flows from the property) divided by debt service (required debt 
payments). A DSCR of less than one indicates that the property is not 
earning sufficient income to make debt payments. See Brueggeman and 
Fisher, supra note 13, at 344-45.
    \233\ See generally The Future Refinancing Crisis, Part II, supra 
note 120, at 11. See additional discussion of credit risk in Section 
B.3.
---------------------------------------------------------------------------

          FIGURE 28: CMBS TERM DEFAULT RATES BY VINTAGE \234\

---------------------------------------------------------------------------
    \234\ Data provided by Richard Parkus, Head of Commercial Real 
Estate Debt Research, Deutsche Bank. 

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    The level of credit risk is also reflected in the price of 
commercial property (as a measure of the present value of 
future cash flows) and the LTV ratio (as a measure of equity or 
negative equity). As commercial property prices continue to 
fall and LTV ratios continue to rise, the risk that additional 
commercial real estate loans will default prior to maturity is 
increasing.\235\ For example, most of the commercial real 
estate loans from the 2002-2008 vintages are three-year to ten-
year loans with LTVs well over 100 percent.\236\ When combined 
with further deterioration in commercial real estate 
fundamentals, these loans are experiencing increasing credit 
risk and are providing continued exposure to term 
defaults.\237\
---------------------------------------------------------------------------
    \235\ See Written Testimony of Jon Greenlee, supra note 93, at 4-5 
(providing that ``the value of both existing commercial properties and 
land has continued to decline sharply, suggesting that banks face 
significant further deterioration in their CRE loans''); Dec. 2009 Dec. 
2009 Moody's/REAL Commercial Property Price Indices, supra note 105, at 
4; see also Commercial Real Estate Take III, supra note 213, at 3, 18-
19; Brueggeman and Fisher, supra note 13, at 344-45.
    \236\ For example, Foresight Analytics LLC estimates that $770 
billion (or 53 percent) of mortgages maturing from 2010 to 2014 have 
current LTVs in excess of 100 percent. Foresight further provides that 
over 60 percent of mortgages maturing in 2012 and 2013 will have LTVs 
over 100 percent.
    \237\ Dec. 2009 Moody's/REAL Commercial Property Price Indices, 
supra note 105, at 4.
---------------------------------------------------------------------------
    Term risk, on the other hand, reflects the borrower's 
ability to repay commercial real estate loans at maturity, and 
will depend more on the borrower's ability to refinance. As 
indicated above, term risk can be experienced even by 
performing properties.\238\
---------------------------------------------------------------------------
    \238\ See Realpoint Report--December 2009, supra note 216, at 5 
(providing that ``balloon default risk is growing rapidly from highly 
seasoned CMBS transactions for both performing and non-performing loans 
coming due as loans are unable to pay off as scheduled'').
---------------------------------------------------------------------------

3. Loans Are Not Refinanced

    Holders of commercial real estate loans and related 
securities are already experiencing significant problems with 
maturing loans that are unable to refinance. As seen by the 
following charts, the number of loans that are unable to 
refinance at maturity is increasing steadily.\239\
---------------------------------------------------------------------------
    \239\ See Parkus and Trifon, supra note 102, at 26-31 (providing 
that the low level of loans paying off each month reflects the 
``current scarcity of financing,'' ``the increasing number of loans 
that do not qualify to refinance,'' and ``the unwillingness of 
borrowers to refinance at high mortgage rates,'' and that the number of 
maturity defaults and extensions also reflects ``the combination of 
scarce financing options and increased number of loans that do not 
qualify to refinance'').
---------------------------------------------------------------------------

                   FIGURE 29: CMBS LOAN PAYOFFS \240\

---------------------------------------------------------------------------
    \240\ Data provided by Richard Parkus, Head of Commercial Real 
Estate Debt Research, Deutsche Bank. 

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

        FIGURE 30: NUMBER OF CMBS MATURITY DEFAULTS/EXTENSIONS 

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    These problems with refinancing are expected to intensify. 
Hundreds of billions of dollars of commercial real estate loans 
are scheduled to mature in the next decade, setting the stage 
for potentially continuing high levels of maturity 
defaults.\241\ The following charts show projected maturity or 
refinancing schedules for all commercial mortgages by lender 
type, CMBS loans by vintage, and commercial real estate loans 
held by banks by origination year.
---------------------------------------------------------------------------
    \241\ See Parkus and Trifon, supra note 102, at 32-33; The Future 
Refinancing Crisis in CRE, supra note 214, at 3. See additional 
discussion of term risk in Section B.3.
---------------------------------------------------------------------------

     FIGURE 31: COMMERCIAL MORTGAGE MATURITIES BY LENDER TYPE \242\

---------------------------------------------------------------------------
    \242\ Data provided by Foresight Analytics LLP. Foresight estimated 
gross originations for commercial and multifamily mortgages based on 
Federal Reserve Flow of Funds data. Then, Foresight applied a 
distribution of loan maturities to the origination year to project 
future mortgage maturity dates. 

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

           FIGURE 32: CMBS MATURITY SCHEDULE BY VINTAGE \243\

---------------------------------------------------------------------------
    \243\ Data provided by Richard Parkus, Head of Commercial Real 
Estate Debt Research, Deutsche Bank. 

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

 FIGURE 33: MATURITY SCHEDULE FOR COMMERCIAL REAL ESTATE LOANS HELD BY 
                    BANKS BY ORIGINATION YEAR \244\

---------------------------------------------------------------------------
    \244\ Data provided by Foresight Analytics LLP. Foresight estimated 
gross originations for commercial and multifamily mortgages based on 
Federal Reserve Flow of Funds data. Then, Foresight applied a 
distribution of loan maturities to the origination year (cross-
tabulating estimates with figures reported in the Call Reports) to 
project future maturity dates for commercial real estate loans held by 
banks. 

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    According to the Real Estate Roundtable, the total rolling 
maturities for vulnerable commercial real estate loans for 
CMBS, insurance companies, and banks and thrifts are $1.3 
trillion through 2013 and $2.4 trillion through 2018.\245\ The 
refinancing risk is particularly significant from 2010 to 
2013.\246\ As a result, expected losses from term defaults and 
maturity defaults are concentrated in the next few years when 
many expect continued weakness or deterioration in the 
commercial real estate market.\247\
---------------------------------------------------------------------------
    \245\ The Real Estate Roundtable, Restoring Liquidity to Commercial 
Real Estate Markets, at 4-5 (Sept. 2009) (online at www.rer.org/
ContentDetails.aspx?id=3045) (hereinafter ``Real Estate Roundtable 
White Paper''). The Real Estate Roundtable is a trade association 
comprised of leaders of the nation's top public and privately-held real 
estate ownership, development, lending and management firms and leaders 
of sixteen national real estate trade associations. The Roundtable 
addresses key national policy issues and promotes policy initiatives 
relating to real estate and the overall economy.
    \246\ See, e.g., Written Testimony of Jon Greenlee, supra note 93, 
at 7-8 (providing that ``more than $500 billion of CRE loans will 
mature each year over the next few years''); Financial Crisis Inquiry 
Commission, Written Testimony of Dr. Kenneth T. Rosen, chair, Fisher 
Center for Real Estate and Urban Economics, University of California--
Berkeley's Haas School of Business, The Current State of the Housing, 
Mortgage, and Commercial Real Estate Markets: Some Policy Proposals to 
Deal with the Current Crisis and Reform Proposals to the Real Estate 
Finance System, at 3 (Jan. 13, 2010) (online at www.fcic.gov/hearings/
01-13-2010.php) (providing that the number of commercial mortgage 
maturities is expected to increase each year through 2013).
    \247\ See The Future Refinancing Crisis, supra note 213, at 7, 14-
16, 23-26; see also Tom Joyce, Toby Cobb, Francis Kelly, and Stefan 
Auer, A Return to Normalcy in 2010?, at 20 (Jan. 2010) (hereinafter 
``Joyce, Cobb, Kelly and Auer''); Parkus and Trifon, supra note 102, at 
30-33, 48; US CRE Debt Markets, supra note 122, at 68-70.
---------------------------------------------------------------------------
    The inclusion of construction loan losses changes the 
magnitude and timing of commercial real estate losses. 
Construction loan losses have accelerated the commercial real 
estate credit cycle because construction credit quality has 
deteriorated faster than non-construction loan quality and 
construction loans generally have
shorter terms.\248\ In addition, construction loans have higher 
loss severity rates leading to higher peak losses.\249\
---------------------------------------------------------------------------
    \248\ Commercial Real Estate Take III, supra note 213, at 11-14.
    \249\ See Commercial Real Estate Take III, supra note 213, at 11-
14; The Future Refinancing Crisis, Part II, supra note 120, at 23-27; 
see also Parkus and Trifon, supra note 102, at 40, 44-45.
---------------------------------------------------------------------------
    The commercial real estate loans at issue--namely, 
construction loans, mini-perm loans,\250\ short-term fixed rate 
whole and CMBS loans, and short-term floating rate whole and 
CMBS loans--are largely structured as interest only, partial 
interest only, or partial amortization loans.\251\ This means 
that the loans typically do not amortize the full principal, 
leaving a large balloon payment at the end of the term. In 
order to make these balloon payments, borrowers typically 
attempt to refinance or apply for new loans with sufficient 
proceeds to pay off the existing loans. Borrowers unable to 
refinance these loans at maturity will have to locate 
additional funds for the balloon payment, sell the property, 
work out an alternative arrangement with the lender, or 
default.\252\
---------------------------------------------------------------------------
    \250\ A mini-perm loan is a short-term bank loan, similar to a 
bridge loan, that is typically offered at the maturity of a 
construction loan so that the borrower can establish an operating 
history, in preparation for obtaining a term loan. See Brueggeman and 
Fisher, supra note 13, at 437-38, 444.
    \251\ See, e.g., Parkus and Trifon: Searching for a Bottom, supra 
note 210, at 24-26, 45. See additional discussion of the structure of 
commercial real estate loans in Section E.
    \252\ See The Future Refinancing Crisis in CRE, supra note 214, at 
11; Parkus and Trifon: Searching for a Bottom, supra note 210, at 33. 
See additional discussion of the options for borrowers and lenders in 
Section G.3.
---------------------------------------------------------------------------
    To qualify for refinancing, under current conditions, the 
borrower must generally satisfy three criteria: (1) the new 
loan balance must be greater than or equal to the existing loan 
balance, (2) the LTV ratio must be no greater than 70 (current 
maximum LTVs are between 60 and 65), and (3) the DSCR (assuming 
a 10-year, fixed rate loan with a 25-year amortization schedule 
and an 8 percent interest rate), must be no less than 1.3.\253\
---------------------------------------------------------------------------
    \253\ See The Future Refinancing Crisis in CRE, supra note 214, at 
11; Parkus and Trifon: Searching for a Bottom, supra note 210, at 33.
---------------------------------------------------------------------------
            a. Qualifying Loans Face Scarcity of Credit
    Many commercial real estate loans from earlier vintages, 
such as 1999 and 2000, that occurred before the dramatic 
weakening in underwriting quality of the bubble years, have 
experienced price appreciation and would normally qualify for 
refinancing, even under the new, stricter underwriting 
standards.\254\ However, as these loans are maturing, they are 
having difficulty refinancing because most credit markets are 
operating at dramatically reduced levels.\255\ For example, the 
CMBS market was essentially frozen from July 2008 to May 2009 
(with no CMBS issued during this time) and is only now starting 
to thaw.\256\ Weak demand for credit, tightened lending 
standards, and potentially large commercial mortgage losses 
have contributed to a contraction in bank lending.\257\ 
Further, many banks have expressed a desire to decrease their 
commercial real estate exposure rather than refinance existing 
loans.\258\
---------------------------------------------------------------------------
    \254\ The Future Refinancing Crisis in CRE, supra note 214, at 3.
    \255\ See COP Field Hearing in Atlanta, supra note 70, at 6-7 
(Testimony of Doreen R. Eberley); Congressional Oversight Panel, 
Written Testimony of Timothy F. Geithner, Secretary of the Treasury, 
COP Hearing with Treasury Secretary Timothy Geithner, at 3, 7-8 (Dec. 
10, 2009) (online at cop.senate.gov/hearings/library/hearing-121009-
geithner.cfm) (hereinafter ``COP Hearing with Secretary Geithner'') 
(``Lending standards are tight and bank lending continues to contract 
overall, although the pace of contraction has moderated''); The Future 
Refinancing Crisis in CRE, supra note 214, at 3.
    \256\ See Commercial Real Estate Securities Association, Exhibit 
19, supra note 146 (updated Jan. 12, 2010); COP Hearing with Secretary 
Geithner, supra note 255, at 3 (``[A]lthough securitization markets 
have improved, parts of those markets are still impaired, especially 
for securities backed by commercial mortgages''). See also discussion 
of the CMBS market in Section E.2.
    \257\ See COP Hearing with Secretary Geithner, supra note 255, at 
3, 8 (``The contraction in many categories of bank lending reflects a 
combination of persistent weak demand for credit and tight lending 
standards at the banks, amidst mounting bank failures and commercial 
mortgage losses''); Board of Governors of the Federal Reserve System, 
National Summary of the October 2009 Senior Loan Officer Opinion Survey 
on Bank Lending Practices, at 2 (Nov. 2, 2009) (online at 
www.federalreserve.gov/boarddocs/snloansurvey/200911/fullreport.pdf) 
(providing that reduced risk tolerance, a less favorable or more 
uncertain economic outlook, and a worsening of industry-specific 
problem contributed to tightened credit standards for C&I loans); see 
also Real Estate Roundtable White Paper, supra note 245, at 4 (accessed 
Feb. 9, 2010).
    \258\ See U.S. Department of the Treasury, Monthly Lending and 
Intermediation Snapshot (Dec. 14, 2009) (online at 
www.financialstability.gov/impact/
monthlyLendingandIntermediationSnapshot.htm) (hereinafter ``Treasury 
Snapshot, Dec. 14 2009''). See also discussion of capital contraction 
in Section G.1.
---------------------------------------------------------------------------
            b. Loans that Fail to Qualify for Refinancing
    Although capital contraction has posed a problem, the 
significant number of loans--especially those originated during 
the peak years of 2005 to 2007--that will not qualify for 
refinancing at maturity pose a far greater problem. As noted 
above, two general types of non-qualifying loans reflect 
different levels of seriousness. The first type includes loans 
that are performing at maturity but are unable to refinance due 
to the collateral effects of wider economic problems, such as 
increases in unemployment and decreases in consumer spending 
leading to less demand for commercial space and higher vacancy 
rates. These loans, while reasonable at their inception, fell 
victim to an unexpected deterioration in commercial market 
fundamentals. Loans that are performing at maturity but have 
difficulty refinancing during a declining real estate market 
because they have an ``equity gap'' provide a good example of 
the first kind of non-qualifying loans.
    As seen by the following table, if the market value of a 
property has fallen significantly, the LTV ratio will rise, 
since the loan-to-value ratio is the loan balance divided by 
the value. Assuming the borrower has a lender who is willing to 
refinance the mortgage, the borrower will need to come up with 
additional equity in order to stay under the lender's LTV ratio 
limit.

                    FIGURE 34: EXAMPLE OF EQUITY GAP
------------------------------------------------------------------------------------------------------------------------------------------------
2005 (Property Financed with 5-year Mortgage)
Property Value.......................................         $1,000,000
Outstanding Principal Balance........................           $750,000
Equity...............................................           $250,000
LTV..................................................                75%2010 (Mortgage Matures--Borrower Must Refinance)
Property Value.......................................           $750,000
Outstanding Principal Balance........................           $700,000
Equity...............................................            $50,000
LTV..................................................                93%Available Loan for 75% LTV (75% of $750,000).........           $562,500
Total Equity Needed ($700,000-$562,500)..............           $187,500
Subtract $50,000 in Existing Equity
Equity Gap at 75% LTV................................           $137,500Available Loan for 65% LTV (65% of $750,000).........           $487,500
Total Equity Needed ($700,000-$487,500)..............           $212,500
Subtract $50,000 in Existing Equity
Equity Gap at 65% LTV................................           $162,500
------------------------------------------------------------------------

    In order to refinance, the borrower in this example needs 
to come up with nearly $140,000 to refinance because of 
declining property values, even though there is equity 
remaining in the property. Increased underwriting standards 
will exacerbate the equity shortfall in this example, requiring 
an additional $25,000 to refinance based upon a more 
conservative 65 percent LTV limit. Underwater borrowers with 
negative equity will be in an even worse situation. Bear in 
mind that the borrowers in this situation may own a property 
that is fully leased and generating more than enough rental 
income to cover debt service. Simply due to the recent decline 
in property values, thousands of otherwise healthy properties 
could now face default and foreclosure because of this problem. 
The Real Estate Roundtable estimates that the total equity gap 
for commercial real estate could be over $1 trillion.\259\
---------------------------------------------------------------------------
    \259\ The Real Estate Roundtable, Challenges Facing Commercial Real 
Estate, at 6 (2009).
---------------------------------------------------------------------------
    The second type of non-qualifying commercial real estate 
loans includes loans, performing or non-performing, that were 
excessively speculative or based on inadequate credit checks or 
underwriting standards. These loans do not qualify for 
refinancing for reasons beyond the unexpected economic 
downturn. Construction loans represent by far the riskiest 
loans and provide a good example of the second type of non-
qualifying loans.
    Currently, the markets are heavily penalizing properties 
with vacancy issues, which translate into cash flow issues. 
Newly or partially constructed commercial properties are 
experiencing the biggest vacancy problems.\260\ Lenders are 
also requiring much lower LTVs (or significantly less 
leverage), and the values of newly constructed properties have 
fallen dramatically. Construction loans originating from 2005 
to 2008, or those based on aggressive rental and cash flow 
projections, have a high likelihood of default and high loss 
severity rates.\261\ The total delinquency rate of construction 
loans is already 16 percent,\262\ but this percentage does not 
necessarily portray the severity of the construction loan 
problem, especially for the smaller and regional banks with the 
highest exposure. Construction loans are generally structured 
as short-term floating rate loans with upfront interest 
reserves that are used to satisfy interest payments until the 
project is completed. Because of historically low interest 
rates, interest reserves are lasting longer, allowing many 
construction loans to remain performing, even though the 
underlying properties may be excessively leveraged or have 
little profit potential. Thus, as interest rate reserves are 
exhausted, delinquency rates and losses will likely increase 
dramatically.\263\
---------------------------------------------------------------------------
    \260\ Parkus and Trifon, supra note 102, at 40.
    \261\ Parkus and Trifon, supra note 102, at 40.
    \262\ Parkus and Trifon, supra note 102, at 44; see also Senate 
Committee on Banking, Housing, and Urban Affairs, Subcommittee on 
Financial Institutions, Statement of Daniel K. Tarullo, member, Board 
of Governors of the Federal Reserve System: Examining the State of the 
Banking Industry, at 7-9 (Oct. 14, 2009) (online at banking.senate.gov/
public/index.cfm?FuseAction=Files.View&FileStore_id=c123f6a9-0b8d-4b22-
ba68-fa900a712d86) (hereinafter ``Testimony of Daniel K. Tarullo'').
    \263\ Parkus and Trifon, supra note 102, at 40-45.
---------------------------------------------------------------------------
    A number of construction projects have been delayed or 
abandoned providing physical proof of problems with 
construction loans. Stalled projects, ranging from high-profile 
to smaller-scale developments, span the country. Higher profile 
examples include a shopping district in Atlanta (Streets of 
Buckhead), redevelopment of a retail store in Boston (Filene's 
Basement), a mixed-use building in Phoenix, a large casino-
hotel in Las Vegas (Fontainebleau), and a retail project in the 
New Jersey Meadowlands (Xanadu).\264\ From a community 
standpoint, half-finished buildings or new commercial 
properties that are vacant or largely vacant can be thought of 
as merely irritating eyesores. But, they can also be symbolic 
of greater problems or misfortunes resulting from the current 
economic downturn (and its general effect on individuals, 
businesses, unemployment, and spending), deterioration in the 
commercial real estate market, and general capital contraction.
---------------------------------------------------------------------------
    \264\ See Alexandra Berzon, Icahn Is Winning Bidder for Casino, 
Wall Street Journal (Jan, 21. 2010); Carrick Mollenkamp and Lingling 
Wei, Unfinished Projects Weigh on Banks, Wall Street Journal (Jan. 20, 
2010).
---------------------------------------------------------------------------

4. New Loans Fail To Get Financing

    The problems which persist for existing loans will also 
contribute to an inability for new loans to get financing.\265\ 
High vacancy rates and weak demand for additional commercial 
property will not only imperil the ability of current loans to 
perform and current borrowers to refinance but also discourage 
additional development and consequently the need for new loans. 
Substantial absorption will have to take place before new 
developments, and the accompanying loans, become 
attractive.\266\ Sharp decreases in commercial and multifamily 
mortgage loan originations, loans for conduits for CMBS, and 
sales of commercial property reflect the existence of tight 
credit conditions and low demand for new commercial real estate 
loans.\267\
---------------------------------------------------------------------------
    \265\ See additional discussion of scarcity of credit in Section 
C.2.
    \266\ See Written Testimony of Mark Elliott, supra note 109, at 7 
(``Because of too much speculative development and the diminished 
economy, there is a fundamental over-supply of real estate in every 
product class and of every type''); COP Field Hearing in Atlanta, supra 
note 70, at 1 (Testimony of Chris Burnett); Treasury Snapshot, Dec. 14 
2009, supra note 258 (``Demand for new commercial real estate loans 
remains low due to the lack of new construction activity. Real estate 
developers are reluctant to begin new projects or purchase existing 
projects under current poor economic conditions, which include a 
surplus of office space as firms downsize and vacancies rise''); 
Commercial Real Estate Take III, supra note 213, at 6-8. See also the 
discussion of capital contraction above in Section G.1.
    \267\ MBA Data Book: Q3 2009, supra note 98, at 30, 39-43; see also 
Matthew Anderson and Susan Persin, Commercial Mortgage Outlook: Growing 
Pains in Mortgage Maturities, at 1, 3 (Mar. 17, 2009) (``[W]e expect 
the commercial real estate debt market to show minimal net growth 
during the next decade. The high volume of loans maturing in the 
multifamily and commercial mortgage markets will absorb most of the 
origination volume for several years. . . . [W]e estimate that 
refinancing of maturing mortgages comprised about 80% of total 
originations in 2008, as compared to 35% during the 2000 to 2007 
period'').
---------------------------------------------------------------------------
    Further, banks facing large potential commercial real 
estate losses may be unable to extend new loans.\268\ In an 
effort to increase loan loss reserves and shore up additional 
capital, banks will have less capital available to make new 
loans.\269\ However, even assuming available capital, banks 
with significant commercial real estate exposure may shy away 
from additional commercial real estate loans, regardless of the 
quality of such loans, opting instead to reduce their current 
exposure because commercial real estate market fundamentals are 
weak and not expected to improve in the near term.\270\ Banks 
may also be unwilling to take originally loans onto their 
balance sheet that will ultimately be securitized because of 
warehousing and arbitrage risk, hindering recovery in the CMBS 
market.\271\
---------------------------------------------------------------------------
    \268\ See, e.g., COP Hearing with Secretary Geithner, supra note 
255, at 3 (``Commercial real estate losses weigh heavily on many small 
banks, impairing their ability to extend new loans'').
    \269\ See COP Field Hearing in Atlanta, supra note 70, at 8-9 
(Testimony of Chris Burnett).
    \270\ See Treasury Snapshot, Dec. 14 2009, supra note 258 
(``Finally, nearly all respondents indicated that they are actively 
reducing their exposure to commercial real estate loans, as banks 
expect commercial real estate loan delinquencies to persist and 
forecasters expect weakness in the commercial real estate market to 
continue'').
    \271\ See Joyce, Cobb, Kelly and Auer, supra note 247, at 21.
---------------------------------------------------------------------------
    In addition, rising interest rates and the withdrawal of 
Federal Reserve liquidity programs may exacerbate the 
problem.\272\ A significant amount of commercial real estate 
loans are floating rate loans. Historically low interest rates 
are helping these loans perform in the face of decreased 
operating income or cash flows by reducing interest payments or 
the level of debt service. However, if interest rates begin to 
rise, the values of commercial property would fall further and 
cash flows and interest rate reserves would be exhausted 
sooner, leading to an accompanying rise in loan defaults.
---------------------------------------------------------------------------
    \272\ These included five programs, the Money Market Investor 
Funding Facility, the Asset-Backed Commercial Paper Money Market Mutual 
Fund Liquidity Facility, the Commercial Paper Funding Facility, the 
Primary Dealer Credit Facility, the Term Securities Lending Facility, 
and the Term Asset-Backed Securities Loan Facility (TALF), designed to 
expand the range and terms of the Board's provision of funds to support 
financial institutions. The Term Auction Facility, which allows 
depository institutions, upon provision of adequate collateral to 
obtain short-term loans from the Board at interest rates determined by 
auction, remains in operation as of the date of this report. Bank 
supervisors have already begun advising the institutions they regulate 
to adopt plans for addressing rising interest rates and illiquidity. 
See, e.g., Board of Governors of the Federal Reserve System, Federal 
Deposit Insurance Corporation, National Credit Union Administration, 
Office of the Comptroller of the Currency, Office of Thrift Supervision 
(OTS), and Federal Financial Institutions Examination Council State 
Liaison Committee, Advisory on Interest Rate Risk Management (Jan. 6, 
2010) (online at www.fdic.gov/news/news/press/2010/pr1002.pdf).
---------------------------------------------------------------------------
    Rising interest rates would also impair refinancing for 
properties that are not aggressively leveraged because of the 
combination of an increasing cost of capital and diminished 
operating income or cash flows. As the DSCR continues to fall, 
the level of risk increases, causing lenders to charge even 
higher rates of interest to compensate for additional 
risk.\273\ The withdrawal of Federal Reserve liquidity 
programs, such as TALF (a partially TARP funded program), may 
result in wider spreads, less readily available capital for 
commercial real estate, and more difficulty refinancing loans 
at maturity.\274\
---------------------------------------------------------------------------
    \273\ See Board of Governors of the Federal Reserve System, Speech 
by Governor Elizabeth A. Duke at the Economic Forecast, at 9 (Jan. 4, 
2010) (online at www.federalreserve.gov/newsevents/speech/
duke20100104a.htm) (discussing unfavorable outlook for commercial real 
estate and higher rates of return required by investors).
    \274\ See, e.g., COP Field Hearing in Atlanta, supra note 70, at 8 
(Testimony of Jon Greenlee) (providing that TALF has been successful in 
helping restart securitization markets and narrowing rate spreads for 
asset-backed securities). See additional discussion of the TALF at 
Section I.1.
---------------------------------------------------------------------------
    From the banks' perspectives, rising interest rates will 
typically reduce profitability as funding costs increase more 
rapidly than the yield on banks' loans and investments. Such 
reduced profitability will put further stress upon banks 
already struggling with sizable exposures of delinquent or non-
performing commercial real estate loans in their portfolios and 
thereby hasten the need for these banks to resolve the status 
of such loans regardless of the accounting treatment of such 
loans.

5. Broader Social and Economic Consequences

    Declining collateral values, delinquent and defaulting 
loans, and inability to secure refinancing in order to make a 
balloon payment can all result in financial institutions having 
to write-down asset values. These write-downs have already 
caused financial institutions to fail, and if commercial real 
estate losses continue to mount, the write-downs and failures 
will only increase. But, it is important to realize that these 
conditions will have a far broader impact.
    Commercial real estate problems exacerbate rising 
unemployment rates and declining consumer spending. 
Approximately nine million jobs are generated or supported by 
commercial real estate including jobs in construction, 
architecture, interior design, engineering, building 
maintenance and security, landscaping, cleaning services, 
management, leasing, investment and mortgage lending, and 
accounting and legal services.\275\ Projects that are being 
stalled or cancelled and properties with vacancy issues are 
leading to layoffs. Lower commercial property values and rising 
defaults are causing erosion in retirement savings, as 
institutional investors, such as pension plans, suffer further 
losses. Decreasing values also reduce the amount of tax revenue 
and fees to state and local governments, which in turn impacts 
the amount of funding for public services such as education and 
law enforcement. Finally, problems in the commercial real 
estate market can further reduce confidence in the financial 
system and the economy as a whole.\276\
---------------------------------------------------------------------------
    \275\ Real Estate Roundtable White Paper, supra note 245, at 1-2 
(accessed Feb. 9, 2010); see also COP Field Hearing in Atlanta, supra 
note 70, at 4.
    \276\ Real Estate Roundtable White Paper, supra note 245, at 1-2 
(accessed Feb. 9, 2010).
---------------------------------------------------------------------------
    To make matters worse, the credit contraction that has 
resulted from the overexposure of financial institutions to 
commercial real estate loans, particularly for smaller regional 
and community banks, will result in a ``negative feedback 
loop'' that suppresses economic recovery and the return of 
capital to the commercial real estate market. The fewer loans 
that are available for businesses, particularly small 
businesses, will hamper employment growth, which could 
contribute to higher vacancy rates and further problems in the 
commercial real estate market.\277\
---------------------------------------------------------------------------
    \277\ See Lockhart Speech before the Atlanta Fed, supra note 128; 
see also COP Field Hearing in Atlanta, supra note 70, at 10, 12 
(Testimony of Doreen Eberley) (providing that small businesses and 
trade groups are having difficulty obtaining credit and renewing 
existing lines of credit and that extending credit to businesses will 
be essential in stimulating economic growth). Consumers or households 
are experiencing similar problems obtaining access to credit, resulting 
in reduced consumer spending. See COP Field Hearing in Atlanta, supra 
note 70, at 4 (Testimony of Jon Greenlee).
---------------------------------------------------------------------------
    The cascading effects of a financial crisis on the economy 
was the justification for the use of public funds under EESA, 
and future problems in the commercial real estate markets may 
create similar conditions or causes for concern.

     G. Bank Capital; Financial and Regulatory Accounting Issues; 
                   Counterparty Issues; and Workouts

    Some of the risks of commercial real estate loans can 
produce a direct impact on bank capital, some trigger related 
financial market consequences, and still others can be eased or 
resolved by private negotiations short of any immediate impact. 
This section discusses (1) the bank capital rules that set the 
terms on which loan failures can affect bank strength, (2) a 
general summary of the accounting policies involved, (3) the 
risk of collateral financial market consequences, and (4) the 
way in which workouts and loan modifications can reduce or 
eliminate, at least for a time, such adverse impacts.

1. Commercial Real Estate and Bank Capital \278\
---------------------------------------------------------------------------

    \278\ This discussion is taken from the Panel's August report. See 
COP August Oversight Report, supra note 5, at 18-19.
---------------------------------------------------------------------------
    Troubled loans have a significant negative effect on the 
capital of the banks that hold them; the two operate jointly. 
Although bank capital computations are often very technical and 
complicated,\279\ the core of the rules can be stated simply. A 
bank's capital strength is generally measured as the ratio of 
specified capital elements on the firm's consolidated balance 
sheet (e.g., the amount of paid-in capital and retained 
earnings) to its total assets.\280\ Decreases in the value of 
assets on a bank's balance sheet change the ratio by requiring 
that amounts be withdrawn from capital to make up for the 
losses. Losses in asset value that are carried directly to an 
institution's capital accounts without being treated as items 
of income or loss have the same effect.\281\
---------------------------------------------------------------------------
    \279\ Capital adequacy is measured by two risk-based ratios, Tier 1 
and Total Capital (Tier 1 Capital plus Tier 2 Capital (Supplementary 
capital). Tier 2 capital may not exceed Tier 1 capital. Tier 1 capital 
is considered core capital while Total Capital also includes other 
items such as subordinated debt and loan loss reserves. Both measures 
of capital are stated as a percentage of risk-weighted assets. A 
financial institution is also subject to the Leverage Ratio 
requirement, a non-risk-based asset ratio, which is defined as Tier 1 
Capital as a percentage of adjusted average assets. See Office of 
Thrift Supervision, Examination Handbook, Capital, at 120.3 (Dec. 2003) 
(online at files.ots.treas.gov/422319.pdf); see also Federal Deposit 
Insurance Corporation, Risk Management Manual of Examination Policies, 
Section 2.1 Capital (April 2005) (online at www.fdic.gov/regulations/
safety/manual/section2-1.html#capital); Office of the Comptroller of 
the Currency, Comptroller's Handbook (Section 303), Capital Accounts 
and Dividends, (May 2004) (online at www.occ.treas.gov/handbook/
Capital1.pdf). In addition, the risk-based capital standards identify 
``concentration of credit risk, risks of nontraditional activities, and 
interest rate risk as qualitative factors to be considered in the 
[supervisory] assessments of an institution's overall capital 
adequacy.'' See Accounting Research Manager, Chapter 1: Industry 
Overview--Banks and Savings Institutions, at 1.31 (online at 
www.accountingresearchmanager.com/wk/ rm.nsf/0/ 
6EE8C13C9815FB4186256E6D00546497? OpenDocument&rnm= 673577&Highlight=2, 
BANKS,SAVINGS,INSTITUTIONS).
    \280\ The value of the assets is generally ``risk-weighted,'' that 
is, determined based on the risk accorded the asset.
    \281\ Although these losses are carried directly to the capital 
account, they have no effect on regulatory capital calculations when 
recorded in the other-comprehensive-income account.
---------------------------------------------------------------------------
    During the financial crisis, all of these steps accelerated 
dramatically. A plunge in the value of a bank's loan portfolio 
that has a significant impact on the value of the bank's 
assets--as it usually will--triggers a response by the bank's 
supervisor, one that usually requires the institution to raise 
additional capital or even push it into receivership. 
Otherwise, the bank's assets simply cannot support its 
liabilities and it is insolvent. The TARP attempted to restore 
the balance during the crisis by shoring up bank capital 
directly.\282\
---------------------------------------------------------------------------
    \282\ Congressional Oversight Panel, Testimony of Assistant U.S. 
Treasury Secretary for Financial Stability Herbert Allison, at 27 (June 
24, 2009) (online at cop.senate.gov/documents/transcript-062409-
allison.pdf) (Treasury seeks to enable banks ``to sell marketable 
securities back into [the] market and free up balance sheets, and at 
the same time [to make] available, in case it's needed, additional 
capital to these banks which are so important to [the] economy''); See 
also id. at 28 (``Treasury . . . is providing a source of capital for 
the banks and capital is essential for them in order that they be able 
to lend and support the assets on their balance sheet and there has 
been . . . there was an erosion of capital in a number of those 
banks'').
---------------------------------------------------------------------------
    The problem of unresolved bank balance sheets is 
intertwined with the problem of lending, as the Panel has 
observed before.\283\ Uncertainty about risks to bank balance 
sheets, including the uncertainty attributable to bank holdings 
of the troubled assets, caused banks to protect themselves 
against possible losses by building up their capital reserves, 
including devoting TARP assistance to that end. One consequence 
was a reduction in funds for lending and a hesitation to lend 
even to borrowers who were formerly regarded as credit-worthy.
---------------------------------------------------------------------------
    \283\ See, e.g., COP June Oversight Report, supra note 6, at 6, 11-
12.
---------------------------------------------------------------------------

2. Accounting Rules \284\
---------------------------------------------------------------------------

    \284\ For a more complete discussion of ``fair value accounting'' 
see COP August Oversight Report, supra note 5, at 18-19.
---------------------------------------------------------------------------
    Under applicable accounting standards, financial 
institutions in general value their assets according to ``fair 
value'' accounting.\285\ Since the beginning of the financial 
crisis, concerns about how financial institutions reflect their 
true financial condition without ``marking their assets to 
market'' have surfaced.
---------------------------------------------------------------------------
    \285\ Financial Accounting Standard 157, adopted in 2006, was meant 
to provide a clear definition of fair value based on the types of 
metrics utilized to measure fair value (market prices and internal 
valuation models based on either observable inputs from markets, such 
as current economic conditions, or unobservable inputs, such as 
internal default rate calculations).
---------------------------------------------------------------------------
    Under the basic ``fair value'' standard, the manner in 
which debt and equity securities and loans are valued depends 
on whether those assets are held on the books of a financial 
institution in its (1) trading account (an account that holds 
debt and equity securities that the institution intends to sell 
in the near term), (2) available-for-sale account (an account 
that holds debt and equity securities that the institution does 
not necessarily intend to sell, certainly in the near term), or 
(3) held-to-maturity account (an account, as the name states, 
for debt securities that the institution intends to hold until 
they are paid off).
    The bank designates assets that are readily tradable in the 
near future by classifying these assets in a trading account. 
Many of these assets are bought and sold regularly in a liquid 
market, such as the New York Stock Exchange or the various 
exchanges on which derivatives and options are bought and sold, 
which sets fair market values for these assets.\286\ There is 
no debate about market value. In the trading account, the value 
must be adjusted to reflect changes in prices. The adjustments 
affect earnings directly.
---------------------------------------------------------------------------
    \286\ See Financial Accounting Standards Board, Statement of 
Financial Accounting Standards No. 157: Fair Value Measurements (SFAS 
157) (September 2006). If assets are not traded in an active market, 
SFAS 157 describes the steps to be taken in the valuation of these 
assets. In this regard, SFAS 157 specifies a hierarchy of valuation 
techniques based on whether the inputs to those valuation techniques 
are observable or unobservable. Observable inputs reflect market data 
obtained from independent sources, while unobservable inputs reflect 
the entity's market assumptions. SFAS 157 requires entities to maximize 
the use of observable inputs and minimize the use of unobservable 
inputs when measuring fair value of assets. These two types of inputs 
have created a three fair value hierarchy: Level 1 Assets (mark-to-
market), Level 2 Assets (mark-to-matrix), and Level 3 Assets (mark-to-
model).
    Level 1--Liquid assets with publicly traded quotes. The financial 
institution has no discretion in valuing these assets. An example is 
common stock traded on the NYSE.
    Level 2--Quoted prices for similar instruments in active markets; 
quoted prices for identical or similar instruments in markets that are 
not active; and model-derived valuations in which all significant 
inputs and significant value drivers are observable in active markets. 
The frequency of transactions, the size of the bid-ask spread and the 
amount of adjustment necessary when comparing similar transactions are 
all factors in determining the liquidity of markets and the relevance 
of observed prices in those markets.
    Level 3--Valuations derived from valuation techniques in which one 
or more significant inputs or significant value drivers are 
unobservable. If quoted market prices are not available, fair value 
should be based upon internally developed valuation techniques that 
use, where possible, current market-based or independently sourced 
market parameters, such as interest rates and currency rates.
    See also footnote 289, which discusses how to determine if there is 
an active market.
---------------------------------------------------------------------------
    Assets in an available-for-sale account are carried at 
their ``fair value.'' In this case, any changes in value that 
are not realized through a sale do not affect earnings but 
directly affect equity on the balance sheet (reported as 
unrealized gains or losses through an equity account called 
``Other Comprehensive Income''). However, unrealized gains and 
losses on available-for-sale assets do not affect regulatory 
capital. Assets that are regarded as held-until-maturity are 
valued at cost minus repaid amounts (i.e., an ``amortized 
basis'').
    The treatment of these assets held in either an available-
for-sale or a held-to-maturity account changes when these 
assets become permanently impaired.\287\ In this case the 
permanent impairment is reported as a realized loss through 
earnings and regulatory capital.
---------------------------------------------------------------------------
    \287\ Credit impairment is assessed using a cash flow model that 
estimates cash flows on the underlying mortgages, using the security-
specific collateral and transaction structure. The model estimates cash 
flows from the underlying mortgage loans and distributes those cash 
flows to various tranches of securities, considering the transaction 
structure and any subordination and credit enhancements that exist in 
the structure. It incorporates actual cash flows on the mortgage-backed 
securities through the current period and then projects the remaining 
cash flows using a number of assumptions, including default rates, 
prepayment rates, and recovery rates (on foreclosed properties). If 
cash flow projections indicate that the entity does not expect to 
recover its amortized cost basis, the entity recognizes the estimated 
credit loss in earnings.
---------------------------------------------------------------------------
    When mortgage defaults rose in 2007 and 2008, the value of 
underlying assets, such as mortgage loans, dropped 
significantly, causing banks to write-down both whole loans and 
mortgage-related securities on their balance sheets. As 
discussed in the August report, financial institutions are 
worried that reflecting on their balance sheets the amounts 
they would receive through forced sales of assets will distort 
their financial positions--to say nothing of threatening their 
capital--although they are not in fact selling the assets in 
question and in fact might well recover more than the fire sale 
write-down price.\288\
---------------------------------------------------------------------------
    \288\ John Heaton, Deborah Lucas, and Robert McDonald, Is Mark to 
Market Destabilizing Analysis and Implications for Policy, University 
of Chicago and Northwestern University (May 11, 2009).
---------------------------------------------------------------------------
    In April 2009, the Financial Accounting Standards Board 
again adjusted the accounting rules to loosen the use of 
immediate fair value accounting. One of the new rules suspends 
the need to apply mark-to-market principles for securities 
classified under trading or available-for-sale if current 
market prices are either not available or are based on a 
distressed market.\289\ The rationale for this amendment is 
that security investments held by an entity can distort 
earnings in an adverse market climate by reducing those 
earnings more than will be required if the loans are held to 
maturity.
---------------------------------------------------------------------------
    \289\ Financial Accounting Standards Board, FASB Staff Position: 
Determining Fair Value When the Volume and Level of Activity for the 
Asset or Liability Have Significantly Decreased and Identifying 
Transactions That Are Not Orderly (FSP FAS 157-4) (Apr. 9, 2009). FSP 
157-4 relates to determining fair values when there is no active market 
or where the price inputs being used represent distressed sales. For 
this the FSP establishes the following eight factors for determining 
whether a market is not active enough to require mark-to-market 
accounting:
    1. There are few recent transactions.
    2. Price quotations are not based on current information.
    3. Price quotations vary substantially either over time or among 
market makers.
    4. Indexes that previously were highly correlated with the fair 
values of the asset or liability are demonstrably uncorrelated with 
recent indications of fair value for that asset or liability.
    5. There is a significant increase in implied liquidity risk 
premiums, yields, or performance indicators (such as delinquency rates 
or loss severities) for observed transactions or quoted prices when 
compared with the reporting entity's estimate of expected cash flows, 
considering all available market data about credit and other 
nonperformance risk for the asset or liability.
    6. There is a wide bid-ask spread or significant increase in the 
bid-ask spread.
    7. There is a significant decline or absence of a market for new 
issuances for the asset or liability or similar assets or liabilities.
    8. Little information is released publicly.
---------------------------------------------------------------------------
    A second new rule, also adopted on April 9, 2009, applies 
to permanently impaired debt securities classified as 
available-for-sale or held-to-maturity, upon which the holder 
does not intend to sell or believes it will not be forced to 
sell before they mature.\290\ Under the new rule, the part of 
the permanent impairment that is attributable to market forces 
does not reduce earnings and does not reduce regulatory 
capital, but other impairment changes, such as volatility of 
the security or changes due to the rating agency, will reduce 
earnings and regulatory capital. The old rule did not 
distinguish how the impairment was derived. All permanent 
impairments, whether related to market forces or other 
conditions, reduced earnings and reduced regulatory capital. 
(The changes in these accounting rules are the subject of a 
continuing debate on which, as in the August report, the Panel 
takes no position.)
---------------------------------------------------------------------------
    \290\ Financial Accounting Standards Board, FASB Staff Position: 
Recognition and Presentation of Other-Than-Temporary Impairments (FSP 
No. FAS 115-2 and FAS 124-2). This FASB Staff Position (FSP) amends the 
recognition guidance for the other-than-temporary impairment (OTTI) 
model for debt securities and expands the financial statement 
disclosures for OTTI on debt securities. Under the FSP, an entity must 
distinguish debt securities the entity intends to sell or is more 
likely than not required to sell the debt security before the expected 
recovery of its amortized cost basis. The credit loss component 
recognized through earnings is identified as the amount of cash flows 
not expected to be received over the remainder term of the security as 
projected based on the investor's projected cash flow projections using 
its base assumptions. Part of the entity's required expansion in 
disclosure includes detailed explanation on the methodology utilized to 
distinguish securities to be sold or not sold and to separate the 
impairment between credit and market losses. For debt securities an 
entity intends to sell before maturity or is more likely than not 
required to sell prior to maturity, the entire loss must be recognized 
through earnings. FSP FAS 115-2 does not change the recognition of 
other-than-temporary impairment for equity securities.
---------------------------------------------------------------------------
    As described below, effective in 2010, two new accounting 
standards, SFAS 166 \291\ and SFAS 167,\292\ will have a 
special impact on institutions' reflection of CMBS that they 
originated, packaged, or both. Prior to 2010, those investments 
in CMBS were generally placed in special purpose vehicles (so-
called ``SPVs'') that financial institutions were permitted not 
to record as part of their balance sheet assets. As a result, 
those assets were not reflected in the institution's financial 
statements.\293\
---------------------------------------------------------------------------
    \291\ Statement of Financial Accounting Standard (SFAS) No. 166, 
``Accounting for Transfers of Financial Assets an amendment of 
Statement No. 140'' (SFAS 166). SFAS 166 revises existing sale 
accounting criteria for transfers of financial assets. Prior to 2010, 
financial institutions that transferred mortgage loans, credit card 
receivables, and other financial instruments to special purpose 
entities (SPEs) that met the definition of a qualifying special purpose 
entity (QSPE) were not currently subject to consolidation by the 
transferor. Among other things, SFAS 166 eliminates the concept of a 
QSPE. As a result, existing QSPEs generally will be subject to 
consolidation in accordance with the guidance provided in SFAS 167. See 
footnote 292 for a discussion of SFAS 167. See Financial Accounting 
Standards Board, Statement of Accounting Standard No.166, Accounting 
for Transfers of Financial Assets, an amendment of FASB Statement 
No.140 (June 2009) (online at www.fasb.org/cs/
BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey= 
id&blobwhere=1175819183786&blobheader=application%2Fpdf).
    \292\ SFAS No. 167, ``Amendments to FASB Interpretation No. 
46(R).'' SFAS 167 significantly changes the criteria by which a 
financial institution determines whether it must consolidate a variable 
interest entity (VIE). A VIE is an entity, typically an SPE, which has 
insufficient equity at risk or which is not controlled through voting 
rights held by equity investors. Currently, a VIE is consolidated by 
the financial institution that will absorb a majority of the expected 
losses or expected residual returns created by the assets of the VIE. 
SFAS 167 requires that a VIE be consolidated by the enterprise that has 
both the power to direct the activities that most significantly impact 
the VIE's economic performance and the obligation to absorb losses or 
the right to receive benefits that could potentially be significant to 
the VIE. SFAS 167 also requires that an enterprise continually 
reassess, based on current facts and circumstances, whether it should 
consolidate the VIEs with which it is involved. See Financial 
Accounting Standards Board, Statement of Accounting Standards No. 167, 
Amendments to FASB Interpretation No. 46(R) (June 2009) (online at 
www.fasb.org/cs/
BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey= 
id&blobwhere=1175819183863&blobheader=application%2Fpdf).
    \293\ In addition, if a financial institution declares bankruptcy, 
the assets in a SPV are generally protected (``sometimes referred to as 
''bankruptcy remote''') from creditors' claims against the institution. 
However, when General Growth Properties, Inc. (GGP) filed for 
bankruptcy in April 2009, it included its affiliates that were SPVs. 
Those affiliates challenged their inclusion since they were considered 
bankruptcy remote. However, given the ``unprecedented collapse of the 
real estate markets'' and ``serious uncertainty'' about when and if 
refinancing would be available, the United States Bankruptcy Court for 
the Southern District of New York Court concluded that GGP's management 
had little choice other than to reorganize the entirety of GGP's 
enterprise capital structure through a bankruptcy filing. Further, the 
court rebuked the commonly held misperception that a ``bankruptcy 
remote'' structure is ``bankruptcy proof.'' The future impact of this 
opinion, and its relationship to the change in accounting standards, is 
unclear at best. See United States Bankruptcy Court Southern District 
of New York, In re: General Growth Properties, Inc. et al., Debtors, 
Case No. 09-11977 (August 2009) (online at www.nysb.uscourts.gov/
opinions/alg/178734--1284--opinion.pdf). For a summary of the case, see 
Sutherland, Legal Alert, Bankruptcy Court Denies CMBS Lenders Request 
to Dismiss Bankruptcy Petitions of SPE Affiliates of General Growth 
Properties, Inc. (Aug. 2009) (online at www.sutherland.com/files/News/
c5bb2175090baa=0943310995b609 a8c6459ab057/=Presentation/
NewsAttachment/f5d5b364=09c8b1094283-af7f-ae99c0b083f3/
=RE%20Alert%208.19.09.pdf).
---------------------------------------------------------------------------
    SFAS 166 and SFAS 167 generally require that those 
investments in CMBS and other assets that a financial 
institution held in an SPV be restored to a financial 
institution's balance sheet. As a result, it is estimated that 
approximately $900 billion in assets will be brought back on 
financial institutions' balance sheets.\294\ Of this amount, 
the four largest stress-tested banks will recognize 
approximately $454 billion. As disclosed in their public 
filings, Citigroup, Bank of America, JPMorgan Chase, and Wells 
Fargo will recognize additional assets of approximately $154 
billion,\295\ $100 billion,\296\ $110 billion,\297\ and $48 
billion,\298\ respectively.\299\
---------------------------------------------------------------------------
    \294\ See COP August Oversight Report, supra note 5, at 13 
(footnote 26).
    \295\ Citigroup disclosed in its 10-Q for the quarter ended 
September 30, 2009 that the proforma effect of the adoption of these 
new accounting standards will increase assets by approximately $154 
billion. Of the total amount, $84 billion is related to credit cards, 
$40 billion is related to commercial paper conduits, and $14 billion is 
related to student loans. The disclosure did not quantify investments 
in CMBS. Citigroup also disclosed that there will be an estimated 
aggregate after-tax charge to Retained earnings of approximately $7.8 
billion, reflecting the net effect of an overall pretax charge to 
Retained earnings (primarily relating to the establishment of loan loss 
reserves and the reversal of residual interests held) of approximately 
$12.5 billion less the recognition of related deferred tax assets 
amounting to approximately $4.7 billion. Further, Citigroup disclosed 
that Tier I capital and Total capital ratios will be decreased by 151 
and 154 basis points. See U.S. Securities and Exchange Commission, 
Citigroup Inc. Form 10-Q for the quarter ended September 30, 2009, at 
97 (Nov. 6, 2009) (online at sec.gov/Archives/edgar/data/831001/
000104746909009754/a2195256z10-q.htm).
    \296\ In its fourth quarter earnings release, Bank of America 
disclosed that of the $100 billion of added loans, $72 billion includes 
securitized credit cards and home equity receivables. The disclosure 
did not quantify investments in CMBS. In addition, regulatory capital 
will be reduced by $10 billion including deferred tax asset 
limitations. Further, it estimates that Tier I Capital will decrease 
between 70 to 75 basis points and Tier I Common Ratio will decrease 
between 65 to 70 basis points. On December 31, 2009, Tier I capital and 
Tier 1 Common Ratio was 10.4 percent and 7.8 percent, respectively. See 
U.S. Securities and Exchange Commission, Bank of America Form 8-K, 
Exhibit 99.2 (Jan. 20, 2010) (online at sec.gov/Archives/edgar/data/
70858/000119312510008505/dex992.htm).
    \297\ JPMorgan Chase did not disclose the category of assets that 
would be added to the balance sheet. In addition, JPMorgan Chase 
further disclosed that the ``[r]esulting decrease in the Tier I capital 
ratio could be approximately 40 basis points. See U.S. Securities and 
Exchange Commission, JP Morgan Chase & Co. Form 10-Q for the quarter 
ended September 30, 2009, at 97 (Nov. 6, 2009) (online at sec.gov/
Archives/edgar/data/70858/000119312509227720/d10q.htm).
    \298\ Wells Fargo did not disclose the category of assets that 
would be added to the balance sheet. See U.S. Securities and Exchange 
Commission, Wells Fargo and Company Form 10-Q for the quarter ended 
September 30, 2009, at 13 (Nov. 6, 2009) (online at sec.gov/Archives/
edgar/data/72971/000095012309059235/f53317e10vq.htm).
    \299\ The supervisors recognized that the adoption of SFAS 166 and 
SFAS 167 could significantly affect the risk-based capital requirements 
of financial institutions and in December 2009 adopted a regulatory 
capital rule that would give a financial institution the option to 
recognize the effects of these new accounting standards over a four-
quarter period. Citigroup disclosed that upon the adoption of these new 
accounting standards, its risk-based capital ratio would decrease by 
approximately 151 basis points. Similarly, Bank of America and JP 
Morgan disclosed that its risk based capital ratio would decrease by 
approximately 75 basis points and 40 basis points, respectively.
    Upon adoption of the regulatory capital rule, FDIC Chairman Shelia 
Bair stated that ``[t]he capital relief we are offering banks for the 
transition period should ease the impact of this accounting change on 
banks' regulatory capital requirements, and enable banks to maintain 
consumer lending and credit availability as they adjust their business 
practices to the new accounting rules.'' However, only time will tell 
how financial institutions will adjust their business practices to the 
new accounting rules and how their capital levels will be affected.
---------------------------------------------------------------------------
    When these assets are put back on the balance sheet, the 
accounting standards require that these assets reflect the 
amounts (i.e., carrying value) that would have been reflected 
on an institution's balance sheet. Because these assets were 
not previously reflected on the institution's balance sheet, 
the institution was not required to recognize any losses 
incurred from holding them. As a result, the recognition of 
these new assets on an institution's balance sheet may result 
in an increase to loan loss reserves (allowance for loan 
losses) as well as additional losses from the write-down in 
values of investments in CMBS. The addition of these assets 
coupled with the decline in value of commercial and commercial 
real estate whole loans (commercial whole loans) could also 
significantly affect the capital of a financial institution.
    For a financial institution, the allowance for loan losses 
is the dollar amount needed to absorb expected loan 
losses.\300\ It is increased by management's estimates of 
future loan losses and by recoveries of loans previously 
recorded as a loss (charged-off) and reduced by loan losses 
incurred when the borrower does not have the ability to repay 
the loan balance. There is no ``check the box'' formula for 
determining the appropriate level of loan losses. Rather, it is 
based upon a high degree of judgment by management.\301\ 
Because this account is based upon management's judgment, there 
is a high degree of risk that a financial institution's 
allowance for loan losses may be insufficient, especially in 
regard to the additional assets that will be recognized upon 
the adoption of these new accounting standards.
---------------------------------------------------------------------------
    \300\ The allowance for loan loss is a balance sheet account. Under 
generally accounting principles (GAAP) in the review of the adequacy of 
loan loss allowance, loans that have common characteristics such as 
consumer and credit cards loans are reviewed by a financial institution 
on a group basis. Commercial real estate loans and certain commercial 
loans are required to be reviewed on an individual basis.
    Further under GAAP, the recognition of loan losses is provided by 
SFAS No. 5, Accounting for Contingencies and No. 114, Accounting by 
Creditors for Impairment of a Loan (SFAS No. 114). An estimated loss 
from a loss contingency, such as the collectability of receivables, 
should be accrued when, based on information available prior to the 
issuance of the financial statements, it is probable that an asset has 
been impaired or a liability has been incurred at the date of the 
financial statements and the amount of the loss can be reasonably 
estimated. SFAS No. 114 provides more specific guidance on measurement 
of loan impairment and related disclosures but does not change the 
fundamental recognition criteria for loan losses provided by SFAS No. 
5. Additional guidance on the recognition, measurement, and disclosure 
of loan losses is provided by Emerging Issues Task Force (EITF) Topic 
No. D-80, Application of FASB Statements No. 5 and No. 114 to a Loan 
Portfolio (EITF Topic D-80), FASB Interpretation No. 14, Reasonable 
Estimation of the Amount of a Loss (FIN 14), and the American Institute 
of Certified Public Accountants (AICPA) Audit and Accounting Guide, 
Banks and Savings Institutions. Further guidance for SEC registrants is 
provided by Financial Reporting Release No. 28, Accounting for Loan 
Losses by Registrants Engaged in Lending Activities (Dec. 1, 1986). See 
SEC Staff Accounting Bulletin No.102--Selected Loan Loss Allowance 
Methodology and Documentation Issues, 1. Accounting for Loan Losses--
General, at 4 (July 6, 2001) (online at sec.gov/interps/account/
sab102.htm).
    \301\ See Financial Reporting Release No. 28 (FRR 28), Accounting 
for Loan Losses by Registrants Engaged in Lending Activities, 
Securities Act Release No. 6679,1986 WL 1177276 (Dec. 1, 1986). See 
also FRR 28A, Amendment of Interpretation Regarding Substantive 
Repossession of Collateral, Securities Release No. 7060, 56 SEC Docket 
1731, 1994 WL 186824 (May 12,1994).
    In order to determine the dollar amount needed to absorb expected 
future loan losses, management reviews the credit quality of all loans 
that comprise a financial institution's loan portfolio (i.e., consumer, 
credit cards, and commercial and commercial real estate loans). The 
accounting guidelines require that management's assessment 
``incorporate [its] current judgments about the credit quality of the 
loan portfolio through a disciplined and consistently applied 
process.'' For example, management's assessments of the credit quality 
of the loan portfolio should include the following characteristics: 
past loan loss experience, known and inherent loss risks in the 
portfolio, adverse situations that may affect the borrower's ability to 
repay, the estimated value of any underlying collateral, current 
economic conditions, in addition to any pertinent characteristics of 
the loan. See SEC Staff Accounting Bulletin (SAB) No.102--Selected Loan 
Loss Allowance Methodology and Documentation Issues, Question. 1 at 5 
(July 6, 2001) (online at sec.gov/interps/account/sab102.htm). Question 
1 further states that'' [a] systematic methodology that is properly 
designed and implemented should result in [an entity's] best estimate 
of its allowance for loan losses.''
---------------------------------------------------------------------------
    The new accounting standards will force more accuracy in an 
institution's financial statements, but the increased accuracy 
will mean that the parlous state of commercial whole loans will 
be even clearer.

3. Commercial Real Estate Workouts

            a. Options for Resolving Defaulting or Non-Performing Loans
    When a permanent commercial mortgage borrower defaults, the 
borrower and the lender or special servicer have a number of 
options available to them to resolve the situation and recover 
as much of their respective interests as possible: (1) the 
lender or servicer can foreclose, (2) the parties can engage in 
a ``workout'' and modify the loan by lowering the principal, 
the interest rate, or both, and (3) the lender can extend the 
borrower's loan on the same terms for an additional period. 
Each of these actions may be the best choice in appropriate 
situations.
    In some cases, after analyzing the property, the servicer 
may determine that foreclosure is the best option. Properties 
with very poor operating fundamentals, such as high vacancy, 
may be unlikely to recover under any probable scenario. In 
these cases it may be best for the lender to resolve the 
situation promptly by taking the property and booking the loss. 
In order to avoidforeclosure costs and delays, commercial real 
estate lenders may be willing to agree to an alternative to a 
traditional hostile foreclosure, such as a deed in lieu of foreclosure, 
a voluntary ``friendly foreclosure'' (where the borrower does not fight 
the foreclosure process), or a short sale.
    If possible, commercial lenders will often arrange for a 
new borrower to step in after foreclosure to purchase the 
property and replace the defaulted borrower. In January 2010, 
Tishman Speyer Properties and BlackRock defaulted on $4.4 
billion in debt from its 2006 purchase of Stuyvesant Town and 
Peter Cooper Village in Manhattan. In defaulting, they turned 
the property over to the lenders. Within several weeks, lenders 
were in serious discussions with potential purchasers and 
property managers.\302\ Also, in December 2009, Morgan Stanley 
and its lenders performed an ``orderly transfer'' of five 
downtown San Francisco office buildings that it had purchased 
in 2007.\303\
---------------------------------------------------------------------------
    \302\ Oshrat Carmiel and Sharon L. Lynch, Wilbur Ross May Go All 
the Way,' Buy Stuyvesant Town, Bloomberg (Jan. 26, 2010) (online at 
www.bloomberg.com/apps/news?pid=newsarchive&sid=aMe55gpowv2g).
    \303\ Dan Levy, Morgan Stanley to Give Up 5 San Francisco Towers 
Bought at Peak, Bloomberg (Dec. 17, 2009) (online at www.bloomberg.com/
apps/news?pid=20601110&sid=aLYZhnfoXOSk).
---------------------------------------------------------------------------
    These alternative strategies are more common in commercial 
real estate than in residential. With residential properties, 
more typically after a default or foreclosure, a property will 
sit vacant for weeks or months before the lender is able to 
sell the home. Commercial defaults are also significantly less 
disruptive to communities and families, as the lenders are 
usually able to manage properties as productive assets. 
Residential foreclosures, on the other hand, force families out 
of their homes and burden neighborhoods with vacant and 
sometimes derelict properties. However, newly built commercial 
properties, especially those built ``on spec'' with no pre-
leased tenants, often do remain empty for some time.
    Loans on properties with viable fundamentals and income 
which cannot support the current payment, but which could 
support a slightly lower payment, may benefit from a loan 
modification such as a rate or principal reduction. In these 
cases, the lender must weigh the present value cost of the 
modification with the costs of foreclosure, which may be 
substantial.
    As with the residential market, commercial borrowers with 
negative equity (``underwater'') have an incentive to default 
in order to avoid an almost certain loss.\304\ Workouts that do 
not address the incentives inherent in negative equity 
situations run the risk of simply delaying an inevitable 
redefault and foreclosure, which can be costly for both lender 
and borrower. Even borrowers in negative equity that continue 
to service their debt may make significant cuts in property 
maintenance and other discretionary expenses in an attempt to 
limit their potential losses.
---------------------------------------------------------------------------
    \304\ Jun Chen and Yongheng Deng, Commercial Mortgage Workout 
Strategy and Conditional Default Probability: Evidence from Special 
Serviced CMBS Loans, Real Estate Research Institute Working Paper (Feb. 
2004) (online at www.reri.org/research/article_pdf/wp120.pdf) 
(hereinafter ``Chen and Deng: Commercial Mortgage Workout Strategy''). 
The GAO made a similar observation in a report about the risks 
associated with TALF, the government lending facility: ``A number of 
scenarios could result in a borrower walking away from a loan. For 
example, the collateral could lose value so that the loan amount 
exceeded the value of the collateral.'' GAO TALF Report, supra note 64, 
at 18.
---------------------------------------------------------------------------
    Principal reductions, or write-downs, have the advantage of 
removing the incentive for these borrowers to default, since 
the new principal balance will usually be less than the sale 
proceeds from the property. The borrower will no longer have to 
come up with cash to pay off the loan when they sell the 
property. On the other hand, principal reductions are not 
favored by many lenders because they are costly, and because 
they force the recognition of a loss on what may already be a 
weak balance sheet. In the case of a bank, this may cause it to 
run afoul of its supervisors over capital requirements.
    Borrowers facing foreclosure may choose to declare 
bankruptcy in order to halt temporarily foreclosure 
proceedings. Unlike the situation in residential real estate, 
bankruptcy courts can order a write-down of a commercial real 
estate loan balance under certain circumstances.\305\ Borrowers 
may be able to use this possibility as a negotiating tactic 
with the lender. The usefulness of this option can be 
influenced by the use of a SPV to hold each property.\306\
---------------------------------------------------------------------------
    \305\ See Brueggeman and Fisher, supra note 13, at 39-41.
    \306\ Proskauer Rose, LLP, Real Estate Bankruptcy Cramdowns: Fact 
or Fiction (Mar. 16, 2009) (online at www.mondaq.in/unitedstates/
article.asp?articleid=76162). But see footnote 293 regarding the 
bankruptcy of GGP. When GGP filed for bankruptcy it included its 
affiliates that were SPVs. Those affiliates challenged their inclusion 
since they were considered bankruptcy remote. However, the bankruptcy 
court held that SPVs may be bankruptcy remote but are not bankruptcy 
proof.
---------------------------------------------------------------------------
    An interest rate reduction reduces the monthly payment and 
may prevent a marginal borrower from defaulting. Lenders may 
also prefer this option to a principal reduction because it 
does not force them to book a large loss. But rate reductions 
do not remove the incentive for underwater borrowers to 
default. And, the low-yielding loan that results from such a 
workout will drop sharply in value if interest rates rise; the 
fact that current interest rates are near record lows makes 
this potential for a dramatic drop in value a serious concern.
    Perhaps the most palatable workout option for the lender is 
a term extension. It does not force a recognized loss, nor does 
it saddle the lender with a low yielding investment sensitive 
to interest rate risks. Unfortunately, there are only certain 
situations where extensions make sense.
    Borrowers that cannot pay their debt service or are 
marginal have little to gain from a term extension. Additional 
time will not enable them to pay their debt service if they 
cannot do so already.\307\ There are a few exceptions, such as 
a case in which a delinquent borrower expects a major increase 
in revenue due, for example, to a large new tenant whose lease 
begins in a few months. In such a case, the borrower may be 
sustained by the extension long enough for the new tenant to 
begin paying rent that will allow the borrower to continue 
paying its debt service. This is an unlikely scenario in the 
current market. In general, extensions will not help properties 
that have low income due to bad business fundamentals, and 
continued loans to failing projects that are simply recycled to 
meet debt service requirements recall some of the worst abuses 
of the last commercial real estate crisis and cannot be 
recreated.
---------------------------------------------------------------------------
    \307\ In residential mortgage workouts, term extensions may extend 
the amortization schedule as well, and thereby reduce the monthly 
payment. Commercial real estate loans tend to have an amortization 
schedule that is longer than the loan term. Extending the term (while 
not changing amortization) will not reduce the mortgage payment, since 
the monthly principal payment will remain unchanged.
---------------------------------------------------------------------------
    The most promising use for term extensions is to help 
healthy borrowers that have sufficient property income but 
cannot refinance due to market difficulties. Most of these 
borrowers will have also suffered losses in property value and 
may be in a negative equity situation, further complicating 
refinancing. In these cases, an extension may make sense if the 
lender and borrower both believe that the property value will 
recover enough over the term of the extension to put the 
borrower back into positive equity.
    However, there is an inherent tension between the economic 
benefits to lenders of modifying loan terms and restructuring 
financing arrangements, on the one hand, and the risk that 
doing so only delays ultimate--some commentators would say 
inevitable--write-downs, foreclosures, and losses.\308\ 
Performing loans will likely require long extensions at below-
market rates that will result in large real losses, even 
assuming an absence of principal loss.\309\ The underwriting 
standards of the bubble years were so aggressive that improving 
economic conditions are unlikely to be enough to save the loans 
made during this time. Accelerated amortization of loan 
balances over a moderate time period is unlikely to address 
sizeable equity deficiencies. And, the likelihood of 
significant price appreciation is remote given tightened 
financing terms and the billions of dollars of distressed loans 
and commercial property that are accumulating due to maturity 
extensions.\310\ Balancing all of these considerations--and 
distinguishing those loans that will continue to perform until 
conditions readjust--and those for which delay in accepting a 
less than full recovery of value--with the requirement of 
accompanying write-downs--is at the core of a bank's and 
investor's judgment about loan strength and responsible credit 
and capital management.
---------------------------------------------------------------------------
    \308\ See, e.g., Mortgage Bankers Association, Commercial Real 
Estate/Multifamily Finance Quarterly Data Book Q3 2009, at 22 (Nov. 
2009); The Future Refinancing Crisis in CRE, supra note 214, at 21; The 
Future Refinancing Crisis, Part II, supra note 120, at 27.
    \309\ Parkus and Trifon: Searching for a Bottom, supra note 210, at 
67.
    \310\ See The Future Refinancing Crisis in CRE, supra note 214, at 
21.
---------------------------------------------------------------------------
    Even under more forgiving standards, many loans will not 
warrant workouts, extensions, or modifications because the 
borrowers cannot show creditworthiness, the problems extend 
beyond a decrease in collateral value, or lenders cannot expect 
to collect the loan in full. Lenders must recognize the losses 
from these poor quality loans when incurred. However, as the 
statistics in Section H.3 suggest, the loss recognition, net 
write-down, and net charge-off process has only just begun.
    Another issue associated with workouts is their impact on 
investor trust and expectations, especially for CMBS. Changing 
the terms of loan contracts from what was originally agreed, 
especially for troubled, but not defaulted or imminently 
defaulting borrowers, can reduce investor trust in the 
certainty of contracts and cause them to rethink their risk 
expectations in this type of investment.\311\ This loss of 
confidence by investors could impede the recovery of the 
commercial real estate secondary market, which is a necessary 
part of a commercial real estate recovery. This consideration, 
as well as other moral hazard concerns must, be balanced 
against the benefits that can be achieved by workouts.
---------------------------------------------------------------------------
    \311\ Commercial Mortgage Securities Association, Concerns with 
REMIC Proposals to Authorize Loan Modifications and Restructure 
Contracts (July 13, 2009).
---------------------------------------------------------------------------
    Successful workouts often depend on access to sufficient 
equity capital. The ``equity gap'' problem borrowers experience 
in a falling market was discussed in section F.3 (b). So far in 
this downturn, there has been very little new equity investment 
in commercial real estate. Foreign investors such as sovereign 
wealth funds, as well as other types of opportunistic 
investors, may prove to be a major source of equity investment 
in the future, whether as purchasers of distressed properties 
or as investors in properties that need equity in order to 
refinance. One prominent expert has estimated that more than 
$100 billion in equity capital from foreign investors and other 
sources is currently waiting on the sidelines for the right 
market conditions. So far, most commercial property owners have 
been reluctant to sell property or accept equity investment at 
the deeply discounted terms these investors are seeking. This 
standoff between property owners and investors has been 
described as ``a game of chicken.'' \312\ As the prospects of 
commercial real estate become clearer over the next few years, 
it is likely that one side or the other will capitulate. This 
may lead to a mass of equity transactions at discounted, but 
ultimately stabilized, prices as this enormous pool of capital 
competes for available properties. The discounted prices will 
in turn generate substantial bank write-downs and capital 
losses. (Prudently managed banks build some assessment of 
default risk into the pricing and terms of the commercial real 
estate (and other) loans they make. But, as noted elsewhere in 
this report, that may well have less effect now, both because a 
number of the loans at issue were not prudently made in the 
first place, and even prudently managed banks could not foresee 
the as yet unknown depth of the financial crisis and economic 
downturn that has marked the last two years.)
---------------------------------------------------------------------------
    \312\ David Geltner, The U.S. Property Market in 2010: The Great 
Game of Chicken, PREA Quarterly (Winter 2010) (hereinafter ``Geltner 
PREA Report'').
---------------------------------------------------------------------------
    Defaulted construction loans are more difficult to resolve 
successfully than are permanent mortgages. Construction lending 
is lending at the margin, and despite careful underwriting and 
provisions such as interest reserves, it is an inherently risky 
activity. While a completed and leased property may be able to 
ride out a recession, new development depends on the marginal 
demand for commercial space, which is likely to collapse 
quickly in a recession. Even in safer build-to-suit 
construction, pre-leased tenants may back out or go under in 
hard times, causing a chain reaction ending in foreclosure.
    In a weak real estate market, the developer has significant 
incentives to default, due to the additional expense needed to 
complete construction, and because of the slim chances of 
successfully leasing the property upon completion. Another risk 
is that the developer goes bankrupt before completion, leaving 
the lender with no borrower and an incomplete property.
    Construction loans carry their own type of term risk. In 
most cases, the construction lender and developer count on a 
permanent lender to take out, or pay off, the construction loan 
upon completion of the property. The construction lender 
usually requires that the developer obtain a commitment for 
this takeout before closing on the construction loan.\313\ In a 
credit crunch and real estate crash, however, permanent lenders 
may renege on their prior loan commitments, or may have simply 
gone out of business by the time the property is completed. 
Under these economic circumstances, it is hard to find a 
replacement lender. Without a takeout, the construction lender 
will probably end up with the property, and with a number of 
problems that this entails.
---------------------------------------------------------------------------
    \313\ Brueggeman and Fisher, supra note 13, at 439-445.
---------------------------------------------------------------------------
    Lender real estate owned foreclosures (REOs) obtained from 
construction loans present a particular burden to lenders, 
since they (1) generate no income, (2) are probably unfinished, 
requiring additional investment before they can be leased, (3) 
are difficult to sell in a depressed market, since there is 
likely to be oversupply of similar properties already, (4) are 
prone to vandalism and theft of materials and fixtures, and (5) 
may present a public relations problem for the lender, since 
surrounding property owners and residents will be unhappy at 
having a half-finished, derelict property nearby.
    Workout options for construction loans are generally 
similar to those used for permanent mortgages but require more 
careful attention and creativity in structuring the workout. 
Term extensions, principal write-offs, rate reductions, changes 
to the amortization schedule, conversion to a different type of 
loan (e.g., amortizing to interest-only), participation stakes, 
and bringing in new investors are all possible options, and 
depend on what can be negotiated considering the unique 
circumstances of the development project. As is the case with 
permanent loans, construction loan workouts often involve a 
degree of hope that the market will turn around in relatively 
short order. In some cases, however, the market may have 
changed to such an extent that the property is simply not 
viable in the foreseeable future, and no reasonable workout can 
be arranged.
    The FDIC's October 30, 2009 policy statement on workouts, 
discussed in Section H.3, directly addresses construction and 
land loan workout strategies, as well as provides some 
illustrative examples with explanations of how they would be 
treated from a regulatory point of view.\314\ It is interesting 
to note that the FDIC statement devotes as much space to 
discussing construction loans as it does to permanent 
mortgages, despite the much smaller pool of construction loans, 
underscoring the concern they appear to have about this 
category of assets.
---------------------------------------------------------------------------
    \314\ Federal Deposit Insurance Corporation, Policy Statement on 
Prudent Commercial Real Estate Loan Workouts (Oct. 30, 2009) (online at 
www.fdic.gov/news/news/financial/2009/fil09061a1.pdf) (hereinafter 
``Policy Statement on CRE Workouts'').
---------------------------------------------------------------------------
    Considering that U.S. banks own $481 billion in 
construction and land loans, this concern is well founded.\315\ 
The approximately 50 percent recovery rate of invested capital 
from defaulted construction loans in 2009, shown in Figure 36 
below, suggests that the ultimate losses from these loans could 
be enormous.\316\
---------------------------------------------------------------------------
    \315\ SNL Financial (accessed on Jan. 13, 2010).
    \316\ Real Capital Analytics, Q4 Update: Recovery Rates on 
Defaulted Mortgages (2010) (hereinafter ``Q4 Update: Recovery Rates on 
Defaulted Mortgages'').
---------------------------------------------------------------------------
            b. Can different structural models and servicing 
                    arrangements allow private markets to function more 
                    effectively than was true for residential real 
                    estate?
    Financial institutions and federal supervisors appear to be 
inclined to extend prudent, performing loans that are unable to 
refinance at maturity. Lenders have an incentive to work with 
borrowers, where possible, to delay, minimize, or avoid writing 
down the value of loans and assets or recognizing losses. 
Workout strategies such as modifications and extensions may 
help lenders avoid the significant costs and discounted or 
distressed sales prices associated with foreclosures and 
liquidations. The hope is that the economy will improve or that 
commercial real estate loans will not be as problematic as 
expected. This may be the case if the economy rebounds during 
the extension period, vacancy rates decrease (or absorption 
rates increase), cash flows strengthen, or commercial property 
values rise. Current historically low interest rates help both 
lenders and borrowers of floating rate loans by significantly 
lowering the debt service so that cash flows and interest rate 
reserves carry loans longer.
    As is the case in the residential real estate market, a 
falling commercial real estate market poses risks to all 
property owners, even supposedly healthy ones. If the 
commercial real estate market does not recover as quickly as 
the lender anticipates in structuring the workout, the property 
is likely to go into default again. The large number of loans 
that for various reasons cannot be refinanced, combined with 
loans in default due to poor property income, puts additional 
downward pressure on property values and discourages lending. 
Since falling values make loans harder to refinance, a falling 
market has the tendency to create a vicious circle of defaults 
of weak properties leading to defaults of stronger properties.
    A number of factors make the consequences of default less 
damaging and somewhat more acceptable to commercial borrowers 
than for residential borrowers. Commercial real estate 
investors often hold their properties in limited partnership or 
limited liability company structures, often with only one 
property in each business entity. This provides a degree of 
protection in default and bankruptcy. REITs organize their 
holdings into single-property limited partnerships, partly for 
this reason. Residential borrowers are unprotected by any 
corporate or liability limiting structure, although the non-
recourse clause in residential mortgages does limit losses in 
default to the property itself.
    There is some evidence that commercial borrowers may also 
have a more lenient or at least pragmatic attitude toward 
default than most residential borrowers. At least in theory, 
commercial borrowers make default decisions based on profit and 
loss considerations, rather than emotional desires or a sense 
of moral obligation. They may opt for a ``strategic default,'' 
and preemptively declare bankruptcy (as discussed in Section 
H.3), in cases where they stand to lose a great deal from 
continuing to pay their debt service.
    The options available to commercial mortgage servicers in 
dealing with delinquencies and defaults are generally similar 
to the options available to residential servicers. One of the 
significant advantages that commercial mortgage servicers have 
over their residential counterparts is that they service fewer, 
larger loans, and can therefore give each loan more individual 
attention. A typical CMBS deal may be backed by a pool of a 
hundred or so loans, while a residential mortgage backed 
security deal may contain many hundreds or thousands of loans.
    This is a major advantage in dealing with defaults, since a 
successful workout requires that the servicer become intimately 
familiar with the property and its income sources. Office and 
retail leases in particular are often quite complicated and 
include various reimbursements, cost sharing arrangements, and 
other negotiated terms. These leases require thorough study in 
order to model properly the cash flows that can be expected 
from the property. The commercial real estate servicer or 
special servicer is also more likely to be dealing with a 
borrower that is knowledgeable about real estate. This may make 
it easier to arrange a workout or other strategy, because the 
borrower is well prepared to discuss and evaluate the options.
            c. Are workouts actually happening? If not, why not?
    Unfortunately, publicly available information on commercial 
real estate workouts is extremely limited, and lacks enough 
detail about the type of workout strategy to draw many 
conclusions about what is currently occurring in the commercial 
real estate market. This is largely due to the fragmented 
nature of workout reporting. Individual servicers, whether for 
CMBS or whole loans, normally report workout information only 
to their lender client or investors. Banks report information 
on loan losses, but typically provide little detail on the 
strategies that were used to resolve defaulted loans.
    Figure 35 below, adapted from research by Real Capital 
Analytics, shows current ``troubled'' (delinquent or defaulted) 
commercial mortgage assets in the United States and their 
status. The terms used in Figure 35 are defined directly below 
the table.

 FIGURE 35: TROUBLED COMMERCIAL MORTGAGE U.S. ASSETS AS OF DECEMBER 2009
                                  \317\
------------------------------------------------------------------------
                                     Number of    Volume in Millions of
              Assets                 Properties          Dollars
------------------------------------------------------------------------
Troubled..........................        6,425               $139,500.6
Restructured/Modified.............          725                 17,109.4
Lender Real Estate Owned (REO)....        1,411                 21,992.1
Total Current Distressed..........        8,651                178,602.1
Resolved..........................        1,314                   24,508
                                   -------------------------------------
    Total.........................        9,875              $203,110.4
------------------------------------------------------------------------
\317\ Real Capital Analytics, Troubled Assets Radar: United States
  Troubled Assets (online at www.rcanalytics.com/commercial-troubled-
  assets-search.aspx) (accessed Jan. 25, 2010).

     Troubled: Properties in the process of being 
foreclosed, in bankruptcy, or undergoing workouts.
     Restructured/Modified: Properties where the lender 
has implemented a workout strategy, including loan extensions 
of less than two years.
     Lender REO: Properties that lenders have taken 
back through foreclosure.
     Resolved: Properties that have moved out of 
distress via refinancing or through a sale to a financially 
stable third party.
    It is clear from Figure 35 that relatively few properties 
have completed workouts, only 725 out of a total of 9,875. This 
does not necessarily indicate reluctance by lenders and 
servicers to deal with troubled assets. Dealing with defaulted 
properties, whether by foreclosure, workout, or another 
strategy, is a lengthy process. It is possible that many of 
these troubled loans are early in the process of resolution due 
to the rapid increase in defaults during 2009.
    Due to the lack of detailed information on workouts, the 
Panel consulted with numerous commercial mortgage lenders, 
servicers, trade organizations, and other knowledgeable 
commercial real estate professionals about their assessments of 
the number and types of workouts currently occurring. Their 
comments were quite consistent, but unfortunately, lacking in 
much useful detail. The consensus is that workout activity has 
increased significantly since the decline in commercial 
property values began, but no quantification is available. 
According to industry experts, commercial real estate servicers 
are actively pursuing workouts where they believe it is 
reasonable. As was mentioned earlier, the large dollar amount 
of the individual loans, combined with the sophistication of 
the commercial real estate borrowers (as compared to 
residential) encourages lenders to attempt workouts where they 
make sense for both parties.
    Anecdotal evidence suggests that whole loans are more 
likely to undergo a workout than securitized loans. It is not 
clear whether this is because of the lower quality collateral 
that is held by whole loan investors, a greater eagerness on 
their part to work out problem loans, or because of issues 
related to CMBS servicing arrangements and standards. Some PSAs 
require the consent of most or all investors in order to modify 
the terms of a loan, making any changes difficult.
    Bank supervisors have sought to deal with these issues in 
an updated policy statement on commercial real estate loan 
workouts (the Policy Statement). That statement is discussed in 
Section H.3.
    An ominous indicator of the future losses that may be 
expected from defaulted commercial real estate debt is the 
declining recovery rate, or the amount of the loan balance that 
the lender ultimately recoups after either foreclosing on or 
working out a defaulted loan. Recovery rates from defaulted 
mortgages fell significantly in the 4Q 2009, as lenders dealt 
with an increasing number of non-performing loans. As with 
residential real estate, foreclosures of commercial real estate 
put additional downward pressures on property values, reducing 
the ultimate recovery rate for all lenders. The provider of 
this data, Real Capital Analytics, uses different terminology 
for the basic categories of real estate debt than has been used 
thus far in this report. Its acquisition/refinancing category 
corresponds to what has been termed permanent mortgages, and 
its development/redevelopment category corresponds to 
construction and development loans.
    Mean recovery rates for development/redevelopment loans 
declined from 57 percent during the first three quarters of 
2009 to 52 percent. Mean recovery rates from acquisition/
refinancing loans similarly declined from 69 percent to 63 
percent over the same time period. On a weighted average basis, 
the decline in acquisition/refinancing loan is even more 
severe, with a drop of 14 percent, as can be seen in Figure 36 
below. The authors of this report interpret the falling 
recovery rates as being the result of lower market pricing as 
well as an increasing willingness on the part of lenders to 
deal seriously and realistically with the large number of non-
performing loans, even if it means incurring additional 
losses.\318\
---------------------------------------------------------------------------
    \318\ Q4 Update: Recovery Rates on Defaulted Mortgages, supra note 
316.

                                                 FIGURE 36: RECOVERY RATES ON DEFAULTED MORTGAGES \ 319\
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                         Q1-Q3 2009                      Q4 2009                     2009 Total
                                                               -----------------------------------------------------------------------------------------
                           Loan Type                                              Weighted                      Weighted                      Weighted
                                                                     Mean         Average          Mean         Average          Mean         Average
                                                                  (Percent)      (Percent)      (Percent)      (Percent)      (Percent)      (Percent)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Development/Redevelopment.....................................          57               49           52               50           56               49
Acquisition/Refinancing.......................................          69               69           63               55           67               66
Overall.......................................................          65               61           59               52           63              59
--------------------------------------------------------------------------------------------------------------------------------------------------------
\319\ Q4 Update: Recovery Rates on Defaulted Mortgages, supra note 316.

    All property types had declining recovery rates in the 
fourth quarter of 2009, with the exception of industrial 
properties. For the entire year of 2009, the lowest recovery 
rates were for bare land and properties under development, with 
mean recovery rates of 46 percent and 50 percent respectively, 
as shown in Figure 37 below. A more unexpected finding was that 
the highest recovery rate was among retail sector mortgages, at 
73 percent.\320\
---------------------------------------------------------------------------
    \320\ Real Capital Analytics, Recovery Rates by Property Type 
(2010) (hereinafter ``Recovery Rates by Property Type'').

                          FIGURE 37: MEAN RECOVERY RATES BY PROPERTY TYPE (2009)\ 321\
                                              [Dollars in millions]
----------------------------------------------------------------------------------------------------------------
                                                                                     Number of     Mean Recovery
                          Property Type                             Outstanding      Defaulted         Rate
                                                                      Balance        Mortgages       (Percent)
----------------------------------------------------------------------------------------------------------------
Office..........................................................        $1,746.7              47              64
Industrial......................................................           153.7              29              72
Retail..........................................................           568.3              26              73
Hotel...........................................................           360.2              25              67
Multifamily.....................................................         1,913.4             130              63
Development Sites...............................................           404.6              13              46
Land............................................................           471.0              24              50
                                                                 --------------------------------
    Total.......................................................        $5,617.8             294             63
----------------------------------------------------------------------------------------------------------------
\321\ Recovery Rates by Property Type, supra note 320.

    The lowest recovery rates by location were in the areas 
hardest hit by the recession--Michigan, Florida, and 
Arizona.\322\ When looked at by lender type, insurance 
companies had the highest recovery rates overall, recouping 79 
percent of their invested capital on acquisition/refinancing 
loans. Although the exact reasons for this are not apparent, it 
is worth noting that life insurance companies are very 
conservative lenders (for example, they often require recourse 
clauses in their loans), because of the long-term nature of 
their own obligations to their policy holders. Interestingly, 
CMBS performed the poorest at recovering losses from 
acquisition/refinancing loans of all lender types, returning 
only 62 percent of invested capital. On the whole, banks 
recovered more of their capital, with the smaller regional or 
local banks slightly outperforming their larger national and 
international counterparts in both the development and 
acquisition/refinancing categories.\323\
---------------------------------------------------------------------------
    \322\ Real Capital Analytics, Recovery Rates by Location (2010).
    \323\ Real Capital Analytics, Recovery Rates by Lender Type (2010).
---------------------------------------------------------------------------
            d. Potential Impediments to Successful Workouts
    Several tax issues complicate workouts and new investment 
in commercial real estate. Although investors have been willing 
to put in additional equity, and although banks and servicers 
have engaged in workouts and other modifications, these issues 
make resolution of problematic commercial real estate loans 
without provoking a financial crisis more difficult.
            i. REMIC
    Although CMBS can be designed in a number of ways, many are 
structured as REMICs.\324\ REMICs are pass-through entities; 
they are not taxed on their income, but rather pass it directly 
through to investors.\325\ Without the REMIC status, the CMBS's 
income could be taxed at the corporate level and then again at 
the investor level.\326\ To maintain the REMIC status, the 
entity must follow strict rules.\327\
---------------------------------------------------------------------------
    \324\ A REMIC is a tax entity, not a legal form of an organization.
    \325\ 26 U.S.C. Sec. 860A.
    \326\ Prior to the 1986 law that created the REMIC status, an MBS 
with only a single type of ownership interest could maintain pass-
through status. An MBS with multiple tranches or both equity and 
residual interests could be seen by the IRS as requiring more active 
management than a pass-through vehicle could allow. The REMIC status 
allows a pass-through entity to have multiple tranches and interests. 
Brueggeman and Fisher, supra note 13, at 558.
    \327\ Rev. Proc. 2009-45, Section 3.
---------------------------------------------------------------------------
    One of these rules is that if a REMIC makes a ``significant 
modification'' to a loan, the IRS can impose severe 
penalties.\328\ These penalties can be up to 100 percent of any 
gain that the REMIC receives from modifying the loan.\329\ The 
REMIC could also lose its status as a pass-through entity.\330\ 
The rules provide an exception for loans that are either in 
default, or for which default is ``reasonably foreseeable.'' 
\331\
---------------------------------------------------------------------------
    \328\ A significant modification will cause the mortgage to no 
longer be treated as a qualified mortgage. It will be considered to be 
a prohibited transaction under 26 U.S.C. Sec. 860F. 26 CFR Sec. 1.860G-
2(b). The purpose behind this is that the REMIC should be a passive 
vehicle, and cannot engage in active business activities.
    A ``modification'' is defined as ``any alteration, including any 
deletion or addition, in whole or in part, of a legal right or 
obligation of the issuer or a holder of a debt instrument, whether the 
alteration is evidenced by an express agreement (oral or written), 
conduct of the parties, or otherwise.'' 26 CFR Sec. 1.1001-3(c)(1)(i). 
In general, ``a modification is a significant modification only if, 
based on all facts and circumstances, the legal rights or obligations 
that are altered and the degree to which they are altered are 
economically significant.'' 26 CFR Sec. 1.1001-3(e)(1).
    \329\ 26 U.S.C. Sec. 860F(a).
    \330\ A significant modification can cause a mortgage to no longer 
be a qualified mortgage. A REMIC can lose its pass-through status if 
one or more significant modifications of its loans cause less than 
substantially all of the entity's assets to be qualified mortgages. 
Rev. Proc. 2009-45 Section 3.09.
    \331\ 26 CFR Sec. 1.860G-2(b)(3)(i).
---------------------------------------------------------------------------
    To enable REMICs to modify loans more freely, the IRS 
published guidance and new regulations in September 2009.\332\ 
These expanded the types of modifications that a REMIC was 
permitted to undertake and provided a safe harbor for certain 
modifications. The safe harbor applies if there is ``a 
significant risk of default . . . upon maturity of the loan or 
at an earlier date'' and if the modification ``presents a 
substantially reduced risk of default.'' \333\
---------------------------------------------------------------------------
    \332\ Rev. Proc. 2009-45; 74 FR 47436. The new regulations were 
initially issued for comment in 2007, so they were not necessarily in 
response to issues in the current commercial real estate market.
    \333\ Rev. Proc. 2009-45, Sections 5.03, 5.04.
---------------------------------------------------------------------------
    Though this guidance provides REMICs with more flexibility, 
it is not a panacea. First, some believe that the guidance is 
vague, and because of the steep penalties, are still wary of 
modifying loans. Second, the PSAs were written under the 
previous rules, and many have language that tracks the earlier 
rules, making modifications either very complicated or barred 
for servicers. At the Panel's Atlanta hearing, Brian Olasov, a 
real estate professional who specializes in securitizations, 
described the REMIC guidance as a ``complete non-event,'' 
saying that the REMIC rules did not ``tie the hands'' of the 
special servicers in ``seeking the highest NPV resolution.'' 
\334\
---------------------------------------------------------------------------
    \334\ COP Field Hearing in Atlanta, supra note 70 (Testimony of 
Brian Olasov).
---------------------------------------------------------------------------
            ii. Taxation of Foreign Investors in U.S. Real Estate
    Outside investors are a possible solution to the equity 
crunch that might hit the commercial real estate sector over 
the next few years. Although many believe that billions of 
dollars in non-U.S. equity are waiting to be invested in U.S. 
commercial real estate, there can be negative tax consequences 
for non-U.S. purchasers of or investors in U.S. real estate. 
Non-U.S. investors can be hit with double or even triple 
taxation on their investments in U.S. real estate.
    Generally, nonresident aliens are not subject to capital 
gains taxes on U.S. investments.\335\ Nonresident aliens are 
generally only subject to U.S. capital gains tax if the income 
is ``effectively connected to a U.S. trade or business.'' \336\ 
The Foreign Investment Real Property Tax Act (FIRPTA), however, 
makes an exception for real estate, and imposes the U.S. tax on 
real estate holdings.\337\ It does so by deeming gains or 
losses from the disposition of real estate ``as if such gain or 
loss were effectively connected with such trade or business.'' 
\338\ Therefore, a nonresident alien seeking to invest in the 
United States will have a financial incentive to choose stocks 
or bonds over real estate.
---------------------------------------------------------------------------
    \335\ 26 U.S.C. Sec. 871(a)(2).
    \336\ 26 U.S.C. Sec. 871(a)(2).
    \337\ 26 U.S.C. Sec. Sec. 897, 882. This tax can be capital gain or 
ordinary income, depending on the character of the asset. 26 U.S.C. 
Sec. Sec. 897, 1221.
    \338\ 26 U.S.C. Sec. 897(a)(1).
---------------------------------------------------------------------------
    If the non-U.S. investor is a corporation, it can be 
subject to two additional layers of tax. The branch profits 
tax, a dividend equivalent tax, subjects a foreign 
corporation's U.S. connected income to a 30 percent tax.\339\ 
The corporation could then also be subject to the standard U.S. 
corporate income tax.
---------------------------------------------------------------------------
    \339\ 26 U.S.C. Sec. 884.
---------------------------------------------------------------------------
    Some have called for congressional or IRS action to 
alleviate this tax burden on nonresident alien investments in 
U.S. real estate.\340\
---------------------------------------------------------------------------
    \340\ Real Estate Roundtable White Paper, supra note 245 (accessed 
on Jan. 25, 2010).
---------------------------------------------------------------------------
            e. Loss Recognition
    The problem of commercial real estate reflects three 
related timelines. The first is the timeline for recovery of 
the economy to a sufficient point that borrowers' cash flows 
return to normal and loan values increase. The second is the 
timeline of loan extensions and restructurings. The third is 
the timeline along which commercial real estate credit markets 
reopen for sound projects. If these timelines do not cross 
within an acceptable period, and there is not a dramatic 
turnaround and quick recovery in commercial real estate prices, 
many commercial real estate loans will produce unavoidable 
losses that in the end must be borne by the borrower, the 
lender, or the taxpayer.
    When prudently managed banks evaluate the strength of 
commercial real estate loans in their portfolios today, they 
try to determine the prospect of each project, against their 
judgment of the path of the three timelines. This means 
projecting, among other things, the income that can be produced 
by the property, the borrower's record in servicing the debt, 
and the present ratio of the property's value to the amount of 
the loan. On that basis, the lender must decide whether the 
loan can be repaid and whether changing the terms of the loan 
increases that possibility. The same judgments are involved in 
setting the terms for a refinancing.
    These judgments are decisions about potential losses. If 
the lender decides that the loan will not be repaid--either 
because the borrower has stopped making payments for a 
sufficiently lengthy period, or because refinancing is 
impossible on terms the lender can accept--it faces the 
prospect of foreclosing and recognizing some degree of loss on 
the loan. If it modifies the loan to accept a lesser amount on 
repayment, it must write-down the difference between the 
original and renewed loan amount. If it decides that the 
borrower and the project have the potential strength, and that 
economic conditions are sufficiently unsettled, it may reach an 
agreement with the borrower to provide an additional period 
before final action is required. The lender hopes, of course, 
that by doing so it will avoid losses as the loan strengthens. 
The extent to which banks should write off their loan in whole 
or in part now or should be encouraged to provide the lender 
with an extended period of time through one of the arrangements 
described in the report is perhaps the major point of 
contention in the commercial real estate markets today.\341\
---------------------------------------------------------------------------
    \341\ Those who fear that the modifying loan terms will make banks 
appear stronger than they really are (because banks are unrealistically 
extending loans) and provide an artificial floor for commercial real 
estate prices (postponing accurate market pricing) refer to it as 
``kicking the can down the road'' or ``extend and pretend.''
---------------------------------------------------------------------------
    The extent to which banks recognize commercial real estate 
losses and how and when they choose to do so can have a direct 
impact on the future viability of many banks. The details of 
workouts, loan extensions, modifications, or refinancings and 
foreclosures can also have collateral consequences for healthy 
institutions as they understandably take steps to protect 
themselves. In particular, it is likely that these banks will 
reduce their lending because, or in anticipation, of loan 
losses, as discussed elsewhere in the report.
    The precipitous drop in commercial property values since 
2007 ultimately means that banks may have to take losses in the 
range of $200 billion-$300 billion.\342\ The timing of the loss 
recognition is critical, but there is no single way to time 
those losses. In many cases, loans that were sound when they 
were made may end up producing little or no loss, because 
economic conditions recover, new investors are found to close 
the equity gap (especially as property values rise), or some 
combination of the two. In other cases, a clear-sighted 
analysis will show that loss from a loan is likely, and banks 
whose loan portfolios contain those loans in amounts large 
enough to threaten their capital should in many cases be placed 
into receivership now.
---------------------------------------------------------------------------
    \342\ See Parkus and Trifon: Searching for a Bottom, supra note 210 
at 65. This estimate appears to be generally consistent with another 
recent estimate by Moody's Investors Service. Moody's projects $77 
billion in commercial real estate losses between Q4 2009 and the end of 
2011 at the banks it rates. This number would be higher were it not for 
the fact that the banks Moody's rates hold only about 50 percent of the 
total bank exposure to commercial real estate. The Moody's report also 
does not include losses incurred in 2012 and beyond. Joseph Pucella et 
al., Moody's Investors Service, U.S. Bank Ratings Incorporate Continued 
High Commercial Real Estate Losses (Feb. 6, 2010).
---------------------------------------------------------------------------
    Any attempt to evaluate these consequences, however, is 
complicated because many loans have yet to mature and many 
borrowers continue to make required payments under their 
existing loans. The problems looming in commercial real estate 
will fully emerge over the next seven to nine years during the 
waves of refinancing expected in 2011-2013 and then in 2016-
2017.\343\ A huge number of the affected properties are now 
under water--that is, they have a value less than the loan 
amount--but the rate of economic recovery and its effect on 
loans that continue to perform are difficult to predict.\344\ 
This does not mean that there is no looming crisis.\345\ Banks 
are already experiencing significant losses on construction 
loans, which have shorter terms of three to four years but in 
many cases financed projects from the bubble years of 2005-
2007, and in others are coming due as values have fallen, and 
incomes have dropped, significantly. The warnings about 
commercial real estate loans are extremely serious, and the 
condition of construction loans now gives these predictions 
substantial credence.
---------------------------------------------------------------------------
    \343\ See Real Estate Roundtable, Continuing the Effort to Restore 
Liquidity in Commercial Real Estate Markets at 5 (online at 
www.rer.org/uploadedFiles/RER/Policy_Issues/Credit_Crisis/
2009_09_Restoring_Liquidity_in_CRE.pdf?n=8270) (accessed on Feb. 6, 
2010); see also The Future Refinancing Crisis in CRE, supra note 214, 
at 3.
    \344\ See Footnote 242 Foresight Analytics LLC estimates that $770 
billion (or 53 percent) of mortgages maturing from 2010 to 2014 have 
current LTVs in excess of 100 percent. Foresight further provides that 
over 60 percent of mortgages maturing in 2012 and 2013 will have LTVs 
over 100 percent, supra.
    \345\ See section F.3(b), supra.
---------------------------------------------------------------------------
    In dealing with potential commercial real estate losses, 
not all banks should be treated in the same way. Banks whose 
portfolios are weak across the board (``C'' banks) should be 
forced to recognize all losses, whatever the consequences. 
``A'' banks, those that have operated on the most prudent terms 
and have financed only the strongest projects, and ``B'' banks, 
those with commercial real estate portfolios that have weakened 
but are largely still based on performing loans, should be 
dealt with more carefully.\346\
---------------------------------------------------------------------------
    \346\ The ``A'', ``B'', and ``C'' classification used in this 
discussion is not meant to reflect any regulatory classification but is 
only used for ease of reference.
---------------------------------------------------------------------------
    There are three reasons not to force all potential losses 
to be recognized immediately. First, doing so could create a 
self-fulfilling prophecy, as selling commercial real estate at 
fire-sale prices could depress values of even relatively strong 
properties. In this way, real estate prices would be driven 
below actual long-term values, pushing the commercial real 
estate sector into what has been termed a negative bubble, not 
only forcing more banks in a particular region into perhaps 
unnecessary insolvency, but having ripple effects across the 
broader markets for commercial real estate.\347\
---------------------------------------------------------------------------
    \347\ Geltner PREA Report, supra note 312.
---------------------------------------------------------------------------
    Second, real estate prices have already fallen far from 
their peak, and some analysts believe prices are now in line 
with historical trends.\348\ Write-downs do not cause sales, 
but a drop in values based on the data generated by unnecessary 
write-downs may indirectly threaten banks, by allowing new 
investors to buy at unrealistically low prices. (As noted 
above, investors holding a great deal of money, much of it 
currently overseas, are waiting for the right time to invest in 
U.S. commercial real estate.) \349\
---------------------------------------------------------------------------
    \348\ Geltner PREA Report, supra note 312.
    \349\ Geltner PREA Report, supra note 312.
---------------------------------------------------------------------------
    Third, loan write-downs are as much about the allocation of 
profits as losses. Purchasers of property at depressed values 
obtain the gain potential inherent in that property. That is 
wholly appropriate when a fire-sale discount is required by 
economic realities. But forcing write-downs can also operate 
unfairly--and be economically inefficient--by unnecessarily 
transferring the profit potential from the banks whose strength 
would increase as the economy--and property values--recover to 
investors pushing to depress prices before that happens.
    In this situation, the job of policy makers, bankers, and 
CMBS master servicers is to determine when and how to evaluate 
honestly the components of the crisis and try to moderate them. 
This does not mean allowing banks that are not viable because 
of the quality of the commercial real estate loans they hold, 
to continue to operate; but neither does it mean forcing banks 
that engaged in relatively prudent lending, but were undercut 
by the depth of the recession, into the same position.
    Again, it is important to recognize that some of the 
economic factors that will determine which side of the argument 
is correct lie outside of the commercial real estate sector. 
Assessing the likelihood and pace of the operation of those 
factors is beyond the scope of this report; nonetheless, they 
provide a picture of the complex economic forces at work here.

           H. Regulatory Guidance, the Stress Tests, and EESA

    As Treasury and federal financial supervisors brace for the 
expected wave of problems in the commercial real estate sector, 
they should consider their decisions in the context of the 
actions already taken by the banking supervisors. In terms of 
commercial real estate, the most important regulatory steps 
during the recent economic cycle have been the following: (1) 
The issuance of regulatory guidance in 2006 about the growing 
risks associated with the concentration of commercial real 
estate loans in banks; (2) the supervisors' administration of 
the stress tests in the first half of 2009 for the nation's 19 
largest BHCs; (3) the issuance of expanded regulatory guidance 
on loan workouts in 2009; and (4) decisions made by supervisors 
with respect to banks' exit from the TARP. In this section the 
report explores those steps.

1. Supervisors' Role Before Mid-2008

    As the credit bubble grew, the supervisors reminded banks 
of commercial real estate risks. In March 2004, FDIC Chairman 
Donald Powell noted, in a speech to members of the Independent 
Community Bankers Association:

          The real question in all this is--and the thing you 
        should think about on the plane ride home--what happens 
        when interest rates rise significantly from these 
        historic lows? . . . The performance of commercial real 
        estate loans has remained historically strong during 
        the past three years even though market fundamentals 
        have been poor. Low interest rates have bailed out many 
        projects that would have sunk if the environment had 
        been different. When the tide of low interest rates and 
        heavy fiscal stimulus recedes, we'll see some 
        vulnerabilities exposed that are currently hidden from 
        view. It is hard to predict how serious these are 
        because we've never seen a cycle quite like this 
        before.\350\
---------------------------------------------------------------------------
    \350\ Federal Deposit Insurance Corporation, Remarks by Chairman 
Donald Powell Before the Independent Community Bankers Association, San 
Diego, Calif. (Mar. 16, 2004) (emphasis added) (online at www.fdic.gov/
news/news/press/2004/pr2204.html).

    The concern actually predated the Powell speech. In 2003, a 
year before the Powell speech, the supervisors began working on 
a more formal regulatory statement about commercial real estate 
lending concentrations, especially those accumulating at small 
and mid-sized banks.\351\ In January 2006, the supervisors 
issued proposed guidance for public comment.\352\ (Regulatory 
guidance is a statement of standards that banks should observe, 
rather than a set of legal requirements. Nonetheless, such 
guidance can serve as part of the basis for regulatory action 
against a particular institution.)
---------------------------------------------------------------------------
    \351\ The situation that sparked the supervisors' concern is 
outlined above, in Section E.
    \352\ Agencies Proposed Guidance, supra note 67.
---------------------------------------------------------------------------
    The January proposal noted that commercial real estate 
markets are cyclical and stated that some banks were not 
setting aside adequate capital or taking other steps necessary 
to manage the risks associated with these loans. The 
interagency proposal included two numerical thresholds for 
determining whether heightened risk-management practices were 
warranted at a particular bank. First, bank examiners were to 
look at whether the bank's outstanding portfolio of 
construction and development loans exceeded its total capital. 
Second, examiners were to determine whether the bank's 
outstanding portfolio of commercial real estate loans exceeded 
300 percent of its total capital.\353\ The proposal also 
included guidance that banks were to use to manage their risks 
and to ensure that they were holding enough capital to protect 
against future losses.\354\
---------------------------------------------------------------------------
    \353\ Agencies Proposed Guidance, supra note 67.
    \354\ Agencies Proposed Guidance, supra note 67. The proposed 
guidance noted that ``institutions with CRE concentrations . . . should 
hold capital higher than regulatory minimums and commensurate with the 
level of risk in their CRE lending portfolios.''
---------------------------------------------------------------------------
    The proposed guidance drew more than 4,400 comment letters, 
most of which came from financial institutions and their trade 
groups and strongly opposed the proposal. Many letters argued 
that existing regulations and guidance were adequate to address 
the risks associated with lending concentrations in commercial 
real estate.\355\ In addition, several comment letters asserted 
that banks' underwriting practices were stronger than they had 
been in the late 1980s and early 1990s, when banks suffered 
losses on their commercial real estate loans, because banks had 
learned lessons from those times.\356\
---------------------------------------------------------------------------
    \355\ U.S. Department of the Treasury, Office of the Comptroller of 
the Currency, Board of Governors of the Federal Reserve System, Federal 
Deposit Insurance Corporation, and Office of Thrift Supervision, 
Concentrations in Commercial Real Estate Lending, Sound Risk Management 
Practices (Dec. 12, 2006) (online at www.fdic.gov/regulations/laws/
federal/2006/06notice1212.html) (hereinafter ``Concentrations in CRE 
Lending'').
    \356\ Concentrations in CRE Lending, supra note 355.
---------------------------------------------------------------------------
    During the comment period, the supervisors gave the banking 
community a nuanced view of their meaning. In an April 2006 
speech that Comptroller of the Currency John Dugan gave to the 
New York Bankers Association, Mr. Dugan made the following 
statement:

          Concentrations in commercial real estate lending--or 
        in any other type of loan for that matter--do raise 
        safety and soundness concerns. . . . Our message is 
        not, `Cut back on commercial real estate loans.' 
        Instead it is this: `You can have concentrations in 
        commercial real estate loans, but only if you have the 
        risk management and capital you need to address the 
        increased risk.' And in terms of `the risk management 
        and capital you need,' we're not talking about 
        expertise or capital levels that are out of reach or 
        impractical for community and mid-size bankers--because 
        many of you already have both.\357\
---------------------------------------------------------------------------
    \357\ Dugan Remarks Before the New York Bankers Association, supra 
note 66.

    In June 2005, then-Federal Reserve Governor Susan Bies 
noted her concerns about the rising concentration of commercial 
real estate loans at some banks, particularly in light of the 
sector's historical volatility. She also said that underwriting 
standards might be under downward pressure but offered the 
assurance that they remained at much higher levels than they 
had been in the periods preceding earlier crises.\358\
---------------------------------------------------------------------------
    \358\ Board of Governors of the Federal Reserve System, Remarks of 
Governor Susan Schmidt Bies at the North Carolina Bankers Association's 
109th Annual Convention, Kiawah Island, South Carolina (June 14, 2005) 
(online at www.federalreserve.gov/boarddocs/speeches/2005/20050614/
default.htm). One key to the commercial real estate crisis of the 1980s 
was similar shoddy underwriting, as the report discusses elsewhere. See 
Annex I.
---------------------------------------------------------------------------
    In congressional testimony in September 2006, the new FDIC 
Chairman Sheila Bair also expressed concern about lending 
concentrations in commercial real estate, in measured tones:

          While the rapid price appreciation seen in recent 
        years in several locations is certainly not sustainable 
        over the long-term, we do not anticipate a wide-spread 
        decline in prices. Overall, market fundamentals are 
        generally sound and FDIC economists do not foresee a 
        crisis on the horizon.\359\
---------------------------------------------------------------------------
    \359\ House Committee on Financial Services, Subcommittee on 
Financial Institutions and Consumer Credit, Statement of Sheila C. 
Bair, Chairman, Federal Deposit Insurance Corporation, Statement on 
Interagency Proposals Regarding the Basel Capital Accord and Commercial 
Real Estate Lending Concentration, 109th Cong., at 14 (Sept. 14, 2006) 
(online at financialservices.house.gov/media/pdf/091406scb.pdf).

    The final guidance, issued in mid-December 2006,\360\ 
reflected changes in response to the comments the proposal had 
generated. (Despite the change, the Office of Thrift 
Supervision did not join in the final statement, choosing 
instead to issue its own guidance.) \361\
---------------------------------------------------------------------------
    \360\ Concentrations in CRE Lending, supra note 355.
    \361\ John Reich, director of the OTS, explained the decision to 
issue separate guidance by saying: ``I thought the guidance was too 
prescriptive, that the numbers would be interpreted by bank examiners 
across the country as ceilings, not screens or thresholds for further 
examination.'' Barbara A. Rehm, Steven Sloan, Stacy Kaper, and Joe 
Adler, OTS Breaks from Pack on Commercial Real Estate Loan Guidelines, 
American Banker (Dec. 7, 2006) (online with subscription at 
www.americanbanker.com/issues/171_239/_297668-1.html).
---------------------------------------------------------------------------
    In the final guidance, the proposed 300 percent threshold 
was changed so that banks with total commercial real estate 
loans representing at least 300 percent of their total capital 
would be identified for further analysis only in cases where 
their commercial real estate portfolios had increased by 50 
percent or more in the previous three years.\362\ New language 
was added to state that the numerical thresholds were not 
limits, but rather a ``monitoring tool,'' \363\ subject to the 
discretion of individual examiners. Text accompanying the final 
guidance contained a related warning that ``some institutions 
have relaxed their underwriting standards as a result of strong 
competition for business.''\ 364\ (The manner in which the 
guidance has been used in individual bank examinations is not 
known, because the results of each examination are confidential 
unless it results in a public supervisory action.)
---------------------------------------------------------------------------
    \362\ Concentrations in CRE Lending, supra note 355.
    \363\ Concentrations in CRE Lending, supra note 355. The final 
guidance stated that ``[a]n institution with inadequate capital to 
serve as a buffer against unexpected losses from a CRE concentration 
should develop a plan for reducing its CRE concentrations or for 
maintaining capital appropriate to the level and nature of its CRE 
concentration risk.''
    \364\ Jon D. Greenlee, associate director of the Federal Reserve 
Board's Division of Bank Supervision and Regulation, summarized the 
reasons for the changes from the proposed to the final guidance at the 
Panel's recent field hearing in Atlanta. He explained that the 
supervisors were seeking to allow banks to pursue their business plans, 
and to avoid overly stringent requirements. COP Field Hearing in 
Atlanta, supra note 70, at 41.
---------------------------------------------------------------------------
    After the 2006 guidance was issued, the cause for concern 
about the commercial real estate sector continued to grow. In 
2007, warning signs emerged in the housing sector, which had 
key parallels with the commercial real estate market, 
including, most notably, the formation of an asset bubble fed 
by poor underwriting standards.\365\ But starting in early 
2008, federal bank supervisors also began warning about bank 
exposure to potentially toxic commercial real estate assets. 
Noting that small and community banks often had especially high 
levels of such exposure, these supervisors began acknowledging 
the potential for a financial crisis resulting from a 
commercial real estate downturn and the resulting 
disproportionate effect on the balance sheets of smaller and 
community banks.
---------------------------------------------------------------------------
    \365\ See Congressional Oversight Panel, December Oversight Report: 
Taking Stock: What Has The Troubled Asset Relief Program Achieved? at 
8-9 (Dec. 9, 2009) (online at cop.senate.gov/documents/cop-120909-
report.pdf) (hereinafter ``COP December Oversight Report'').
---------------------------------------------------------------------------
    In February 2008, the FDIC Office of Inspector General 
released a report on commercial real estate that concluded: 
``commercial real estate concentrations have been rising in 
FDIC-supervised institutions and have reached record levels 
that could create safety and soundness concerns in the event of 
a significant economic downturn.'' \366\ The Inspector 
General's report found that the rising concentrations were in 
part a reflection of demand for credit, as well as banks' 
searches for loans that would yield higher profits. The report 
expressed particular concern about the increasing reliance on 
commercial real estate loans at small and mid-sized banks.\367\ 
The report also found that examiners underutilized tools at 
their disposal to uncover and address excessive concentration 
in commercial real estate assets.\368\ In particular, examiners 
were often not adhering to 2006 regulatory guidance issued 
jointly by the FDIC and other federal bank supervisors.\369\
---------------------------------------------------------------------------
    \366\ Federal Deposit Insurance Corporation, Office of Inspector 
General, FDIC's Consideration of Commercial real estate Concentration 
Risk in FDIC-Supervised Institutions, at 2 (Feb. 2008) (online at 
www.fdicoig.gov/reports08/08-005.pdf) (hereinafter ``FDIC's 
Consideration of CRE Risk'').
    \367\ FDIC's Consideration of CRE Risk, supra note 366, at 2.
    \368\ FDIC's Consideration of CRE Risk, supra note 366, at 8.
    \369\ State banking regulatory organizations had also been active 
in implementing the 2006 Federal regulatory guidance. See Neil Milner, 
President and CEO of the Council of State Bank Supervisors, Iowa Day 
with the Superintendent (Apr. 12, 2007) (online at 
www.idob.state.ia.us/bank/docs/ppslides/DWS07/CSBSPresentation.ppt). 
The guidance materials called for further scrutiny of banks with at 
least 300 percent of total capital in commercial real estate loans and 
where commercial real estate portfolios had increased 50 percent or 
more in the past three years. 71 Fed. Reg. 74580, 74584.
---------------------------------------------------------------------------
    The FDIC responded to the 2008 Inspector General report by 
issuing a Financial Institutions Letter about the risks 
associated with loan concentrations in commercial real estate 
to state banks that it regulates.\370\ The letter recommended 
that banks with significant commercial real estate 
concentrations ensure appropriately strong loan loss allowances 
and bolster their loan workout infrastructures and risk 
management procedures, among other precautions.\371\ The FDIC's 
March 2008 letter was more strongly worded than the 2006 
interagency guidance had been. It stated that the agency was 
``increasingly concerned'' about commercial real estate 
concentrations; it also ``strongly recommended'' that banks 
with commercial real estate concentrations increase their 
capital to protect against unexpected losses.\372\
---------------------------------------------------------------------------
    \370\ Financial Institution Letters, supra note 58. As far back as 
2003, the FDIC Inspector General found that its examiners were not 
properly estimating risks associated with commercial real estate loans. 
Federal Deposit Insurance Program, Office of the Inspector General, 
Examiner Assessment of Commercial Real Estate Loans (Jan. 3, 2003) 
(Audit Report No. 03-008) (online at www.fdicoig.gov/reports03/03-008-
Report.pdf).
    \371\ Federal Deposit Insurance Corporation, Press Release: Federal 
Deposit Insurance Corporation Stresses Importance of Managing 
Commercial Real Estate Concentrations (Mar. 17, 2008) (online at 
www.fdic.gov/news/news/press/2008/pr08024.html).
    \372\ Financial Institution Letters, supra note 58.
---------------------------------------------------------------------------
    Around the time that the FDIC sent its letter, the 
commercial real estate market began to slow considerably. 
Lending standards rose in early 2008,\373\ and spending on 
commercial construction projects slowed.\374\ In March 2008, 
FDIC Chairman Sheila Bair testified before a congressional 
committee that liquidity in commercial real estate capital 
markets was sharply curtailed, and that loans were showing 
signs of deterioration at a time when loan concentration levels 
were at or near record highs.\375\ At the same hearing, Federal 
Reserve Vice Chairman Donald Kohn testified that the agency had 
recently surveyed its bank examiners in an effort to evaluate 
the implementation of the 2006 guidance. This survey found that 
while many banks had taken prudent steps to manage their 
commercial real estate lending concentrations, other banks had 
used interest reserves and maturity extensions to mask their 
credit problems, or had failed to update appraisals despite 
substantial changes in local real-estate values.\376\
---------------------------------------------------------------------------
    \373\ Board of Governors of the Federal Reserve System, Minutes of 
the Federal Open Market Committee (Jan. 29-30, 2008) (online at 
www.federalreserve.gov/monetarypolicy/fomcminutes20080130.htm).
    \374\ Board of Governors of the Federal Reserve System, Minutes of 
the Federal Open Market Committee (Apr. 29-30, 2008) (online at 
www.federalreserve.gov/monetarypolicy/fomcminutes20080430.htm).
    \375\ March 4, 2008 Written Testimony of Sheila Bair, supra note 
76.
    \376\ Written Testimony of Donald Kohn, supra note 80.
---------------------------------------------------------------------------
    By late summer 2008, the securitization markets for 
commercial real estate had shut down, a milestone followed by 
the market panic of September 2008 and the enactment of EESA.

2. Supervisors' Role in the Stress Tests

    In February 2009, the Obama Administration announced that 
bank supervisors would subject the nation's 19 largest BHCs to 
stress tests to determine their ability to weather future 
economic distress. The stress tests began with the 
determination of three variable assumptions: unemployment, 
housing prices, and GDP. The assumptions were used to test the 
banks' portfolios over 2009 and 2010 under two scenarios: a 
``baseline'' scenario and a ``more adverse'' scenario. Banks 
were required to hold a capital buffer adequate to protect them 
against the more adverse downturn.
    For specific loan categories, including commercial real 
estate, the supervisors established ``indicative loss rates,'' 
which they described as useful indicators of industry-wide loss 
rates, and from which banks could diverge if they provided 
evidence that their own estimated ranges were appropriate.\377\ 
These indicative loss rates were estimated expected loss rates 
if the economy followed either the baseline or more adverse 
scenarios. The supervisors explained that they derived the 
indicative loss rates ``using a variety of methods for 
predicting loan losses, including analysis of historical loss 
experience at large BHCs and quantitative models relating the 
performance of individual loans and groups of loans to 
macroeconomic variables.'' \378\
---------------------------------------------------------------------------
    \377\ The supervisors described these indicative loss rates as 
``useful indicators of industry loss rates and [could] serve as a 
general guide.'' Banks could vary from these loss rates if they 
provided evidence that their own estimated ranges were appropriate. 
Federal Reserve Board of Governors, The Supervisory Capital Assessment 
Program: Overview of Results at 5 (May 7, 2009) (online at 
www.federalreserve.gov/newsevents/press/bcreg/bcreg20090507a1.pdf) 
(hereinafter ``SCAP Overview of Results'').
    \378\ Federal Reserve Board of Governors, The Supervisory Capital 
Assessment Program: Design and Implementation at 8 (Apr. 24, 2009) 
(online at www.federalreserve.gov/newsevents/press/bcreg/
bcreg20090424a1.pdf).
---------------------------------------------------------------------------
    The indicative loss rates for commercial real estate loans 
were broken into loss rates for construction, multifamily, and 
non-farm/non-residential; they are shown in Figure 38.

 FIGURE 38: STRESS TEST INDICATIVE LOSS RATES FOR COMMERCIAL REAL ESTATE
              (CUMULATIVE 2009-2010, IN PERCENTAGES) \379\
------------------------------------------------------------------------
                                            Baseline      More Adverse
------------------------------------------------------------------------
All commercial real estate..............        5-7.5               9-12
    Construction........................         8-12              15-18
    Multifamily.........................      3.5-6.5              10-11
    Non-farm, Non-residential...........          4-5               7-9
------------------------------------------------------------------------
\379\ SCAP Overview of Results, supra note 377.

    In May 2009, the results of the stress tests were released, 
providing a window into the potential losses that large 
financial institutions faced in seven different lending 
markets, including commercial real estate. The results showed 
that most of the stress-tested 19 institutions hovered around 
or well below a median loss rate of 10.6 percent for commercial 
real estate loans. Three institutions had significantly higher 
loss rates: GMAC at 33.3 percent, Morgan Stanley at 45.2 
percent, and State Street at 35.5 percent. While useful, the 
details of the results that the supervisors released publicly 
are limited. For example, although the indicative loan loss 
rates for commercial real estate are broken into three buckets, 
the institution-specific results did not provide this level of 
detail, only showing estimated commercial real estate losses. 
Also, the results did not break down estimated losses by year, 
showing instead total estimated losses for 2009 and 2010.\380\ 
In addition, at its September 10, 2009 hearing and in a follow-
up letter, the Panel questioned Secretary Geithner on the 
inputs for and results of the stress tests. Secretary Geithner 
stated that he would provide further information, but after two 
request letters and three months, he provided no additional 
data. Instead he referred the Panel back to the bank 
supervisors, who have not yet provided any data.\381\
---------------------------------------------------------------------------
    \380\ For further discussion of the limits of the stress tests, see 
the Panel's June report. COP June Oversight Report, supra note 6, at 
30, 39-49. In the June Report, the Panel recommended, among other 
things, that ``more information should be released with respect to the 
results of the stress tests. More granular information on estimated 
losses by sub-categories (e.g., the 12 loan categories that were 
administered versus the eight that were released) should be 
disclosed.'' COP June Oversight Report, supra note 6, at 49 .
    \381\ Letter from Chair Elizabeth Warren, Congressional Oversight 
Panel, to Secretary Timothy F. Geithner (Sept. 15, 2009) (online at 
cop.senate.gov/documents/letter-091509-geithner.pdf); Letter from Chair 
Elizabeth Warren, Congressional Oversight Panel, to Secretary Timothy 
F. Geithner (Nov. 25, 2009) (cop.senate.gov/documents/letter-112509-
geithner.pdf); Letter from Secretary Timothy F. Geithner to Chair 
Elizabeth Warren, Congressional Oversight Panel, at 188 (Dec. 10, 2009) 
(cop.senate.gov/documents/cop-011410-report.pdf). The Panel requested 
inputs and formulae for the stress tests, more information about 
estimates for indicative loss rates, actual loss rates two quarters 
after the implementation of the stress tests, and the impact of 
unemployment metrics.
---------------------------------------------------------------------------
    The results of these tests are of very limited value in 
evaluating commercial real estate losses in the tested BHCs. 
First, the testing measured only losses through the end of 
2010.\382\ As discussed, commercial real estate losses are 
expected to continue and possibly even accelerate in 2012 or 
beyond.\383\ Thus, the degree to which the capital buffers 
required through 2010 will be sufficient for later periods is 
unclear.
---------------------------------------------------------------------------
    \382\ With the exception of loan losses, for which institutions 
would be required to reserve in 2010 for 2011 loan losses.
    \383\ COP June Oversight Report, supra note 6, at 41-42.
---------------------------------------------------------------------------
    More important, of course, as the Panel has noted several 
times before, no effort has been made by the Federal Reserve 
Board and the other supervisors to extend the regulatory stress 
testing regime in an appropriate way to other banks. (The 2006 
guidance did suggest that banks conduct their own stress 
testing if their concentrations of commercial real estate 
lending were significantly high.)
    Second, since February 2009, the economic indicators used 
in the stress testing have been moving in unanticipated 
directions. The most recent figures for those three metrics 
show that GDP increased at an annual rate of 5.7 percent from 
the third to the fourth quarter of 2009,\384\ a 9.3 percent 
annual unemployment rate as of December 2009,\385\ and a 4.5 
annual percent decrease in housing prices as of the end of 
November 2009.\386\ Real GDP decreased by 2.4 percent from 2008 
to 2009.\387\ Under the more adverse predictions for 2009, GDP 
fell by 3.5 percent, housing fell by 22 percent, and 
unemployment was at 8.9 percent. For the entire year, while the 
housing price indicator is performing significantly better than 
expected, unemployment is higher, and the change in GDP is 
approaching its range in the more adverse scenario. As 
discussed in the Panel's June Report, the Federal Reserve would 
not disclose to the Panel the model used for the stress tests, 
making a complete evaluation of the process impossible.\388\ 
The Panel cannot, therefore, determine how different variables 
were weighted in the tests, and their interactive effects.
---------------------------------------------------------------------------
    \384\ BEA Fourth Quarter GDP Estimate, supra note 95. See section 
D,1 supra, for a discussion of economists' views of the 5.7 percent GDP 
growth.
    \385\ This represents an average of the monthly unemployment rate 
for the previous 12 months. Bureau of Labor Statistics: Labor Force 
Statistics from the Current Population Survey (Jan. 24, 2010) (online 
at data.bls.gov/PDQ/servlet/
SurveyOutputServlet?data_tool=latest_numbers&series_id=LNS14000000).
    \386\ Id.
    \387\ BEA Fourth Quarter GDP Estimate, supra note 95.
    \388\ COP June Oversight Report, supra note 6.
---------------------------------------------------------------------------
    Figure 39 shows, for each of the 19 stress test 
institutions, the commercial real estate loans outstanding, and 
the stress test loan loss rates for commercial real estate. 
These institutions have not publicly disclosed their actual 
commercial real estate losses, so it is difficult to evaluate 
the accuracy of the stress test loss rates.

          FIGURE 39: COMMERCIAL REAL ESTATE EXPOSURE OF STRESS TEST INSTITUTIONS (AS OF Q3 2009) \389\
----------------------------------------------------------------------------------------------------------------
                                                                 CRE Loans                           CRE/  Risk
                                                                Outstanding       CMBS  Holdings       Based
                                             Total Assets      (thousands of      (thousands of       Capital
                                                                  dollars)           dollars)        (Percent)
----------------------------------------------------------------------------------------------------------------
Bank of America Corporation.............     $2,251,043,000        $91,031,681         $7,931,055          49.3
JPMorgan Chase & Co.....................      2,041,009,000         66,281,865          6,010,000          43.5
Citigroup Inc...........................      1,888,599,000         16,904,864          2,119,000          12.7
Wells Fargo & Company...................      1,228,625,000         96,424,887         11,163,000          79.4
Goldman Sachs Group, Inc................        882,185,000            219,000                 --           1.0
Morgan Stanley..........................        769,503,000          1,106,000                 --          14.0
MetLife.................................        535,192,209         30,495,694         15,534,957          99.1
PNC Financial Services Group, Inc.......        271,407,000         14,290,871          6,825,278          97.8
U.S. Bancorp............................        265,058,000         28,988,774            161,982         110.4
Bank of New York Mellon Corporation.....        212,007,000          1,523,042          2,895,000          10.5
GMAC Inc................................        178,254,000              1,473                 --           0.0
SunTrust Banks, Inc.....................        172,717,747         16,448,434                 --          99.5
Capital One Financial Corporation.......        168,463,532         17,625,230                 --         100.5
BB&T Corporation........................        165,328,000         27,450,854             51,842         173.7
State Street Corporation................        163,277,000            592,344          3,903,374           5.2
Regions Financial Corporation...........        139,986,000         24,639,026             20,993         165.6
American Express Company................        120,445,000              9,614                 --           0.2
Fifth Third Bancorp.....................        110,740,000         13,435,515            139,901          85.3
KeyCorp.................................         96,989,000         15,340,865             45,607        131.1
----------------------------------------------------------------------------------------------------------------
\389\ SNL Financial (accessed on Jan. 13, 2010). MetLife was not a TARP participant.

    The stress tests were a central element of Treasury's 
Financial Stability Plan, intended to ``clean up and strengthen 
the nation's banks.'' \390\ The markets and the public have 
placed a great deal of confidence in the results, and yet 
serious questions remain about the timeframe, variables, and 
model, especially with regard to commercial real estate losses. 
As much of the statement of economic recovery is based on the 
stress test results, the Panel renews its call to the 
supervisors to provide more transparency in the process and 
possibly to rerun the tests with a longer time horizon, in 
order to capture more accurately commercial real estate losses.
---------------------------------------------------------------------------
    \390\ U.S. Department of the Treasury, Secretary Geithner 
Introduces Financial Stability Plan (Feb. 10, 2008) (online at 
www.financialstability.gov/latest/tg18.html).
---------------------------------------------------------------------------

3. Supervisors' Role Regarding Loan Workouts

    As 2009 continued, the outlook for commercial real estate 
loans continued to worsen. At the end of the second quarter, 
nine percent of the commercial real estate debt held by banks 
was delinquent, almost double the level of a year earlier. 
Prospects were particularly bad for construction and 
development loans, more than 16 percent of which were 
delinquent.\391\ By October 2009, commercial property values 
had fallen 35 to 40 percent from their peaks in 2007.\392\ And 
there were signs of more trouble ahead. Comptroller of the 
Currency John Dugan told a congressional committee in October 
2009 that construction and development loans for housing, 
which, as noted above, are classified as commercial real estate 
loans, were by far the largest factor in commercial bank 
failures over the previous two years. He stated that the health 
of the broader commercial real estate sector was dependent on 
the overall performance of the economy.\393\ FDIC Chairman 
Sheila Bair voiced additional concerns about the risk that 
commercial real estate posed to community banks. She said that 
commercial real estate comprised more than 43 percent of the 
portfolios of community banks. In addition, she noted that the 
average ratio of commercial real estate loans to total capital 
at these banks was above 280 percent--or close to one of the 
thresholds established in the 2006 regulatory guidance.\394\
---------------------------------------------------------------------------
    \391\ Testimony of Daniel K. Tarullo, supra note 262.
    \392\ Testimony of Daniel K. Tarullo, supra note 262, at 7-9.
    \393\ Senate Committee on Banking, Housing & Urban Affairs, 
Subcommittee on Financial Institutions, Written Testimony of John C. 
Dugan, Comptroller of the Currency: Examining the State of the Banking 
Industry, 111th Cong. (Oct. 14, 2009) (online at banking.senate.gov/
public/index.cfm?FuseAction=Files.View&FileStore_id=a2046ce1-1c34-4533-
91ef-d6d6311760a7) (hereinafter ``Testimony of John Dugan'').
    \394\ Senate Committee on Banking, Housing, and Urban Affairs, 
Subcommittee on Financial Institutions, Statement of Sheila C. Bair, 
chairman, Federal Deposit Insurance Corporation: Examining the State of 
the Banking Industry, 111th Cong. (Oct. 14, 2009) (online at 
banking.senate.gov/public/
index.cfm?FuseAction=Files.View&FileStore_id=6277ecd6-1d5c-4d07-a1ff-
5c4b72201577).
---------------------------------------------------------------------------
    The supervisors took their first major step to address 
these problems on October 30, 2009, releasing a policy 
statement that takes a generally positive view of workouts for 
commercial real estate loans.\395\ The policy statement came 
amid concerns from banks that supervisors too often look 
askance at workouts, which allow lenders to protect themselves 
against defaults, because the supervisors worry that workouts 
allow lenders to delay acknowledging the bad loans on their 
books. The 33-page document, titled ``Policy Statement on 
Prudent Commercial Real Estate Loan Workouts,'' states the 
following:
---------------------------------------------------------------------------
    \395\ The regulatory agencies that released the statement were the 
Board of Governors of the Federal Reserve System, the Federal Deposit 
Insurance Corporation, the Office of the Comptroller of the Currency, 
the Office of Thrift Supervision, the National Credit Union 
Administration, and the Federal Financial Institutions Examination 
Council State Liaison Committee. Policy Statement on CRE Workouts, 
supra note 314.

          The regulators have found that prudent commercial 
        real estate loan workouts are often in the best 
        interest of the financial institution and the borrower. 
        Examiners are expected to take a balanced approach in 
        assessing the adequacy of an institution's risk 
        management practices for loan workout activity. 
        Financial institutions that implement prudent 
        commercial real estate loan workout arrangements will 
        not be subject to criticism for engaging in these 
        efforts even if the restructured loans have weaknesses 
        that result in adverse credit classification. In 
        addition, renewed or restructured loans to borrowers 
        who have the ability to repay their debts according to 
        reasonable modified terms will not be subject to 
        adverse classification solely because the value of the 
        underlying collateral has declined to an amount that is 
---------------------------------------------------------------------------
        less than the loan balance.

    Elsewhere, the document states that ``loans to sound 
borrowers that are renewed or restructured in accordance with 
prudent underwriting standards should not be adversely 
classified or criticized unless well-defined weaknesses 
jeopardize repayment. Further, loans should not be adversely 
classified solely because the borrower is associated with a 
particular industry that is experiencing financial 
difficulties.'' \396\ But the document also makes clear that 
write-downs are still necessary in some cases. For example, it 
states that if an underwater borrower is solely dependent on 
the sale of the property to repay the loan, and has no other 
reliable source of repayment, the examiner should classify the 
difference between the amount owed and the property value as a 
loss.\397\ It also states that performing loans should be 
adversely classified when they have ``well-defined weaknesses'' 
that will ``jeopardize repayment.'' \398\
---------------------------------------------------------------------------
    \396\ Policy Statement on CRE Workouts, supra note 314, at 7.
    \397\ Policy Statement on CRE Workouts, supra note 314, at 9.
    \398\ Policy Statement on CRE Workouts, supra note 314, at 7.
---------------------------------------------------------------------------
    While the policy statement does not establish many bright 
lines for what qualifies as a prudent workout, it does provide 
guidance in the form of hypothetical examples. One such example 
involved a $10 million loan for the construction of a shopping 
mall. The original loan was premised on the idea that the 
borrower would obtain long-term financing after construction 
was completed, but with a weak economy and a 55 percent 
occupancy rate at the mall, such financing was no longer 
feasible. In these circumstances, the lender split the loan in 
two--a $7.2 million loan that would have enough cash flow to 
allow the borrower to make payments, and a $2.8 million loan 
that the lender charged off, reflecting the loss on its books. 
For the lender, creating a good loan and a bad loan, as opposed 
to keeping one bad loan on its books, provided certain 
accounting benefits, and the regulator did not object to the 
debt restructuring.\399\
---------------------------------------------------------------------------
    \399\ The description here is a condensed version of a scenario 
described in the supervisors' policy statement. It is meant to provide 
only a general understanding of the kinds of loan workouts that 
supervisors deem prudent. See Policy Statement on CRE Workouts, supra 
note 314, at 18-19.
---------------------------------------------------------------------------
    A second hypothetical example of a workout deemed 
acceptable by the supervisors involved a $15 million loan on an 
office building, under which the borrower was required to make 
a $13.6 million balloon payment at the end of the third year. 
Over those three years, the property's appraised value had 
fallen from $20 million to $13.1 million, meaning that the 
outstanding value of the loan now exceeded the property's 
value. Two factors suggested that the loan could be paid off if 
it were restructured, even though the property was valued at 
less than the remaining amount owed under the loan: (1) the 
borrower had been making timely payments; and (2) the office 
building was generating more revenue than the borrower owed 
each month. Under these circumstances, the lender was not 
penalized for restructuring the loan in such a way that the 
outstanding $13.6 million was amortized over the next 17 
years.\400\
---------------------------------------------------------------------------
    \400\ The description here is a condensed version of a scenario 
described in the supervisors' policy statement. It is meant to provide 
only a general understanding of the kinds of loan workouts that 
supervisors deem prudent. See Policy Statement on CRE Workouts, supra 
note 314, at 14-0915.
---------------------------------------------------------------------------
    The key point that industry participants have taken from 
the policy statement is that under certain circumstances an 
underwater loan will not have to be written down as long as the 
borrower is able to make monthly payments on the restructured 
debt. Indeed, the document states: ``The primary focus of an 
examiner's review of a commercial loan, including binding 
commitments, is an assessment of the borrower's ability to 
repay the loan.''\401\ Focusing on the borrower's ability to 
service the loan, even when the borrower owes more than the 
value of the loan, of course carries the risk of 
underestimating the impact that negative equity has on rates of 
default and, consequently, on losses for lenders.\402\
---------------------------------------------------------------------------
    \401\ Policy Statement on CRE Workouts, supra note 314, at 3. See 
David E. Rabin and David H. Jones, New Policy on Commercial Real Estate 
Loan Workouts--Providing Welcomed Flexibility, K&L Gates Distressed 
Real Estate Alert (Nov. 10, 2009) (online at www.klgates.com/newsstand/
detail.aspx?publication=6010) (hereinafter ``Rabin and Jones'').
    \402\ A 2004 research paper found that CMBS borrowers are likely to 
decide whether to make payments based not only on their cash flow, but 
also on their equity position in the mortgage. Chen and Deng: 
Commercial Mortgage Workout Strategy, supra note 304. This greater 
willingness to walk away from a property that is underwater has also 
been observed in residential real estate. A July study found that 26 
percent of underwater borrowers decided to walk away even when they can 
afford to pay their mortgage. Luigi Guiso, Paola Sapienza, and Luigi 
Zingales, Moral and Social Constraints to Strategic Default on 
Mortgages, Financial Trust Index (July, 2009) (online at 
www.financialtrustindex.org/images/
Guiso_Sapienza_Zingales_StrategicDefault.pdf). Another complicating 
factor involves whether the loan is recourse, in which case the lender 
can recover from other assets of the borrower, or non-recourse. There 
are instances of both types of loan in the residential sector; in the 
commercial real estate sector, as discussed in infra, most construction 
loans are recourse, while most permanent loans are non-recourse. It is 
unclear whether the phenomenon's effects are larger, similar in size, 
or smaller in the commercial sector. On one hand, real estate 
developers are less likely than homeowners to worry about the stigma 
associated with walking away from a loan. In addition, people need a 
place to live, and consequently residential borrowers are often more 
tethered to their properties than commercial borrowers are. On the 
other hand, commercial properties produce income, which is usually not 
true of residential properties. Rental income may be large enough to 
change the commercial borrower's calculus, so that the borrower decides 
to continue making payments even when the loan is worth more than the 
property.
---------------------------------------------------------------------------
    At the Panel's January 27 field hearing on commercial real 
estate, Doreen Eberley, acting regional director in the FDIC's 
Atlanta Regional Office, argued that loans should not be 
written down solely because the property value has fallen. She 
noted that the primary source of repayment for a loan is the 
borrower's ability to pay, while the collateral is the 
secondary source. There is no reason to write down a loan, she 
argued, when a borrower has the wherewithal and the 
demonstrated willingness to repay it. And she said that 
requiring banks to mark all of their loans to their fair market 
value would lead to a lot of volatility on bank balance 
sheets.\403\ Jon Greenlee, associate director of the Federal 
Reserve's Division of Bank Supervision and Regulation, said 
that the upcoming wave of expected refinancings is one reason 
why loan workouts are necessary. If a borrower can continue to 
make payments at a certain level, Mr. Greenlee argued, that is 
a better outcome than foreclosure for both the bank and the 
borrower.\404\ Chris Burnett, chief executive officer of 
Cornerstone Bank, an Atlanta-based community bank, offered a 
different rationale in favor of the regulatory policy statement 
on loan workouts. He stated that if banks were required to mark 
their loan portfolios to their fair market value, it is unclear 
how deep the holes in their capital bases would be.\405\
---------------------------------------------------------------------------
    \403\ Written Testimony of Doreen Eberley, supra note 91, at 57, 
61-62.
    \404\ Written Testimony of Jon Greenlee, supra note 93, at 59.
    \405\ Written Testimony of Chris Burnett, supra note 92, at 126.
---------------------------------------------------------------------------
    The impact of the policy statement is subject to debate, in 
three broad areas.
    The first involves the statement's immediate effect on loan 
write-downs. As noted above, there is no single write-down 
formula that applies to all loans. Too few write-downs can 
allow banks that have acted imprudently or even recklessly in 
managing their loan portfolios to survive unjustifiably. But in 
other cases forcing write-downs can create self-fulfilling 
prophecies. For every ``extend and pretend,'' there can also be 
an ``extend and soundly lend.''
    Second, the policy statement has the potential to affect 
banks' capital. If it leads to fewer write-downs, that may mean 
that banks will be required to set aside less capital; banks 
often seek to avoid larger capital reserves, because they 
reduce the bank's ability to earn profits. It is important to 
note, however, that the policy statement does not change the 
accounting rules that apply to the effects of loan write-downs 
on bank balance sheets, and that banks will still have to take 
write-downs when their auditors instruct them to do so.
    Third, the policy statement may have an impact on bank 
lending. Banks with overvalued loans on their books may hoard 
capital and reduce sound lending. But if instead banks were 
being forced prematurely to write down possible losses, that 
could lead them to curtail lending.
    Again, as discussed above, there is no one solution that 
fits all banks or all loans and properties; that is why the 
crisis requires forcing losses where necessary to protect the 
deposit insurance system, but not forcing banks into insolvency 
or depressing the value of projects that have a substantial 
chance of regaining value as the economy recovers, or as 
changes in real estate prices draw investors back into the 
market to close the equity gap. Often, a partial write-down may 
be appropriate as part of a refinancing package.
    It is also important to note that the 2009 policy statement 
is not entirely new. It closely resembles another policy 
statement that federal banking supervisors issued in 1991, 
during that earlier wave of problems in the commercial real 
estate sector. In 1991 supervisors published a document that 
instructed examiners to review commercial real estate loans 
``in a consistent, prudent, and balanced fashion'' and to 
ensure that regulatory policies and actions not inadvertently 
curtail the flow of credit to sound borrowers.\406\ The 1991 
statement also stated that evaluation of real estate loans ``is 
not based solely on the value of the collateral'' but on a 
review of the property's income-producing capacity and of the 
borrower's willingness and capacity to repay.\407\ The issuance 
of a similar document in 2009 highlights the subjective nature 
of bank examinations; indeed, bank examiners must apply the 
rules, along with their own judgment and discretion, to the 
specific facts they encounter. The new policy statement 
provides a reminder of the criteria that are to be applied, and 
therefore may have an impact in situations where the question 
of whether to write-down the loan's value is not clear cut. It 
is unclear how much impact the 2009 policy statement is having 
at the field level, but especially in light of bankers' 
concerns that supervisors tend to become overly cautious in 
depressed markets,\408\ the actual impact could be smaller than 
banks would like it to be.\409\
---------------------------------------------------------------------------
    \406\ House Financial Services Committee, Written Testimony of 
Elizabeth Duke, Federal Reserve Governor, Credit Availability and 
Prudent Lending Standards, 111th Cong. (Mar. 25, 2009) (online at 
www.federalreserve.gov/newsevents/testimony/duke20090325a.htm).
    \407\ Office of the Comptroller of the Currency, Federal Deposit 
Insurance Corporation, Federal Reserve Board, Office of Thrift 
Supervision, Interagency Policy Statement on the Review and 
Classification of Commercial Real Estate Loans (Nov. 7, 1991) (online 
at files.ots.treas.gov/86028.pdf).
    \408\ See, e.g., House Financial Services Committee, Subcommittee 
on Oversight and Investigations, Written Testimony of Michael Kus, 
Legal Counsel, Michigan Association of Community Bankers, Field Hearing 
on Improving Responsible Lending to Small Businesses, 111th Cong. (Nov. 
30, 2009) (online at www.house.gov/apps/list/hearing/financialsvcs--
dem/kus--testimony.pdf) (``[I]nstead of working with community banks to 
help both banks and their customers overcome current economic stress, 
some federal examiners have become extremely harsh in their assessment 
of the value of commercial real estate loans and their collateral. This 
extreme examination environment is adding to the commercial real estate 
contraction for small businesses. Community banks are effectively being 
forced to avoid making good loans out of fear of examination criticism, 
forced write-downs and the resulting loss of income and capital'').
    \409\ See, e.g., Written Testimony of Mark Elliott, supra note 109 
(stating that ``the guidance given is still open to interpretation and, 
in this environment, that interpretation will trend toward the cautious 
. . .'').
---------------------------------------------------------------------------
    The policy statement has evoked a range of reactions among 
industry participants. Lenders obviously like it because it 
allows them to avoid writing down problematic loans. On the 
other hand, investors who would like to buy those distressed 
loans at a discount have a less favorable view.\410\ The likely 
net effect is to make the downturn in commercial real estate at 
least somewhat less severe in the short term while also 
extending the period of uncertainty by pushing some losses 
further into the future. It is critical that bank supervisors 
fully recognize and are publicly clear about the potential for 
a commercial real estate crisis and are quick to force loss 
recognition where necessary before the commercial real estate 
sector can return to health.
---------------------------------------------------------------------------
    \410\ Rabin and Jones, supra note 401 (``lenders now have new 
breathing room and may be permitted to retain billions of dollars of 
undersecured commercial real estate loans without having to write-down 
these assets. The investors who have been waiting on the sidelines 
thinking that this recession might present a new opportunity to pluck 
out investments for pennies on the dollar . . . will have to keep 
waiting'').
---------------------------------------------------------------------------

4. Supervisors' Role in Banks' Exit from the TARP 

    Bank supervisors play a key role in determining when TARP-
recipient banks may leave the program, and their judgments 
about commercial real estate loans continue to impact that 
success. A bank may not repurchase its preferred stock without 
the approval of its primary federal regulator.\411\ If a bank 
has significant commercial real estate holdings, it might be 
told by its regulator that it will benefit from continuing to 
hold TARP funds, although it could also reach the same judgment 
by itself. Some banks might have capital levels that appear 
safe and stable, but are choosing not to repay because of the 
possibility of future commercial real estate losses. For 
example, as of the 3Q 2009, Marshall & Ilsley Corp., a 
Wisconsin bank, had a tier 1 capital ratio of 9.61 
percent,\412\ but in its 3Q 10-Q has disclosed that it had $6.3 
billion in construction and development loans, of which $984.5 
million is non-performing.\413\ M&I's CFO explained that 
``[f]rom our perspective, it's still good to have that 
incremental capital. As we get through the economic cycle and 
return to profitability, I think we then start considering what 
our TARP repayment strategies are going to be.''\414\ Other 
banks have been allowed to repay, even though they hold 
significant commercial real estate assets. For example, Sun 
Bancorp, Bank of Marin Bancorp, Old Line Bancshares, and Bank 
Rhode Island have all repurchased their Capital Purchase 
Program (CPP) preferred stock, and have commercial real estate 
loans to total loans of 42.3, 41.2, 36.0, and 23.2 percent, 
respectively.\415\ This shows that commercial real estate 
concentrations are high even in some institutions that are 
considered well capitalized.
---------------------------------------------------------------------------
    \411\ 12 U.S.C. 5221(g).
    \412\ Marshall & Ilsley Corp., Form 10-Q for the quarter ended 
September 30, 2009, at 44 (Nov. 9, 2009) (online at www.sec.gov/
Archives/edgar/data/1399315/000139931509000034/micorp10q--09-2009.htm) 
(hereinafter ``Marshall & Ilsley Form 10-Q'').
    \413\ Marshall & Ilsley Form 10-Q, supra note 412.
    \414\ Marshall & Ilsley Corp, Remarks by Gregory A. Smith, Senior 
Vice President and Chief Financial Officer at the Merrill Lynch 2009 
Banking and Financial Services Conference (Nov. 11, 2009) (online at 
phx.corporate-ir.net/External.File?item=UGFyZW50 
SUQ9MzU4ODEzfENoaWxkSUQ9MzUxMzEzfFR5cGU9MQ=&t=1). In its 3Q 2009 10-Q, 
Marshall & Ilsley explained: ``Notwithstanding the current national 
capital market impact on the cost and availability of liquidity, 
management believes that it has adequate liquidity to ensure that funds 
are available to the Corporation and each of its banks to satisfy their 
cash flow requirements. However, if capital markets deteriorate more 
than management currently expects, the Corporation could experience 
stress on its liquidity position.'' Marshall & Ilsley Form 10-Q, supra 
note 412, at 74.
    \415\ SNL Financial (accessed on Jan. 13, 2010).
---------------------------------------------------------------------------
    Among the large banks, BB&T, for which commercial real 
estate makes up a larger proportion of its assets than other 
large banks, has commercial real estate holdings (loans and 
CMBS) constituting 24.47 percent of its total assets. Wells 
Fargo, which also holds larger proportions of commercial real 
estate holdings, has a commercial real estate to total assets 
ratio of 11.63 percent. Figure 40 shows the commercial real 
estate holdings of the top 10 institutions that have redeemed 
their TARP funds, as well as an aggregated number for the 
remaining institutions that have redeemed. The top 10 
institutions have a commercial real estate to total assets 
ratio of 5.35 percent, while the institutions outside of the 
top 10 have a ratio of 16.17 percent.

      FIGURE 40: PERCENTAGE OF CRE LOANS TO TOTAL LOANS OF REDEEMED CPP PARTICIPANTS (AS OF 3Q 2009) \416\
----------------------------------------------------------------------------------------------------------------
                                                                 CRE Loans                            CRE/Risk
                                                                Outstanding       CMBS Holdings    Based Capital
                                             Total Assets      (thousands of      (thousands of       (Percent)
                                                                  dollars)           dollars)
----------------------------------------------------------------------------------------------------------------
Bank of America Corporation.............     $2,251,043,000        $91,031,681         $7,931,055          49.3
JPMorgan Chase & Co.....................      2,041,009,000         66,281,865          6,010,000          43.5
Wells Fargo & Company...................      1,228,625,000         96,424,887         11,163,000          79.4
Goldman Sachs Group, Inc................        882,185,000            219,000  .................           1.0
Morgan Stanley..........................        769,503,000          1,106,000  .................          14.0
U.S. Bancorp............................        265,058,000         28,988,774            161,982         110.4
Bank of New York Mellon Corporation.....        212,007,000          1,523,042          2,895,000          10.5
Capital One Financial Corporation.......        168,463,532         17,625,230  .................         100.5
BB&T Corporation........................        165,328,000         27,450,854             51,842         173.7
State Street Corporation................        163,277,000            592,344          3,903,374           5.2
                                         --------------------------------------
Top 10 Total............................      8,146,498,532        331,243,677         32,116,253          57.8
All Others Total........................        521,017,638         55,639,492            145,666         136.8
                                         ---------------------------------------------------------
    Total ..............................     $8,667,516,170       $386,883,169        $32,261,919          63.0
----------------------------------------------------------------------------------------------------------------
\416\ This figure is based on guidance established by federal supervisors in December 2006. The numerator, total
  commercial real estate loans, is comprised of items 1a, 1d, 1e, and Memorandum Item 3 in the Call Report FFIEC
  031 and 041 schedule RC-C. The denominator, total risk-based capital, is comprised of line 21 in the Call
  Report FFIEC 031 and 041 schedule RC-R-Regulatory Capital. Office of the Comptroller of the Currency, Board of
  Governors of the Federal Reserve System, and Federal Deposit Insurance Corporation, Concentrations in
  Commercial Real Estate Lending, Sound Risk Management Practices (Dec. 12, 2006) (online at
  frwebgate1.access.gpo.gov/cgi-bin/PDFgate.cgi?WAISdocID=661175176921+0+2+0&WAISaction=retrieve).

    There are two other issues involving commercial real estate 
that may have an impact on financial institutions' exit from 
the TARP. First, although many banks have already taken write-
downs on their CMBS portfolios, there may be more write-downs 
to come. For banks that have already repaid their TARP funds, 
these write-downs could affect their capital levels. For those 
that still hold TARP funds, write-downs could keep them in the 
program longer than expected. At the Panel's field hearing in 
Atlanta, Doreen Eberley, the acting Atlanta regional director 
of the FDIC, testified that ``capital is the most significant 
concern facing [Atlanta area] financial institutions'' and that 
these institutions are ``facing capital pressures now.'' \417\
---------------------------------------------------------------------------
    \417\ Written Testimony of Doreen Eberley, supra note 91.
---------------------------------------------------------------------------
    Figure 41 shows commercial real estate loans and CMBS as a 
percentage of all assets for the top 20 institutions that are 
still participating in the CPP, as well as aggregated numbers 
for the remaining participating institutions. The top 20 
institutions have a commercial real estate to all assets 
percentage of 4.84 percent; the remaining institutions' 
percentage is 38.03 percent.

       FIGURE 41: PERCENTAGE OF CRE LOANS TO TOTAL LOANS OF CURRENT CPP PARTICIPANTS (AS OF 3Q 2009) \418\
----------------------------------------------------------------------------------------------------------------
                                                                 CRE Loans                           CRE/Risk-
                                                                Outstanding       CMBS Holdings        Based
                                            Total Assets       (thousands of      (thousands of       Capital
                                                                  dollars)           dollars)        (Percent)
----------------------------------------------------------------------------------------------------------------
Citigroup Inc...........................     $1,888,599,000         16,904,864          2,119,000          12.7
American International Group, Inc.......        844,344,000
Hartford Financial Services Group, Inc..        316,720,000
PNC Financial Services Group, Inc.......        271,407,000         14,290,871          6,825,278          97.8
Lincoln National Corporation............        181,489,200
GMAC Inc................................        178,254,000              1,473  .................           0.0
SunTrust Banks, Inc.....................        172,717,747         16,448,434  .................          99.5
Fifth Third Bancorp.....................        110,740,000         13,435,515            139,901          85.3
KeyCorp.................................         96,989,000         15,340,865             45,607         131.1
Comerica Incorporated...................         59,590,000          9,292,959  .................         110.7
Marshall & Ilsley Corporation...........         58,545,323         14,792,400  .................         245.5
Zions Bancorporation....................         53,298,150         15,246,020  .................         242.9
Huntington Bancshares Incorporated......         52,512,659         10,528,342  .................         203.8
Discover Financial Services.............         42,698,290
Popular, Inc............................         35,637,804          5,888,803  .................         184.5
Synovus Financial Corp..................         34,610,480         12,353,093              1,566         362.6
First Horizon National Corporation......         26,465,852          2,677,495  .................          59.1
Associated Banc-Corp....................         22,881,527          4,198,449  .................         204.5
First BanCorp...........................         20,081,185          3,795,482  .................         201.9
City National Corporation...............         18,400,604          2,648,255             19,629         146.7
                                         ---------------------------------------------------------
Top 20 Total............................      4,485,981,821        157,843,320          9,150,981          63.4
Total of All Others.....................        709,674,170        175,437,021            937,419         273.2
                                         ---------------------------------------------------------
    Total...............................    $5,195,655,991       $333,280,341        $10,088,400          106.4
----------------------------------------------------------------------------------------------------------------
\418\ This figure is based on guidance established by federal supervisors in December, 2006. The numerator,
  total commercial real estate loans, is comprised of items 1a, 1d, 1e, and Memorandum Item 3 in the Call Report
  FFIEC 031 and 041 schedule RC-C. The denominator, total risk-based capital, is comprised of line 21 in the
  Call Report FFIEC 031 and 041 schedule RC--R--Regulatory Capital. Office of the Comptroller of the Currency,
  Board of Governors of the Federal Reserve System, and Federal Deposit Insurance Corporation, Concentrations in
  Commercial Real Estate Lending, Sound Risk Management Practices (Dec. 12, 2006) (online at
  frwebgate1.access.gpo.gov/cgi-bin/PDFgate.cgi?WAISdocID=661175176921+0+2+0&WAISaction=retrieve).

    A similar issue arises with regard to the effect of SFAS 
167. Banks large and small will be required to bring off 
balance sheet vehicles back onto their balance sheets. Bringing 
these assets onto the balance sheets of institutions that still 
hold TARP funds could require them to remain in the program for 
longer than they would have without the new accounting rule.

5. Summary

    The effect of the 2006 guidance on banks and examiners and 
the impact it might have had if it had been proposed earlier, 
or in more binding form, are impossible to gauge. The stress 
tests provided greater clarity about the impact of troubled 
assets on balance sheets, but only for the nation's largest 
banks.\419\ Furthermore, their usefulness beyond 2010, when a 
large wave of commercial real estate loans comes due, is less 
clear.
---------------------------------------------------------------------------
    \419\ See COP June Oversight Report, supra note 6.
---------------------------------------------------------------------------
    The moderating effect of the 2009 policy statement on loan 
workouts depends on the clarity and clear-sightedness with 
which both banks and examiners apply its terms. The Panel is 
concerned about the possibility that the supervisors, by 
allowing banks to extend certain underwater loans rather than 
requiring them to recognize losses, will inadvertently delay a 
rebound in bank lending. But the opposite scenario--in which 
bank write-downs themselves cause other banks to restrain 
lending, as prices fall and a negative bubble starts to grow--
is also worrisome.
    In assessing the supervisors' actions and attempts to 
balance the considerations involved in the face of uncertain 
economic timelines, the Panel notes that it is neither 
desirable nor possible to prevent every bank failure. The 
greatest difficulty is determining the point at which the 
number and velocity of failures can create a broader risk to 
the financial sector, the citizens who rely on smaller banks, 
and the people and communities whose lives are affected by 
property foreclosures. As noted throughout the report, 
stabilization of the commercial real estate market is dependent 
on a broad economic recovery; \420\ likewise, a long downturn 
in the commercial real estate sector has the potential to 
stifle a recovery.
---------------------------------------------------------------------------
    \420\ See Written Testimony of Doreen Eberley, supra note 91, at 
51; see also Written Testimony of Jon Greenlee, supra note 93.
---------------------------------------------------------------------------

                              I. The TARP

    Since the passage of EESA, Treasury has periodically taken 
steps to address specific risk and potential losses in the 
commercial real estate market. For example, in November 2008, 
Treasury, the FDIC, the Federal Reserve, and Citigroup agreed 
on a pool of ring-fenced Citigroup assets the three agencies 
would guarantee as part of the Asset Guarantee Program 
(AGP).\421\ The asset pool included certain commercial real 
estate investments,\422\ though neither the value of the 
commercial real estate assets in the pool, nor the ratio of 
commercial real estate assets to other assets, is clear. But 
Treasury exhibited enough concern about the risk posed by some 
of Citigroup's commercial real estate investments in November 
2009 to provide a guarantee of these assets in order to 
stabilize the bank.
---------------------------------------------------------------------------
    \421\ U.S. Department of the Treasury, Summary of Terms: Eligible 
Asset Guarantee (Nov. 23, 2008) (online at www.ustreas.gov/press/
releases/reports/cititermsheet_112308.pdf).
    \422\ Board of Governors of the Federal Reserve System, Report 
Pursuant to Section 129 of the Emergency Economic Stabilization Act of 
2008: Authorization to Provide Residual Financing to Citigroup, Inc. 
for a Designated Asset Pool, at 3 (Nov. 23, 2009) (online at 
www.federalreserve.gov/monetarypolicy/files/129citigroup.pdf).
---------------------------------------------------------------------------
    In this section the report describes the accomplishments 
and limitations of the TARP with respect to commercial real 
estate, and also explores what other support Treasury might 
consider providing under the TARP. It should be noted at the 
outset that there is no indication that Treasury has treated 
commercial real estate as a separate category of problem faced 
by one or more classes of financial institutions.

1. The Term Asset-Backed Securities Loan Facility (TALF)

    The TALF was established by the Federal Reserve Bank of New 
York (FRBNY) and Treasury in November 2008, with the goal of 
restarting lending for asset-backed securities, a class of 
securities that includes consumer-sector loans for credit cards 
and auto purchases.\423\ Under the TALF, the government extends 
loans to securities investors, and the assets that comprise the 
securities serve as collateral aimed at protecting the 
government against losses. Interest rates on TALF loans are 
below the prevailing market rates.\424\ Thus, the TALF is both 
a way to provide liquidity to impaired markets, as well as a 
subsidy that reduces the price investors otherwise would have 
to pay for the securities they are buying.
---------------------------------------------------------------------------
    \423\ For a broader discussion of TALF's implementation and impact, 
see the Panel's May and December reports. Congressional Oversight 
Panel, May Oversight Report: Reviving Lending to Small Businesses and 
Families and the Impact of the TALF (May 7, 2009) (online at 
cop.senate.gov/documents/cop-050709-report.pdf); COP December Oversight 
Report, supra note 365.
    \424\ Federal Reserve Bank of New York, Term Asset-Backed 
Securities Loan Facility: Frequently Asked Questions (Jan. 15, 2010) 
(online at www.newyorkfed.org//markets/talf_faq.html#12) (``The 
interest rates on TALF loans are set with a view to providing borrowers 
an incentive to purchase eligible ABS at yield spreads higher than in 
more normal market conditions but lower than in the highly illiquid 
market conditions that have prevailed during the recent credit market 
turmoil'').
---------------------------------------------------------------------------
    In February 2009, Treasury announced its intention to 
expand the TALF to commercial mortgage-backed securities as 
part of its comprehensive Financial Stability Plan.\425\ In May 
2009, the Federal Reserve followed through by expanding 
eligible TALF collateral to include new CMBS issuance (i.e., 
CMBS issued in 2009 and beyond) and legacy CMBS (i.e., CMBS 
issued in 2008 or earlier).\426\ Newly issued CMBS includes not 
only new mortgages, but also loans that provide refinancing of 
existing commercial mortgages.
---------------------------------------------------------------------------
    \425\ U.S. Department of the Treasury, Fact Sheet: Financial 
Stability Plan, at 4 (Feb. 10, 2009) (online at 
www.financialstability.gov/docs/fact-sheet.pdf).
    \426\ Board of Governors of the Federal Reserve System, Press 
Release (May 19, 2009) (online at www.federalreserve.gov/
monetarypolicy/20090519b.htm); Board of Governors of the Federal 
Reserve System, Press Release (May 1, 2009) (online at 
www.federalreserve.gov/newsevents/press/monetary/20090501a.htm).
---------------------------------------------------------------------------
    In order to qualify for TALF financing, newly issued CMBS 
must meet specific criteria, which are designed to protect the 
government against losses; for example, the underlying 
commercial mortgage loans must be fixed-rate, they cannot be 
interest-only loans, and the borrowers must be current on their 
payments at the time the loans are securitized. Similarly, 
legacy CMBS must meet various criteria in order to qualify for 
the TALF. For example, legacy securities must hold the most 
senior claim on the underlying pool of loans; consequently, 
only the senior-most piece of the CMBS, which generally carries 
an AAA rating, is eligible for government financing.\427\
---------------------------------------------------------------------------
    \427\ Federal Reserve Bank of New York, Term Asset-Backed 
Securities Loan Facility: Terms and Conditions (Nov. 13, 2009) (online 
at www.newyorkfed.org/markets/talf_terms.html).
---------------------------------------------------------------------------
    Treasury has committed up to $20 billion in TARP funds to 
the TALF. Those dollars are in a first-loss position, meaning 
that if the TALF loses money, the TARP would pay for the first 
$20 billion in losses.\428\
---------------------------------------------------------------------------
    \428\ Board of Governors of the Federal Reserve System, Term Asset-
Backed Securities Liquidity Facility (TALF) Terms and Conditions 
(online at www.federalreserve.gov/newsevents/press/monetary/
monetary20081125a1.pdf). Treasury projects that it will actually make 
money from the TALF. The GAO, however, projects that the CMBS portion 
of the TALF could lose as much as $500 million under what GAO deemed a 
worst-case scenario for commercial real estate prices. Some of those 
losses would likely be offset, though, by interest payments on other 
TALF loans; in addition, Treasury disputes GAO's methodology, and says 
that commercial real estate prices would have to decline by 65 percent 
for the CMBS portion of TALF to incur losses. GAO TALF Report, supra 
note 64.
---------------------------------------------------------------------------
    There are different ways to assess the TALF's impact on the 
commercial real estate market. One measure is the volume of 
commercial mortgages that have been securitized since the 
program was unveiled. Prior to the time CMBS was made eligible 
under TALF, the market for commercial mortgage-backed 
securities was frozen. At the market's peak in 2006 and 2007, 
$65 billion to $70 billion in commercial mortgage-backed 
securities were being issued each quarter; but between July 
2008 and May 2009, not a single CMBS was issued in the United 
States.\429\ That changed following the announcement that CMBS 
would become eligible under the TALF. Between June and December 
2009, a total of $2.33 billion of U.S. CMBS was issued.\430\ 
While this figure represents a small fraction of the commercial 
mortgage securitization volume at the market's peak, that peak 
was in part the result of an asset bubble. Given the current 
upheaval in the commercial real estate market--with property 
values plummeting, rents falling and vacancy rates rising--it 
is not clear what a healthy level of commercial mortgage 
securitization would be. It is also not clear how much of the 
partial return of this previously moribund market is 
attributable to the TALF. Of the $2.33 billion in CMBS issued 
in 2009, $72.25 million, or about three percent of the total, 
was financed through the TALF.\431\
---------------------------------------------------------------------------
    \429\ Commercial Real Estate Securities Association, Exhibit 19, 
supra note 146 (accessed Jan. 12, 2010).
    \430\ Commercial Real Estate Securities Association, Exhibit 19, 
supra note 146 (accessed Jan. 12, 2010).
    \431\ Federal Reserve Bank of New York, Term Asset-Backed 
Securities Loan Facility: CMBS (online at www.newyorkfed.org/markets/
CMBS_recent_operations.html) (hereinafter ``Term Asset-Backed 
Securities Loan Facility: CMBS'') (accessed Jan. 22, 2010).
---------------------------------------------------------------------------
    The TALF has financed a larger volume of sales of 
commercial real estate securities in the secondary market. 
Between July and December 2009, $9.22 billion was requested 
through the TALF for legacy CMBS.\432\ As was described above, 
these TALF loans are not providing new financing for the 
commercial real estate market, but they do offer a channel to 
finance the resale of existing real estate debt. As such, they 
provide a government-subsidized channel for the removal of 
troubled commercial real estate assets from bank balance 
sheets. It is important to note, though, that the $9.22 billion 
in TALF funds requested for legacy CMBS represents only about 1 
percent of the approximately $900 billion CMBS market.\433\ In 
comparison to the entire commercial real estate debt market, 
which is valued at over $3 trillion,\434\ the program's impact 
is even smaller. Figure 42 shows the total value of TALF CMBS 
loans requested by month, including both legacy and newly 
issued CMBS.
---------------------------------------------------------------------------
    \432\ See Term Asset-Backed Securities Loan Facility: CMBS, supra 
note 431 (accessed Jan. 22, 2010).
    \433\ Joint Economic Committee, Testimony of Jon D. Greenlee, 
Associate Director, Division of Bank Supervision and Regulation, Board 
of Governors of the Federal Reserve System, Commercial Real Estate 
(July 9, 2009) (online at www.federalreserve.gov/newsevents/testimony/
greenlee20090709a.htm).
    \434\ Board of Governors of the Federal Reserve System, Flow of 
Funds Accounts of the United States: Flows and Outstandings, Third 
Quarter 2009, at 96-97 (Dec. 10, 2009) (online at 
www.federalreserve.gov/Releases/z1/Current/z1r-1.pdf).
          FIGURE 42: TALF CMBS LOANS REQUESTED BY MONTH \435\

---------------------------------------------------------------------------
    \435\ Requested funds do not all result in actual loans; the 
requested figure is used because the FRBNY did not report the amount of 
actual ``settled'' loans until October 2009. Term Asset-Backed 
Securities Loan Facility: CMBS, supra note 431 (accessed Jan. 22, 
2010). 

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    Another way to evaluate the TALF's impact is by assessing 
how the program has affected the market's view of the risk 
associated with real-estate bonds. In particular, the spread 
between the interest rate paid on Treasury notes and the rate 
paid on the highest-rated pieces of CMBS shows the market's 
view of the riskiness of those investments. Prior to the credit 
crunch that began in 2007, these spreads were generally at or 
below 200 basis points. What this means is that if Treasury 
notes were paying four percent interest, the top-rated pieces 
of CMBS generally paid interest of six percent or less. Spreads 
on these bonds rose in 2007 and skyrocketed in 2008, reflecting 
the rise in perceived risk. At their peak, the spreads were 
above 1,000 basis points, meaning that these bonds were paying 
interest rates more than 10 percentage points above the 
Treasury rate.\436\ Needless to say, in such an environment it 
was difficult, if not impossible, to find reasonably priced 
financing for commercial real estate. Spreads began to fall 
around the time that the TALF was introduced in May 2009. By 
the summer of 2009, spreads were back in the range of 400-500 
basis points--still elevated by historical standards, but 
reflecting a healthier real-estate finance market.\437\ Market 
observers attribute the fall in spreads to the announcement 
that CMBS would become eligible under the TALF,\438\ and market 
data support that hypothesis.\439\
---------------------------------------------------------------------------
    \436\ Commercial Real Estate Securities Association, Exhibit 19, 
supra note 146 (accessed Jan. 12, 2010).
    \437\ Commercial Real Estate Securities Association, Exhibit 19, 
supra note 146 (accessed Jan. 12, 2010).
    \438\ See, e.g., Bank of America Merrill Lynch, CMBS Year Ahead: 
2010 Year Ahead: Better, but not Out of the Woods Yet (Jan. 8, 2010) 
(hereinafter ``CMBS Year Ahead: 2010'') (``Of the changes that occurred 
in 2009, we think the introduction of TALF to CMBS was one of the 
biggest drivers of spreads throughout the year. We believe that CMBS 
spreads would have tightened even absent TALF, but to a far lesser 
degree. We think this is true despite the fact that both the new issue 
and the legacy portions have been used less than most people 
anticipated'').
    \439\ In the spring and summer of 2009, spreads on lower-rated 
commercial real-estate bonds, which are not eligible for financing 
under the TALF, did not fall substantially the way that spreads on 
TALF-eligible bonds did. Commercial Real Estate Securities Association, 
Exhibit 19, supra note 146 (accessed Jan. 12, 2010).
---------------------------------------------------------------------------
Still, the TALF's impact on the pricing of credit in the 
commercial real estate market should not be exaggerated. 
Spreads on lower-rated CMBS bonds, which are not eligible under 
the TALF, remain remarkably high--in the range of 3,000-7,000 
basis points as of August 2009.\440\ Spreads on new CMBS deals 
will be lower, because the underlying loans are less risky than 
loans in older CMBS; still, these data help to explain the 
constrained market for new CMBS deals.
---------------------------------------------------------------------------
    \440\ See Commercial Real Estate Securities Association, Exhibit 
19, supra note 146 (accessed Jan. 12, 2010).
---------------------------------------------------------------------------
    In general, though, private actors have been making 
commercial real estate loans on more favorable terms since the 
introduction of the TALF.\441\ And while it is impossible to 
untangle the impact of the TALF from the effect of improved 
economic conditions, it is fair to conclude that when all else 
is equal, a market with a liquidity facility like the TALF will 
almost certainly have narrower spreads and more readily 
available credit than a market that does not have such a 
facility.\442\ The TALF is scheduled to expire this year--the 
last subscriptions secured by legacy CMBS are to be offered in 
March, and the last subscriptions secured by newly issued CMBS 
are to be offered in June.\443\ Many analysts anticipate that 
the program's withdrawal will exacerbate the difficulties 
associated with refinancing commercial real estate loans.\444\ 
Some analysts doubt that credit markets will have sufficient 
capacity to refinance the loans coming due in the next few 
years without additional government liquidity.\445\ If credit 
is available only on less favorable terms, or if the market 
simply contains insufficient credit to accommodate maturing 
commercial real estate loans, then more loans will default at 
maturity, forcing banks to take losses, resulting in greater 
strain on the financial system. On the other hand, Treasury 
states that liquidity has re-entered the commercial real estate 
sector; \446\ three CMBS deals closed late in 2009, including 
two that did not rely on TALF financing.\447\
---------------------------------------------------------------------------
    \441\ See, e.g., David Lynn, Signs of Life Emerge in Commercial 
Real Estate Lending Market, National Real Estate Investor (Dec. 7, 
2009) (online at nreionline.com/finance/news/signs_of_life_emerg_1207/
).
    \442\ See, e.g., U.S. Department of the Treasury, The Consumer and 
Business Lending Initiative: A Note on Efforts to Address 
Securitization Markets and Increase Lending, at 3 (Mar. 3, 2009) 
(online at www.ustreas.gov/press/releases/reports/
talf_white_paper.pdf).
    \443\ Board of Governors of the Federal Reserve System, Press 
Release (Aug. 17, 2009) (online at www.federalreserve.gov/
monetarypolicy/20090817a.htm) (hereinafter ``TALF Extension Press 
Release'').
    \444\ See, e.g., Standard & Poor's, Report From ABS East 2009: 
Securitization Begins To Move Past The Fear, at 10 (Nov. 6, 2009) 
(online at www.securitization.net/pdf/sp/ABS-East_6Nov09.pdf); New Oak 
Capital, TALF for CMBS: A Bridge to Better Days or a Bridge to Nowhere? 
(Feb. 26, 2009) (online at www.newoakcapital.com/market-outlook/?p=67).
    \445\ CCIM Institute, December 2009 Legislative Bulletin, at 1-2 
(Dec. 2009) (online at www.ccim.com/system/files/2009-12-legislative-
bulletin.pdf) (hereinafter ``CCIM Institute Bulletin'').
    \446\ Treasury conversations with Panel staff (Feb. 2, 2010).
    \447\ Strong investor demand surrounded the recent issuance of a 
new CMBS issuance in November 2009, only a portion of which was TALF-
eligible, contributing to narrower than expected spreads. Two non-TALF 
new CMBS issuances followed in December. Anusha Shrivastava, Investors 
Welcome Commercial Mortgage Deal Without TALF, Dow Jones Newswires 
(Nov. 18, 2009) (online at www.nasdaq.com/aspx/company-news-
story.aspx?storyid=200911181112dowjonesdjonline000478); CCIM Institute 
Bulletin, supra note 445, at 1.
---------------------------------------------------------------------------
    The Federal Reserve has previously extended the TALF out of 
a concern that the securitization markets lacked sufficient 
liquidity to function properly on their own, and it could do so 
again.\448\ If the Federal Reserve decides to end the TALF for 
CMBS in the first half of 2010,\449\ the decision will likely 
reflect a judgment that the markets have become healthier or a 
judgment that the TALF is not a solution to those problems that 
continue to plague the commercial real estate markets.
---------------------------------------------------------------------------
    \448\ The Federal Reserve could also extend the new issue CMBS 
portion of TALF, while terminating the legacy securities portion, or 
vice versa. TALF Extension Press Release, supra note 443.
    \449\ One large bank, Bank of America, believes the legacy CMBS 
portion is unlikely to be extended, but assigns a higher probability to 
the extension of the newly issued CMBS portion. CMBS Year Ahead: 2010, 
supra note 438.
---------------------------------------------------------------------------

2. The Public Private Investment Program (PPIP) 

    Treasury announced the PPIP in March 2009. The idea behind 
this program is to combine TARP funds with private investment 
in an effort to spur demand for the troubled assets that have 
been weighing down bank balance sheets. Like the TALF, by 
providing a subsidy to investors, the PPIP is designed to 
increase liquidity in the marketplace. Assets that are eligible 
for purchase under the PPIP include both residential and 
commercial real estate loans. If these assets increase in 
value, the government shares the profits with private 
investors. If the assets lose value, the two parties share the 
losses. The PPIP has two components: a program for buying 
troubled securities, which is now under way; and a program for 
buying troubled whole loans, which has yet to launch on a large 
scale.
    The program for buying troubled securities is known as the 
Legacy Securities PPIP. Treasury has committed $30 billion in 
TARP funds to the program, comprised of $10 billion in equity 
and up to $20 billion in debt. The taxpayer dollars are being 
split between eight separate funds, which are under private-
sector management, and which will also hold private-sector 
investments totaling $10 billion.\450\ The investment funds may 
only buy certain types of securities--specifically, commercial 
and residential mortgage-backed securities that were issued 
prior to 2009 and originally had AAA ratings.\451\ As such, the 
program overlaps with the TALF, providing support to the 
secondary market for commercial mortgage-backed securities, but 
only for the highest-rated bonds. So far, the program's impact 
on the CMBS market appears to be quite limited.\452\ This is in 
part because the program only recently became operational; 
eight investment funds were established between late September 
and mid-December 2009, and as of Dec. 31, 2009, they had 
invested only $3.4 billion. Just $440 million, or 13 percent of 
the total, was spent buying CMBS.\453\ Even in the long term, 
the program appears unlikely to have a large impact on the $900 
billion CMBS market because the investment funds will only be 
able to spend a maximum of $40 billion, and they will likely 
spend the large majority of that money on residential mortgage 
bonds.
---------------------------------------------------------------------------
    \450\ Originally, the $30 billion was to be split between nine 
funds, but Treasury is dissolving one of the funds, the UST/TCW Senior 
Mortgage Securities Fund, under a contractual provision that allowed 
for its dissolution upon the departure of key personnel. The eight 
remaining funds are the Invesco Legacy Securities Master Fund; 
Wellington Management Legacy Securities PPIF Master Fund; 
AllianceBernstein Legacy Securities Master Fund; Blackrock PPIF; AG 
GECC PPIF Master Fund; RLJ Western Asset Public/Private Master Fund; 
Marathon Legacy Securities Public-Private Investment Partnership; and 
Oaktree PPIP Fund. Treasury conversations with Panel staff (Jan. 5, 
2010); U.S. Department of the Treasury, Troubled Asset Relief Program 
Transaction Report for Period Ending February 1, 2010 (Feb. 2, 2010) 
(online at www.financialstability.gov/docs/transaction-reports/2-3-
10%20Transactions%20Report%20as%20of%202-1-10.pdf) (hereinafter 
``Treasury Transaction Report'').
    \451\ For the complete eligibility rules, see U.S. Department of 
the Treasury, Legacy Securities Public-Private Investment Funds, 
Summary of Proposed Terms (Apr. 6, 2009) (online at www.treas.gov/
press/releases/reports/legacy_securities_terms.pdf).
    \452\ CMBS Year Ahead: 2010, supra note 438 (stating that the 
PPIP's arrival led to CMBS purchases by non-PPIP investment managers, 
and that the PPIP has helped to keep CMBS spreads in check, but also 
that the activity of PPIP funds within CMBS has been ``rather muted'').
    \453\ Of the $440 million total, the PPIP funds spent $182 million 
on super-senior tranches of CMBS at a median price of 81.1 percent of 
their par value. They spent $169 million on AM tranches, which were 
below the super-senior tranches but still initially rated AAA, at a 
median price of 72.1 percent of par. And they spent $89 million on AJ 
tranches, which were the lowest-rated AAA tranches, at a median price 
of 64.7 percent of par. U.S. Department of the Treasury, Legacy 
Securities Public-Private Investment Program: Program Update--Quarter 
Ended December 31, 2009 at 4, 6 (Jan. 29, 2010) (online at 
financialstability.gov/docs/External Report--12-09 FINAL.pdf).
---------------------------------------------------------------------------
    The second program, known as the Legacy Loans Program, was 
also announced in March 2009. It has since been indefinitely 
postponed,\454\ although the FDIC says that it continues to 
work on ways to refine the program.\455\ The Legacy Loans 
Program was meant to purchase whole loans from banks, using a 
combination of public and private equity capital and debt 
guaranteed by the FDIC.\456\ The program would have benefitted 
smaller banks that hold whole loans, as opposed to securities. 
At this stage, though, it has not had any impact on the 
commercial real estate market. According to Treasury, the 
program's key problem was that banks that held commercial real 
estate loans were unwilling to sell them at prices investors 
were willing to pay.\457\
---------------------------------------------------------------------------
    \454\ Following a test run in the summer of 2009, which involved 
assets from failed banks, the FDIC has been unable to resolve two major 
problems with the program: (1) how to protect the FDIC from losses if 
the purchased assets lose value; and (2) how to devise a pricing 
mechanism that determines the loans' long-term value and that results 
in sale prices that selling banks would accept. FDIC conversations with 
Panel staff (Jan. 11, 2010); Federal Deposit Insurance Corporation, 
Legacy Loans Program--Winning Bidder Announced in Pilot Sale (Sept. 16, 
2009) (online at www.fdic.gov/news/news/press/2009/pr09172.html) 
(describing results of pilot sale).
    \455\ COP Field Hearing in Atlanta, supra note 70 (Testimony of 
Doreen Eberley).
    \456\ Federal Deposit Insurance Corporation, Legacy Loans Program--
Program Description and Request for Comments (Apr. 15, 2009) (online at 
www.fdic.gov/llp/progdesc.html).
    \457\ Treasury conversations with Panel staff (Feb. 2, 2010).
---------------------------------------------------------------------------
    Both the legacy securities and legacy loan programs, 
moreover, raise two more general points. Unless the CMBS and 
whole loans are bought at or close to par, the purchases will 
not prevent write-downs that can reduce bank capital.\458\ At 
the same time, buying the assets at inflated prices causes its 
own problems, by exposing the government to future losses.\459\
---------------------------------------------------------------------------
    \458\ COP August Oversight Report, supra note 5, at 45-46.
    \459\ COP August Oversight Report, supra note 5, at 45-46.
---------------------------------------------------------------------------

3. The CPP

    A third, albeit indirect way that Treasury has addressed 
the looming problems in commercial real estate is by injecting 
capital into banks. To date, 708 financial institutions have 
received capital injections from the government under the 
TARP's CPP. Providing assistance to commercial real estate 
lenders was never a stated goal of the CPP, but it was one 
effect of the program. Before the CPP expired at the end of 
2009, Treasury used the program to provide nearly $205 billion 
to financial institutions, generally by purchasing preferred 
stock in those institutions. The banks that received CPP funds 
put them to a variety of uses, but one fairly common use was 
for the maintenance of an adequate capital cushion so that the 
bank could absorb losses on its portfolios,\460\ including 
commercial real estate loans.
---------------------------------------------------------------------------
    \460\ Office of the Special Inspector General for the Troubled 
Asset Relief Program, SIGTARP Survey Demonstrates That Banks Can 
Provide Meaningful Information On Their Use of TARP Funds, at 9 (July 
20, 2009) (online at www.sigtarp.gov/reports/audit/2009/
SIGTARP_Survey_Demonstrates_That_Banks_Can_Provide_Meaningfu_Information
 On_Their_Use_Of_TARP_Funds.pdf) (``[M]ore than 40 percent of banks 
reported using some TARP funds to generate capital reserves to help the 
institution remain well-capitalized from a regulatory capital 
perspective'').
---------------------------------------------------------------------------
    The CPP, which was meant to restore stability to the 
financial system, was, perhaps not surprisingly, a blunt 
instrument for remedying the problems related to commercial 
real estate. First, while some banks that received CPP funds 
held large concentrations of commercial real estate loans, a 
large majority of the funds went to big banks,\461\ which, as 
noted earlier, tend to be much less dependent on commercial 
real estate lending than their smaller counterparts.\462\ 
Treasury argues that it could not force small banks to 
participate in the CPP.\463\ But there are also stories of 
small banks that made great efforts to get these funds but were 
denied them,\464\ although it is difficult from the outside to 
assess whether a particular bank met the program's criteria. 
Second, because Treasury did not attach strings to the money it 
provided to CPP recipients--Treasury could have required the 
banks to submit regular lending plans, for example--the flow of 
credit to commercial real estate borrowers, and particularly 
those borrowers who rely on small banks, remained more 
constricted than it might have if the program had been designed 
differently. Third, Treasury closed the CPP at the end of 2009.
---------------------------------------------------------------------------
    \461\ Roughly $163.5 billion of the CPP funds disbursed, or nearly 
80 percent, went to 17 large financial institutions. The 18 
institutions were Citigroup, Bank of America, JPMorgan Chase, Goldman 
Sachs, Morgan Stanley, Wells Fargo, The Bank of New York Mellon, State 
Street, SunTrust, BB&T, Regions Financial, Capital One, KeyCorp, U.S. 
Bancorp, PNC, Fifth Third Bancorp, and American Express. Treasury 
Transaction Report, supra note 450.
    \462\ As of June 2009, large national banks held commercial real 
estate loans valued at 56 percent of their capital, while the same 
percentage for mid-size banks and community banks was 191 percent. 
Testimony of John Dugan, supra note 393, at 25.
    \463\ Treasury conversations with Panel staff (Feb. 2, 2010).
    \464\ See, e.g., Written Testimony of Chris Burnett, supra note 92 
(``The application process was perhaps the most frustrating regulatory 
experience in my 30 years in this business. Our bank applied in 2008 as 
soon as the program was announced. We were finally told to withdraw our 
application in October, 2009, almost a year after the program began. 
Early in the process, we had new capital lined up to invest alongside 
TARP, but after ten months of waiting for an answer, those capital 
sources had dried up'').
---------------------------------------------------------------------------
    Thus, until now, to the extent that the TARP has had any 
impact on the commercial real estate sector, that impact has 
been centered around the CMBS market; the TALF focuses on 
securitizations, and the PPIP is designed to buy legacy 
securities--that is, already-issued mortgage-backed 
instruments. In light of the fact that large banks tend to have 
more exposure to securitized commercial real estate loans than 
smaller banks do, and smaller banks tend to have more relative 
exposure to whole loans,\465\ the TARP's assistance in the 
commercial real estate market has been confined mostly to the 
large financial institutions. While Treasury notes that the 
TALF and the PPIP have had a positive impact on the cost of 
financing throughout the commercial real estate sector,\466\ 
the fact remains that Treasury has not used the TARP to provide 
direct targeted help to smaller banks with commercial real 
estate problems.
---------------------------------------------------------------------------
    \465\ The 20 largest banks have 89.4 percent of the total bank 
exposure to CMBS, as noted in Section E.2, even though they hold only 
57 percent of assets in the banking system. But those same 20 large 
banks have an average commercial real estate exposure equal to 79 
percent of their total risk-based capital--far lower than for banks 
with assets under $10 billion, where the average commercial real estate 
exposure equals 288 percent of total risk-based capital. COP staff 
calculations based on CRE Exposure by Size of Bank, supra note 138.
    \466\ Treasury conversations with Panel staff (Feb. 2, 2010).
---------------------------------------------------------------------------
    This disparity creates a tension with EESA, which contains 
provisions aimed at ensuring that small banks are able to 
benefit from the TARP. The statute directs the Secretary, in 
exercising his authority, to consider ``ensuring that all 
financial institutions are eligible to participate in the 
program, without discrimination based on size, geography, form 
of organization, or the size, type, and number of assets 
eligible for purchase under this Act . . ..'' \467\ The law 
also directs the Secretary to consider providing assistance 
under certain circumstances to financial institutions with 
assets of less than $1 billion.\468\
---------------------------------------------------------------------------
    \467\ 12 U.S.C. Sec. 5213.
    \468\ Specifically, the law refers to financial institutions with 
assets of less than $1 billion that had been adequately capitalized or 
well capitalized but experienced a drop of at least one capital level 
as a result of the 2008 devaluation of Fannie Mae and Freddie Mac 
preferred stock. See 12 U.S.C. 5213.
---------------------------------------------------------------------------

4. Small Banks, Small Business, and Commercial Real Estate

    In October 2009, the Administration announced another TARP 
initiative that held the potential to have an impact on the 
commercial real estate sector, and specifically on small banks 
and the whole loans they tend to hold. The program was to look 
much like the CPP--it would have provided low-cost capital to 
financial institutions--but with modifications aimed at 
remedying some of the CPP's previously mentioned shortcomings. 
First, only small financial institutions--specifically, 
community banks and community development financial 
institutions (CDFIs)--were to be eligible to participate.\469\ 
Second, in order to qualify, the institutions were to submit 
small business lending plans, and the TARP funds would have to 
be used to make qualifying small business loans.\470\
---------------------------------------------------------------------------
    \469\ The proposal stated that participating community banks would 
have access to capital at a dividend rate of 3 percent, compared with 
the 5 percent rate under the CPP. Community development financial 
institutions, which are lenders that serve low-income or underserved 
populations, would be able to borrow at 2 percent. White House, 
President Obama Announces New Efforts to Improve Access to Credit for 
Small Businesses (Oct. 21, 2009) (online at www.whitehouse.gov/assets/
documents/small_business_final.pdf) (hereinafter ``President's Small 
Business Announcement'').
    \470\ President's Small Business Announcement, supra note 469.
---------------------------------------------------------------------------
    Even though commercial real estate was not mentioned in the 
press release announcing this new program, Treasury has noted 
that the problems of commercial real estate and the restricted 
flow of credit to small business are related.\471\ When the 
inability of small businesses to borrow causes them to close 
their doors, vacancy rates increase, which then drag down 
commercial real estate values.\472\ In a recent speech, Dennis 
Lockhart, president of the Federal Reserve Bank of Atlanta, 
expanded on this theme. He spoke about ``the potential of a 
self-reinforcing negative feedback loop'' involving bank 
lending, small business employment, and commercial real estate 
values.\473\ Lockhart noted that small businesses tend to rely 
heavily on smaller financial banks as a source of credit. He 
further noted that smaller financial institutions tend to have 
a larger-than-average concentration in commercial real estate 
lending.\474\ Lastly, he noted that banks with the highest 
levels of exposure to commercial real estate loans account for 
almost 40 percent of all small business loans.\475\ What this 
means is that a small bank that does not make many loans--
perhaps because it is hoarding capital to offset future losses 
in the value of its commercial real estate portfolio--can feed 
a vicious cycle that does additional damage to the bank itself. 
The lack of lending may mean that small businesses that rely on 
the bank as a source of credit will be forced to shut their 
doors. This drives up vacancy rates on commercial real estate 
in the local region, which puts more downward pressure on real 
estate prices, and those falling prices can lead to additional 
write-downs in the bank's commercial real estate portfolio.
---------------------------------------------------------------------------
    \471\ Treasury conversations with Panel staff (Nov. 4, 2009).
    \472\ Treasury conversations with Panel staff (Nov. 4, 2009).
    \473\ Federal Reserve Bank of Atlanta, Speech by President and 
Chief Executive Officer Dennis P. Lockhart to the Urban Land 
Institute's Emerging Trends in Real Estate Conference: Economy 
Recovery, Small Business, and the Challenge of Commercial Real Estate 
(Nov. 10, 2009) (online at www.frbatlanta.org/news/speeches/
lockhart_111009.cfm) (hereinafter ``Lockhart Speech at the Urban Land 
Institute'').
    \474\ Banks with total assets of less than $10 billion accounted 
for only 20 percent of commercial banking assets in the United States, 
but they accounted for almost half of all commercial real estate loans. 
Small banks also accounted for almost half of all small business loans. 
Lockhart Speech at the Urban Land Institute, supra note 473.
    \475\ Lockhart Speech at the Urban Land Institute, supra note 473.
---------------------------------------------------------------------------
    It is therefore possible that a program aimed at improving 
access to credit for small businesses could also have 
beneficial effects on the commercial real estate sector. 
However, the program announced in October 2009 never got off 
the ground. At a Panel hearing in December, Secretary Geithner 
said that banks are reluctant to accept TARP funding and 
participate in the program because they fear being stigmatized, 
and they are concerned about restrictions that the program 
would impose; he said that dealing with those concerns would 
require action by Congress.\476\ Some small banks told Treasury 
that they were not interested in participating--in part because 
of the stigma associated with the TARP, and in part because of 
the TARP's restrictions, including its limits on executive 
compensation.\477\ So in February 2010, Treasury announced that 
it was splitting the small business lending initiative into two 
parts. One part would remain with the TARP, while the other 
much larger part would not.
---------------------------------------------------------------------------
    \476\ Congressional Oversight Panel, Testimony of Treasury 
Secretary Timothy Geithner, at 24 (Dec. 10, 2009).
    \477\ Even though small bank employees generally do not earn as 
much as their counterparts at the largest banks, they are not exempt 
from certain executive compensation restrictions under the TARP. For 
example, restrictions on bonuses and golden parachutes apply to the 
highest paid employees of a TARP-recipient financial institution, 
regardless of the employees' salaries. Treasury conversations with 
Panel staff (Feb. 2, 2010).
---------------------------------------------------------------------------
    Within the TARP, Treasury proposes to provide up to $1 
billion in low cost capital to CDFIs (lending institutions that 
provide more than 60 percent of their small business lending 
and other economic development activities to underserved 
communities).\478\ The plan would allow CDFIs to apply for 
funds up to five percent of their risk-weighted assets. They 
would pay a two percent dividend, well under the CPP's five 
percent dividend rate. CDFIs that already participate in the 
CPP would be allowed to transfer into this new program. If the 
CDFI's regulator determines that it is not eligible to 
participate, it would be allowed to take part in a matching 
program. Under the matching program, Treasury would match 
private funds raised on a dollar-for-dollar basis, as long as 
the institution would be viable after the new capital has been 
raised.\479\ As announced, the CDFI program does not include 
any requirement that the participating financial institutions 
increase their small business lending. Treasury says that 
CDFIs, by virtue of their mission of lending in underserved 
areas, are already fulfilling the Administration's lending 
objectives.\480\
---------------------------------------------------------------------------
    \478\ U.S. Department of the Treasury, Obama Administration 
Announces Enhancements for TARP Initiative for Community Development 
Financial Institutions (Feb. 3, 2010) (online at 
www.financialstability.gov/latest/pr_02032010.html) (hereinafter 
``Community Development Announcement'').
    \479\ Treasury will not provide capital until the CDFI has raised 
the private funds, and Treasury's contribution will be senior to the 
private investment. Community Development Announcement, supra note 478; 
Treasury conversations with Panel staff (Feb. 2, 2010).
    \480\ Treasury conversations with Panel staff (Feb. 2, 2010).
---------------------------------------------------------------------------
    President Obama announced the second part of the small 
business lending initiative during his recent State of the 
Union Address.\481\ It would require legislation, and would 
establish a new $30 billion Small Business Lending Fund outside 
of the TARP. The program would be aimed at midsized and 
community banks, those with assets under $10 billion, which 
have less than 20 percent of all bank assets but account for 
more than 50 percent of small business lending.\482\ Because 
the funds would not be provided through the TARP, participating 
banks would not be subject to the TARP's restrictions, 
including those on executive compensation.\483\ The Fund would 
provide capital to those banks with incentives for them to 
increase their small business lending. The dividend rate paid 
by participating banks would be five percent, but it would 
decrease by one percent for every two and a half percent 
increase in incremental small business lending over a two-year 
period, down to a minimum dividend rate of one percent.\484\ 
Consequently, banks that increase their small business lending 
by at least two and a half percent would get the money on more 
favorable terms than were available under the CPP. Banks could 
borrow up to between three and five percent of risk weighted 
assets, depending on the size of the institution.\485\ As with 
the CDFI program, financial institutions that currently 
participate in the CPP would be able to convert their capital 
into the new program.\486\
---------------------------------------------------------------------------
    \481\ State of the Union Remarks, supra note 132.
    \482\ White House, Administration Announces New $30 Billion Small 
Business Lending Fund (Feb. 2, 2010) (online at www.whitehouse.gov/
sites/default/files/FACT-SHEET-Small-Business-Lending-Fund.pdf) 
(hereinafter ``Administration Announces Small Business Lending Fund'').
    \483\ Id.
    \484\ The baseline for the bank's small business lending would be 
2009. Id.
    \485\ Banks with less than $1 billion in assets would be eligible 
to receive capital equal to as much as five percent of their risk-
weighted assets, while banks with between $1 billion and $10 billion in 
assets could receive capital equal to as much as three percent of their 
risk-weighted assets. Id.
    \486\ Id.
---------------------------------------------------------------------------
    Banks received another signal aimed at spurring small 
business lending--this time from their supervisors--in a 
February 5, 2010 interagency statement. The document cautions 
that financial institutions may sometimes become overly 
cautious in small business lending during an economic downturn, 
and states that bank examiners will not discourage prudent 
small business lending.\487\
---------------------------------------------------------------------------
    \487\ Federal Deposit Insurance Corporation, Office of the 
Comptroller of the Currency, Board of Governors of the Federal Reserve 
System, Office of Thrift Supervision, National Credit Union 
Administration, Conference of State Bank Supervisors, Interagency 
Statement on Meeting the Credit Needs of Creditworthy Small Business 
Borrowers (Feb. 5, 2010) (online at www.federalreserve.gov/newsevents/
press/bcreg/bcreg20100205.pdf).
---------------------------------------------------------------------------
    At this stage it is unclear whether the Small Business 
Lending Fund will have a significant impact on small business 
lending and, by extension, commercial real estate. The first 
hurdle the program faces is getting congressional 
authorization.\488\ Even if that happens, it remains an open 
question whether a sufficiently large number of banks will 
choose to participate. And even if many banks do participate, 
it is unclear whether it will result in a large increase in 
small business lending. Unlike the Administration's initial 
plan, the new program encourages banks to increase their small 
business lending, but does not require them to submit quarterly 
reports detailing those lending activities.\489\
---------------------------------------------------------------------------
    \488\ In addition to the Administration's proposal, members of 
Congress have made proposals to increase small business lending. For 
example, in late 2009, Senator Mark Warner (D-VA) and 32 other senators 
proposed the creation of a loan pool, using $40 billion of TARP funds 
and an additional $5 billion-$10 billion contributed by participating 
banks. Participating banks would make small business loans from this 
pool, and the funds would remain off the banks' balance sheets, so that 
they could not be used to bolster capital levels rather than to make 
loans. Senator Mark Warner, Press Release, Warner Urges Action to 
Revive Lending to Small Businesses (Oct. 21, 2009) (online at 
warner.senate.gov/public/
index.cfm?p=PressReleases&ContentRecord_id=7dd28f00-d69f-44e4-a6b9-
8826c1106a88&ContentType_id=0956c5f0-ef7c-478d-95e7-
f339e775babf&MonthDisplay=10&YearDisplay=2009). Senator Cardin has also 
proposed that Treasury and the Small Business Administration jointly 
establish a small business lending fund, using $30 billion from the 
TARP. Under this proposal, loans would ``have the same terms and 
conditions as, and may be used for any purpose authorized for, a direct 
loan under section 7(a) of the Small Business Act.'' Boosting 
Entrepreneurship and New Jobs Act, Section 5, S. 2967 (Jan. 28, 2010).
    \489\ President's Small Business Announcement, supra note 469.
---------------------------------------------------------------------------

5. What Approach to Take?

    This report has outlined the risks posed by the current and 
projected condition of commercial real estate. A second wave of 
real-estate driven bank difficulties, even if not as large as 
the first, can have an outsize effect on a banking sector 
weakened by both the current crisis and by the economy 
remaining in a severe recession. In the same way, even if 
smaller absolute numbers are involved, a second wave of bank 
losses and defaults can have a serious effect on public access 
to banking facilities in smaller communities, lending to small 
business, and more importantly, on confidence in the financial 
system. The system, as noted above, cannot, and should not, 
keep every bank afloat. But neither should it turn a blind eye 
to the impact of unnecessary bank consolidation. And the 
failure of mid-size and small banks because of commercial real 
estate might even require a significant recapitalization of the 
FDIC with taxpayer funds.
    As the report has pointed out, the risks are not limited to 
banks and real estate developers. A wave of foreclosures can 
affect the lives of employees of retail stores, hotels, and 
office buildings, and residents of multifamily buildings. It 
can reduce the strength of the economic recovery, especially 
the small business recovery. And it can change the character of 
neighborhoods that contain foreclosed buildings whose condition 
is deteriorating.
    Moreover, worries about the problems facing commercial real 
estate may already be adding to the very credit crunch that, by 
limiting economic growth, makes those risks more likely to 
mature. In the words of Martin Feldstein, professor of 
economics at Harvard University and a former chair of the 
Council of Economic Advisors:

          Looking further ahead, it will be difficult to have a 
        robust recovery as long as the residential and 
        commercial real estate markets are depressed and the 
        local banks around the country restrict their lending 
        because of their concern about possible defaults on 
        real estate loans.\490\
---------------------------------------------------------------------------
    \490\ Martin Feldstein, U.S. Growth in the Decade Ahead, American 
Economics Association (online at www.aeaweb.org/aea/conference/program/
retrieve.php?pdfid=449).

    The risks on the horizon could open a way to undoing what 
the TARP has accomplished, but any crisis triggered by problems 
in commercial real estate will reach fruition after the 
Secretary's TARP authority expires at the beginning of October 
2010. Loans generated during the bubble period are likely to go 
bad in substantial numbers; LTVs, and even loan servicing, for 
other properties have dropped despite what may have been 
careful underwriting of the initial loans. It is unlikely, 
however, that the actual extent of the projected difficulties 
can be determined until the onset of the refinancing cycles 
that begin in 2011-13 and beyond (that may themselves be 
subject to extensions or workouts).
    Supervisors, industry, Congress, and the public could 
consider one, or a combination of the approaches discussed 
below. The Panel takes no position on which are preferable, 
other than to note that any continued subsidization with 
taxpayer funds creates substantial additional problems. 
Continued subsidization is not an essential element of any 
solution.
            a. Mid-Size and Small Banks
    According to witnesses at the Panel's field hearing, adding 
capital to banks whose commercial real estate exposure exceeds 
a certain level, is composed of a higher proportion of low 
quality properties, or both, could provide a cushion against 
potential commercial real estate losses.\491\ Capital additions 
could be supplemented by attempts to remove especially risky 
assets from bank balance sheets altogether through a public or 
private purchase program (perhaps a structure that is a variant 
of the never-used legacy loans program). Either way it will be 
essential to manage potential bank exposures carefully in light 
of economic conditions. This means forcing immediate write-
downs where necessary to reflect the true condition of an 
institution holding a high percentage of the weakest commercial 
mortgages, in order to protect both bank creditors and the 
FDIC. But it also means recognizing that managing risk involves 
difficult judgments about the level LTVs will ultimately reach 
at the time refinancing is required and working with borrowers 
to prevent foreclosure when new equity and improved economic 
conditions can make loans viable.
---------------------------------------------------------------------------
    \491\ COP Field Hearing in Atlanta, supra note 70.
---------------------------------------------------------------------------
    Capital enhancement and removal of troubled assets from 
balance sheets could be the subject of a revised government 
effort under the TARP (or thereafter). Stronger banks could be 
induced to offer packages of those loans for purchase by 
investment vehicles combining TARP and private capital, at 
manageable discounts (perhaps also reflecting Treasury 
guarantees). Treasury could use its EESA authority to create a 
guarantee fund for loans held by banks below a certain size, 
upon payment of regular premiums, to support commercial real 
estate loans that meet defined standards, preventing write-offs 
and aiding in refinancing. The agencies could revive and expand 
the PPIP legacy loans program and create a fund, through either 
the FDIC or the Federal Reserve System, that can support the 
purchase of legacy loans after October 3, 2010. And the TALF 
could be extended for both legacy and new CMBS, either to 
complement other actions or to keep the securitization markets 
liquid.\492\
---------------------------------------------------------------------------
    \492\ If the potential crisis that the report identifies comes to 
pass, stronger action could prove necessary to prevent unwarranted bank 
failures. As the Panel discussed in its April and January Reports, at 
pages 39 and 23 respectively, the Emergency Banking Act of 1933 
authorized the Reconstruction Finance Corporation to make preferred 
stock investments in financial institutions and instituted procedures 
for reopening sound banks and resolving insolvent banks. As part of the 
effort to restore confidence in the banking system, only banks liquid 
enough to do business were to be reopened when President Roosevelt's 
nation-wide banking holiday was lifted. As part of the process, banks 
were separated into three categories, based on an independent valuation 
of assets conducted by teams of bank examiners from the RFC, Federal 
Reserve Banks, Treasury, and the Comptroller of the Currency. The 
categories comprised: (1) banks whose capital structures were 
unimpaired, which received licenses and reopened when the holiday was 
lifted; (2) banks with impaired capital but with assets valuable enough 
to repay depositors, which remained closed until they could receive 
assistance from the RFC; and (3) banks whose assets were incapable of a 
full return to depositors and creditors, which were placed in the hands 
of conservators who could either reorganize them with RFC assistance or 
liquidate them. See James S. Olson, Saving Capitalism: The 
Reconstruction Finance Corporation and the New Deal, 1933-1940, at 64 
(1988).
---------------------------------------------------------------------------
    But there are also arguments for another approach, based on 
a conclusion that the problem of commercial real estate can 
only be worked through by a combination of private market and 
regulatory action. Any government capital support program can 
create as much moral hazard for small banks as for large 
financial institutions, and government interference in the 
marketplace could result in bailing out the imprudent, 
upsetting the credit allocation function of the capital 
markets, or protecting developers and investors from the 
consequences of their decisions.
    ``Awareness'' on the part of both the private and public 
sectors would be the hallmark of the second approach. The 
supervisors would manage their supervisory responsibilities for 
the safety and soundness of the banking system and individual 
institutions to allow failures where necessary and apply 
guidance to give more soundly capitalized banks breathing room 
for economic recovery. Banks that should fail on the basis of 
an objective assessment of their record and prospects would be 
allowed to fail. Commercial real estate lenders and borrowers 
(who are business professionals) would understand that the 
government would not automatically come to their rescue and 
that taking on new equity, taking losses, admitting true 
positions and balance sheets, were all necessary. They would 
know that if they agreed to refinancing based on faulty 
underwriting or unrealistic expectations of economic growth, 
traffic in particular retail establishments or the prospects of 
changing the occupancy rates and rents in multifamily 
buildings, they were doing so at their own risk.
            b. Large Banks
    The situation of the large banks is more complicated. 
Although it is impossible to predict whether CMBS exposure 
poses a risk of reigniting a financial crisis on the order of 
2008, there are disquieting similarities between the state of 
the RMBS markets then and the CMBS markets now. To be sure, 
there are some important differences; asset quality is 
reportedly higher, pools are smaller, and the supervisors have 
at least promised more extensive monitoring.\493\ But if the 
economy does not recover in time, a high default rate remains a 
possibility (or, in the view of some observers, more than a 
possibility).\494\ No one agrees on the point at which default 
levels can cause a severe break in CMBS values, but a break 
could trigger the same round of capital-threatening write-downs 
and counterparty liability that marked the financial crisis of 
mid-2007. Again, more flexible extension and workout terms can 
buy time until the economy recovers and values strengthen 
sufficiently to permit the return of the markets to normal 
parameters. But without a willingness to require loss 
recognition on appropriate terms, postponement will be just 
that.
---------------------------------------------------------------------------
    \493\ The degree to which that monitoring is in fact occurring and 
is matched by appropriately strong regulatory action is outside the 
scope of this report, as is the degree to which bank auditing is 
sufficiently strict to prevent financial reporting distortions.
    \494\ COP Field Hearing in Atlanta, supra note 70, at 50 (Testimony 
of Doreen Eberley).
---------------------------------------------------------------------------
    Given the stress tests and promises of greater regulatory 
and market vigilance, it may be that the large institution 
sector can be left without additional assistance. But for that 
to be a safe approach, supervisors must monitor risk and not 
hesitate to increase capital to offset prospective losses in 
place of the capital that came from Treasury during the TARP. 
Without stronger supervision, the risks of commercial real 
estate even for large institutions are not negligible. The 
willingness of supervisors to engage in such supervision before 
the fact is the most important factor in preventing those risks 
from occurring.

                             J. Conclusion

    There is a commercial real estate crisis on the horizon, 
and there are no easy solutions to the risks commercial real 
estate may pose to the financial system and the public. An 
extended severe recession and continuing high levels of 
unemployment can drive up the LTVs, and add to the difficulties 
of refinancing for even solidly underwritten properties. But 
delaying write-downs in advance of a hoped-for recovery in mid- 
and longer-term property valuations also runs the risk of 
postponing recognition of the costs that must ultimately be 
absorbed by the financial system to eliminate the commercial 
real estate overhang.
    It should be understood that not all banks are the same. 
There are ``A'' banks, those who have operated on the most 
prudent terms and have financed only the strongest projects. 
There are ``B'' banks, whose commercial real estate portfolios 
have weakened but are largely still based on performing loans. 
There are ``C'' banks, whose portfolios are weak across the 
board. The key to managing the crisis is to eliminate the C 
banks, manage the risks of the B banks, and to avoid 
unnecessary actions that force banks into lower categories.
    Any approach to the problem raises issues previously 
identified by the Panel: the creation of moral hazard, 
subsidization of financial institutions, and providing a floor 
under otherwise seriously undercapitalized institutions. That 
should be balanced against the importance of the banks involved 
to local communities, the fact that smaller banks were not the 
recipients of substantial attention during the administration 
of the TARP, and the desire that any shake-out of the community 
banking sector should proceed in a way that does not repeat the 
pattern of the 1980s. The alternative, illustrated by recent 
actions of the FDIC, is to accept bank failures, and, when 
write-downs are no longer a consideration, sell the assets at a 
discount, and either create a partnership with the buyers to 
realize future value (as was done in the Corus Bank situation) 
or absorb the losses.
    There appears to be a consensus, strongly supported by 
current data, that commercial real estate markets will suffer 
substantial difficulties for a number of years. Those 
difficulties can weigh heavily on depository institutions, 
particularly mid-size and community banks that hold a greater 
amount of commercial real estate mortgages relative to total 
size than larger institutions, and have--especially in the case 
of community banks--far less margin for error. But some aspects 
of the structure of the commercial real estate markets, 
including the heavy reliance on CMBS (themselves backed in some 
cases by CDS) and the fact that at least one of the nation's 
largest financial institutions holds a substantial portfolio of 
problem loans, mean that the potential for a larger impact is 
also present.
    There is no way to predict with assurance whether an 
economic recovery of sufficient strength will occur to reduce 
these risks before the large-scale need for commercial mortgage 
refinancing that is expected to begin in 2011-2013. The 
supervisors bear a critical responsibility to determine whether 
current regulatory policies that attempt to ease the way for 
workouts and lease modifications will hold the system in place 
until cash flows improve, or whether the supervisors must take 
more affirmative action quickly, as they attempted to do in 
2006, even if such action requires write-downs (with whatever 
consequences they bring for particular institutions). And, of 
course, they must be especially firm with individual 
institutions that have large portfolios of loans for projects 
that should never have been underwritten.
    The stated purpose of the TARP, and the purpose of 
financial regulation, is to assure financial stability and 
promote jobs and economic growth. The breakdown of the 
residential real estate markets triggered economic consequences 
throughout the country. Treasury has used its authority under 
the TARP, and the supervisors have taken related measures in 
ways they believe will protect financial stability, revive 
economic growth, and expand credit for the broader economy.
    The Panel is concerned that until Treasury and bank 
supervisors take coordinated action to address forthrightly and 
transparently the state of the commercial real estate markets--
and the potential impact that a breakdown in those markets 
could have on local communities, small businesses, and 
individuals--the financial crisis will not end.
     Annex I: The Commercial Real Estate Boom and Bust of the 1980s

    As indicated in the main text,\495\ the initial boom of the 
1980s was so great that between 1980 and 1990 the total value 
of commercial real estate loans issued by U.S. banks tripled, 
representing an increase from 5.8 percent to 11.0 percent of 
banks' total assets.\496\ Several factors converged to cause 
the real estate crash of the late 1980s: growth in demand, 
economic conditions, tax incentives, a descent into faulty 
practices, and lax regulatory policies.
---------------------------------------------------------------------------
    \495\ See Section B.
    \496\ This does not include the quantities being loaned by credit 
unions or thrift institutions. See History of the Eighties, supra note 
36, at 153.
---------------------------------------------------------------------------
    Although the commercial real estate market was not the only 
market suffering a downturn at this time, and therefore cannot 
be labeled as the only cause of these failures, an analysis of 
bank assets indicates that those institutions which had 
invested heavily in commercial real estate during the preceding 
decade were substantially more likely to fail than those which 
had not.
    The majority of lending institutions that failed were from 
specific geographic regions: ones which had been economically 
prosperous in the early 1980s and had therefore attracted the 
greatest levels of investment and generated the most inflated 
real estate prices. The failing banks and thrifts also tended 
to be small, regional institutions. These, unlike their 
national counterparts, could not hedge their bets by lending in 
multiple regions; their loans were made in a more concentrated 
and inflated property market. Furthermore, in the interest of 
economic stability, the federal banking and savings and loan 
deposit insurance agencies, the Federal Deposit Insurance 
Corporation, and the Federal Home Loan Bank Board, seemed 
willing to extend protections to large banks that it would not 
offer to local thrifts. For example, they agreed to extend 
coverage to the uninsured depositors of certain large banks but 
would not offer similar treatment to regional savings and 
loans.\497\ This is not to say that the large institutions were 
unharmed; the large banks and thrifts had thrown themselves 
into commercial real estate lending with greater vigor than the 
smaller ones and had allowed these loans to account for a far 
greater proportion of their assets. As a result, and in spite 
of their advantages, many large banks came to the brink of 
collapse as well.
---------------------------------------------------------------------------
    \497\ See History of the Eighties, supra note 36, at 151 (Dec. 
1997).
    FIGURE 43: TOTAL VALUE OF COMMERCIAL REAL ESTATE LOANS BY U.S. 
                         COMMERCIAL BANKS \498\

      
---------------------------------------------------------------------------
    \498\ See Cole and Fenn, supra note 43, at 21. A comparable chart 
for current values of commercial real estate loans by U.S. banks is 
provided in Section E on page 46.

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    FIGURE 44: TOTAL VALUE OF COMMERCIAL REAL ESTATE LOANS BY U.S. 
                         COMMERCIAL BANKS \499\

      
---------------------------------------------------------------------------
    \499\ See Cole and Fenn, supra note 43, at 21. 

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
    
1. Demand for Office Space and Regional Impact

    During the 1970s, increasing rates of inflation made real 
estate a popular investment.\500\ Furthermore, with the United 
States shifting away from manufacturing toward a more services-
based economy, there was a growing demand for additional office 
space. From the late 1970s until the end of the 1980s (with the 
exception of 1982), the number of people working in offices 
grew by more than four percent every year.\501\ Existing office 
space was fully absorbed, and by 1980, the office vacancy rate 
had fallen to 3.8 percent.\502\ There was, therefore, 
significant demand for the construction of new workspace in 
most major U.S. markets.\503\
---------------------------------------------------------------------------
    \500\ See Lynn E. Browne and Karl E. Case, ``How the Commercial 
Real Estate Boom Undid the Banks,'' in Real Estate and the Commercial 
Real Estate Crunch, at 61 (1992) (online at www.wellesley.edu/
Economics/case/PDFs/banks.pdf) (hereinafter ``Browne and Case 
Article'').
    \501\ See History of the Eighties, supra note 36, at 92.
    \502\ See History of the Eighties, supra note 36, at 93.
    \503\ See Garner Economic Review Article, supra note 34, at 93-94.
---------------------------------------------------------------------------
    Despite this high demand, the increase in supply that was 
forthcoming proved to be excessive. All sectors of commercial 
real estate experienced a boom in the early 1980s, but 
investments in office space were the ones yielding the highest 
returns, and the majority of new construction loans were for 
the building of office space.\504\ Office construction 
increased by 221 percent between 1977 and 1984,\505\ meaning 
that in spite of steadily increasing demand, office vacancy 
rates rose rapidly.\506\ Although investment began to level off 
in 1986, office vacancy rates reached 16.5 percent and then 
began climbing toward 20 percent during the credit crunch of 
the early 1990s.
---------------------------------------------------------------------------
    \504\ See History of the Eighties, supra note 36, at 141, 145.
    \505\ See History of the Eighties, supra note 36, at 143.
    \506\ See Garner Economic Review Article, supra note 34, at 93.
---------------------------------------------------------------------------
    Demand for office space was a driving factor for the boom 
and is one of the reasons why the majority of lending 
institution failures are centered on specific regions. Although 
most of the country saw fluctuations in commercial real estate 
values and the whole country suffered from the fallout of the 
crisis, the most significant swings in property values occurred 
in states or regions which had comparatively prosperous 
economies in the early 1980s, such as Arizona, Arkansas, 
California, Florida, Kansas, Oklahoma, Texas, and the 
Northeast.\507\ These areas' strong economies had more growing 
businesses and investors, which heightened their demand for 
office space, and therefore increased both the amount of 
overbuilding and the amount of real estate investment that 
occurred there during the 1980s.\508\
---------------------------------------------------------------------------
    \507\ See History of the Eighties, supra note 36, at 13-26.
    \508\ See History of the Eighties, supra note 36, at 13-26.
---------------------------------------------------------------------------

          FIGURE 45: OFFICE VACANCY RATE FROM 1979-1990 \509\

---------------------------------------------------------------------------
    \509\ See Garner Economic Review Article, supra note 34, at 93. 

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
    
     FIGURE 46: INCREASE IN OFFICE EMPLOYMENT FROM 1979-1990 \510\

---------------------------------------------------------------------------
    \510\ See History of the Eighties, supra note 36, at 146. 

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
    
2. Tax Law Changes

    The Economic Recovery Tax Act of 1981 (ERTA) incentivized 
investment in commercial real estate by introducing an 
Accelerated Cost Recovery System (ACRS) which dramatically 
improved the rate of return on commercial properties.\511\ 
During the 1970s, the high rate of inflation had reduced the 
value of depreciation tax deductions on commercial 
buildings.\512\ The ACRS resolved this by shortening building 
lives from 40 years to 15 and by allowing investors to use a 
175 percent declining-balance method of depreciation rather 
than simple straight-line depreciation.\513\ These measures 
increased the tax deductions which were available in the early 
years of a property's holding period. The ACRS also made 
commercial real estate investments a useful tax shelter for 
high-income individuals. A commercial property could be 
financed largely by debt (which conferred additional tax 
advantages), depreciated at an accelerated rate, and then sold 
for a capital gain to others who wished to repeat the 
process.\514\ Furthermore, the passive losses which an investor 
suffered prior to the resale could be deducted from ordinary 
income for tax purposes.\515\ Not surprisingly, the period 
after 1981 saw a sharp increase in investments in commercial 
real estate.\516\
---------------------------------------------------------------------------
    \511\ See Joint Committee on Taxation, General Explanation of the 
Economic Recovery Tax Act of 1981, at 68-69 (Dec. 19, 1981) (online at 
www.archive.org/stream/generalexplanati00jcs7181#page/n1/mode/2up) 
(hereinafter ``Economic Recovery Tax Act of 1981'').
    \512\ See Browne and Case Article, supra note 500, at 63.
    \513\ See Economic Recovery Tax Act of 1981, supra note 511, at 68-
69.
    \514\ See James R. Hines, ``The Tax Treatment of Structures,'' in 
The Effects of Taxation on Capital Accumulation (1987).
    \515\ See Browne and Case Article, supra note 500, at 64.
    \516\ See Garner Economic Review Article, supra note 34, at 93.
---------------------------------------------------------------------------
    The Tax Reform Act of 1986 eliminated many of the 
advantages which ERTA had created for commercial real estate 
investors.\517\ The ACRS was removed, and losses from passive 
activities, such as real estate investment could no longer be 
deducted from active sources of income. These developments 
limited the profitability of commercial real estate 
development, curtailing investor interest and prompting a 
general softening of property prices.\518\
---------------------------------------------------------------------------
    \517\ See Andrew A. Samwick, ``Tax Shelters and Passive Losses 
after the Tax Reform Act of 1986,'' in Empirical Foundations of 
Household Taxation, at 193-223 (1996).
    \518\ See Garner Economic Review Article, supra note 34, at 93.
---------------------------------------------------------------------------

3. Inflation, Interest Rates, and the Deregulation of Thrift 
        Institutions

    During the late 1970s, the unexpected doubling of oil 
prices helped drive inflation into the double digits.\519\ The 
Federal Reserve moved under Chairman Paul Volcker to break the 
inflation cycle by dramatically increasing the federal funds 
rate in 1979, which in turn caused a sharp increase in interest 
rates in general.\520\ The funding liabilities of lending 
institutions (the amount of interest they had to pay on their 
short-term loans) increased sharply as well. This put thrifts 
in a bind because they specialized in residential mortgages, 
which meant that their main source of income was the repayments 
on long-term mortgages with low, fixed interest rates.\521\ 
With the revenue from these low-interest loans now being 
surpassed by their losses on high-interest borrowing, many 
thrifts faced an unsustainable asset-liability gap that put 
them on the path to insolvency.\522\ The situation was 
exacerbated when Regulation Q--which had placed ceilings on the 
interest rates which saving institutions could offer to 
depositors--was phased out between 1980 and 1982.\523\ In order 
to remain competitive, thrifts therefore had to start offering 
interest rates to savers which matched or bettered inflation, 
which increased their funding liabilities even further.\524\ 
This higher interest rate environment was also highly 
detrimental to the ability of borrowers, such as real estate 
investors, to refinance their loans, further exacerbating the 
economic contraction that was then underway.
---------------------------------------------------------------------------
    \519\ There is now general agreement that the surge in inflation in 
the late 1970s resulted from both excessive fiscal stimulus (fiscal 
deficits over this period were -2.7 percent in 1977 and 1978, 1.6 
percent in 1979, and 2.7 percent in 1980) and loose monetary policy. 
The budget deficits in the 1970s were the largest since the end of 
World War II. Congressional Budget Office, A 125 Year Picture of the 
Federal Government's Share of the Economy, 1950 to 2075 (online at 
www.cbo.gov/doc.cfm?index=3521&type=0) (accessed Feb. 9, 2010). See 
also Congressional Budget Office, Budget and Economic Outlook: 
Historical Budget Data, January 2010 (online at www.cbo.gov/ftpdocs/
108xx/doc10871/historicaltables.pdf) (accessed Feb. 9, 2010).
    \520\ See Federal Reserve Bank of St. Louis, The Reform of October 
1979: How It Happened and Why, remarks by D.E. Lindsey, A. Orphanides, 
and R.H. Rasche at the Conference on Reflections on Monetary Policy 25 
Years after October 1979 (Oct. 2004) (online at 
research.stlouisfed.org/conferences/smallconf/lindsey.pdf).
    \521\ See Rob Jameson, Case Study/US Savings & Loan Crisis (Aug. 
2002) (online at erisk.com/learning/casestudies/
ussavingsloancrisis.asp) (hereinafter ``Jameson Case Study'').
    \522\ See Jameson Case Study, supra note 521.
    \523\ See Jameson Case Study, supra note 521.
    \524\ See Jameson Case Study, supra note 521.
---------------------------------------------------------------------------
    Rather than allow the thrifts to fail, Congress decided to 
loosen the regulations on these institutions' lending practices 
so that they would be able to experiment with new methods of 
generating revenue. The Depository Institutions Deregulation 
and Monetary Control Act of 1980, followed by the Garn-St 
Germain Depository Institutions Act of 1982, significantly 
reduced the amount of capital which thrifts had to keep in 
their mandatory reserve accounts at Federal Reserve Banks and 
increased the proportions of their total assets which could be 
used for consumer and commercial loans. They also increased the 
amounts which the FDIC would guarantee from $40,000 per account 
to $100,000, meaning that even if a thrift's financial future 
was uncertain, the average saver would not feel he were taking 
as much risk by maintaining an account there. Further, the 
thrift industry's regulator, the Federal Home Loan Bank Board, 
set regulatory standards that allowed savings and loans broad 
latitude in the resources that could be counted as capital. 
Thrifts now had the opportunity to engage in riskier lending 
and investing with the hope of achieving increased 
profitability in new and uncertain markets, with the added 
confidence of knowing that they would not lose depositors by 
doing so.

4. Competition Among Lending Institutions and Lax Lending Practices

    Thrifts were not the only lending institutions which felt 
pushed to take greater risks. The 1980s had brought challenges 
to banks' profitability. The high interest rates and 
elimination of Regulation Q had affected banks as well as 
thrifts, increasing their costs of doing business. 
Simultaneously, the number of lenders was on the rise; in 
addition to the thrifts moving into new markets, approximately 
2,800 new banking charters were granted in the 1980s, and the 
rapid growth of the commercial paper market had taken a 
sizeable proportion of banks' commercial and industrial lending 
business.\525\ In the face of this increased competition, banks 
became more willing to take risky investments on the principle 
that ``if we don't make the loan, the institution across the 
street will.'' \526\
---------------------------------------------------------------------------
    \525\ See History of the Eighties, supra note 36, at 154.
    \526\ See History of the Eighties, supra note 36, at 154.
---------------------------------------------------------------------------
    In this difficult lending environment, commercial real 
estate loans were an attractive revenue earner. The booming 
commercial real estate market made nonperformance seem 
unlikely, and commercial real estate lending involved large, 
up-front fees.\527\ For struggling institutions--both banks and 
thrifts--this sort of immediate income could be essential.
---------------------------------------------------------------------------
    \527\ See Garner Economic Review Article, supra note 34, at 93.
---------------------------------------------------------------------------
    Competition for commercial real estate loans rapidly 
intensified. In order to secure the largest possible share of 
this booming market, lending institutions started to engage in 
risky business practices. Many lowered their maximum LTV 
ratios, decreasing the amount of borrowers' equity at risk and 
increasing the potential loss to the lender.\528\ Some became 
less rigorous in enforcing principal payment schedules, and 
would allow principal payments to be renewed repeatedly or 
unpaid interest simply to be added to the unpaid principal 
(practices which were uncommon prior to the 1980s).\529\ 
Perhaps most significantly, underwriting standards in some 
cases became laxer. Traditionally, the decision to extend a 
loan collateralized by commercial real estate was made by 
evaluating whether the project in which the borrower wished to 
invest was likely to generate sufficient earnings to cover the 
debt payments. As a backup measure, lenders would evaluate the 
value of the collateralized investment property and whether it 
would cover the value of the loan if the borrower defaulted. 
From the late 1970s onward, lenders started to place increasing 
emphasis on the backup criterion and less on whether the 
project was likely to succeed.\530\ This might not have been 
dangerous were it not for the fact that property valuations 
were being increasingly inflated as well. Once the market began 
to decline in the late 1980s, lenders found not only that their 
borrowers were defaulting but that the sale of foreclosed 
properties would not recoup their loan principal.
---------------------------------------------------------------------------
    \528\ See History of the Eighties, supra note 36, at 155.
    \529\ See History of the Eighties, supra note 36, at 155.
    \530\ See History of the Eighties, supra note 36, at 155.
---------------------------------------------------------------------------

5. Faulty Appraisals

    Before committing funds to a real estate loan, federally 
insured deposit institutions are required to hire an outside 
appraiser to deliver an independent opinion on the collateral 
value of the property in question. This is to ensure that an 
informed but impartial individual is present who can assess the 
project's viability and hopefully steer the lender away from 
risky loans.\531\ However, prior to 1987, federal bank 
examiners had very few guidelines for how to assess an 
appraiser's credibility, and state licensing standards for 
appraisers were practically non-existent.\532\ A federal review 
of appraisal practices in the mid-1980s revealed that many 
appraisers had embraced the flawed belief that the real estate 
boom was sustainable and had tended to over-value properties as 
a result.\533\ Since there were no mechanisms by which 
appraisers could be held accountable for faulty appraisals, 
they had never had sufficient motivation to analyze whether 
their assumptions were accurate.\534\ Furthermore, the 
commercial real estate market was growing so rapidly in the 
early 1980s that many appraisal offices had to hire new and 
inexperienced appraisers, who were less likely to question the 
prevailing wisdom that commercial property values would 
continue to increase.\535\ For all these reasons, appraisals 
failed to provide a reliable check on risky lending in the 
early 1980s and helped contribute to the severity of the bust 
which followed.
---------------------------------------------------------------------------
    \531\ See History of the Eighties, supra note 36, at 156.
    \532\ See History of the Eighties, supra note 36, at 157.
    \533\ See History of the Eighties, supra note 36, at 157.
    \534\ See History of the Eighties, supra note 36, at 157.
    \535\ See History of the Eighties, supra note 36, at 157.
---------------------------------------------------------------------------
    It should be noted that the economic recession of 1990-1991 
affected the multifamily sector in a similar fashion. 
Overbuilding in this sector ultimately led to a collapse in 
values, which in turn led to tighter underwriting standards. 
Fortunately, with inflation under control and with the fall in 
interest rates during the 1980s, borrowers took advantage of 
the opportunity to refinance, and the multifamily market began 
to loosen substantially by 1992.\536\
---------------------------------------------------------------------------
    \536\ Rent Guidelines Board, 1996 Mortgage Survey Report (online at 
tenant.net/Oversight/RGBsum96/msurv/96msurv.html) (accessed Feb. 7, 
2010).
                    SECTION TWO: UPDATE ON WARRANTS

    On Tuesday, January 19, 2010, the Office of Financial 
Stability (OFS) issued a Warrant Disposition Report detailing 
the Department of the Treasury's approach to warrant 
dispositions related to TARP CPP investments.\537\ The Panel 
has performed its own analysis of Treasury's warrant 
disposition process using an internally created model, 
beginning with its July report. Based upon 11 initial warrant 
sales of relatively small institutions, Treasury received only 
66 percent of the Panel's estimated value of warrants 
sold.\538\ Subsequently, Treasury's return on warrant sales has 
improved to 92 percent of Panel estimates.\539\ In its July 
report, the Panel recommended that Treasury be more forthcoming 
on the details of its disposition process and valuation 
methodology. The July report also recommended that Treasury 
provide periodic written reports on its warrant fair market 
value determinations and subsequent disposition rationale.\540\
---------------------------------------------------------------------------
    \537\ Warrant Disposition Report, United States Department of the 
Treasury--Office of Financial Stability (online at 
www.financialstability.gov/docs/
TARP%20Warrant%20Disposition%20Report%20v4.pdf) (hereinafter ``Warrant 
Disposition Report'').
    \538\ See COP August Oversight Report, supra note 5, at 54-57.
    \539\ See Warrant table at Figure 47.
    \540\ Warrant Disposition Report, supra note 537.
---------------------------------------------------------------------------
    Upon repayment of Treasury's CPP investment, a financial 
institution has the right to repurchase its warrants at an 
agreed-upon fair market value.\541\ The repurchase process 
follows a set timeline that includes bid submission(s), 
Treasury bid evaluation, and a final appraisal option.\542\ 
This Warrant Disposition Report provides Treasury's first 
comprehensive and systematic public explanation of its internal 
procedures and specific details for each warrant sale.
---------------------------------------------------------------------------
    \541\ Warrant Disposition Report, supra note 537.
    \542\ Under the repurchase through bid process, financial 
institutions have 15 days from CPP preferred repayment to submit an 
initial bid. Then, Treasury has 10 days to accept or reject the bid. 
Additional bids may be submitted at any time, even if an agreement on 
fair market value is not reached within the 25-day timeframe.
    Under the repurchase through appraisal process, Treasury or the 
repaying financial institution may invoke an appraisal procedure within 
30 days following Treasury's response to the institution's first bid if 
no agreement on fair market value has been reached. In this scenario, 
both parties select independent appraisers who conduct their own 
valuations and work toward fair market value agreement. If both 
appraisers are in agreement, that valuation becomes the repurchase 
basis. If they are not in agreement, a third appraiser creates a 
composite valuation of the three appraisals to establish the fair 
market value (subject to some limitations). However, this process has 
yet to be used to date.
---------------------------------------------------------------------------
    Treasury utilizes three sources in its determination of the 
fair market value of warrants and subsequent evaluation of an 
institution's bid to repurchase its warrants: market quotes; 
independent, third-party valuations; and internal model 
valuations.\543\
---------------------------------------------------------------------------
    \543\ Warrant Disposition Report, supra note 537.
---------------------------------------------------------------------------
     Market quotes: Though warrants are similar in 
structure to options, there is little market data for long-
dated options that is comparable in length and terms to those 
of the warrants held by Treasury. Accordingly, Treasury 
collects what market pricing information is available from 
various market participants who are active in the options and/
or convertible securities markets and uses this data to 
estimate warrant valuations. In the future, Treasury plans to 
use the market values from the trading of recently auctioned 
CPP warrants as some indication of the market's expectations 
for long-term volatility (in addition to continuing to collect 
valuation estimates from market participants).
     Independent valuation: Outside consultants and 
external asset managers provide estimated valuation and a range 
of values to Treasury for use as a third-party valuation 
source.
     Internal modeling: Treasury uses a binomial option 
model adjusted for American-style options as its primary 
internal valuation model.\544\ Treasury uses the 20-trading day 
trailing average stock price of a company in its valuations and 
updates this data if negotiations continue over an extended 
period of time. A binomial option pricing model values a 
warrant based on how the price of its underlying shares may 
change over the warrant's term. The binomial model allows for 
changes to input assumptions (e.g., volatility) over time.\545\
---------------------------------------------------------------------------
    \544\ Dr. Robert Jarrow, an options expert and professor at Cornell 
University, reviewed Treasury's internal valuation model and concluded 
that it is consistent with industry best practice and the ``highest 
academic standards.''
    \545\ Congressional Oversight Panel, July Oversight Report: TARP 
Repayments, Including the Repurchase of Stock Warrants (July 10, 2009) 
(online at cop.senate.gov/documents/cop-071009-report.pdf).
---------------------------------------------------------------------------
    The OFS Warrant Committee, comprised of Treasury officials 
within OFS, makes a recommendation to the Assistant Secretary 
for Financial Stability regarding acceptance or rejection of a 
bank's bid based on these three valuation sources. In the event 
that there is no fair market value agreement between parties 
and no invocation of the appraisal process, Treasury seeks to 
sell the warrants to third parties ``as quickly as 
practicable'' and, when possible, through public auction.\546\ 
Treasury has conducted the three warrant auctions to date as 
public modified ``Dutch'' auctions registered under the 
Securities Act of 1933 and administered by Deutsche Bank.\547\ 
In a ``Dutch'' auction, bidders submit one or more independent 
bids at different price-quantity combinations and have no 
additional information on others' bids. Bids must be greater 
than the minimum price set by Treasury. The warrants are then 
sold at a uniform price that clears the auction.\548\
---------------------------------------------------------------------------
    \546\ Warrant Disposition Report, supra note 537.
    \547\ As auction agent, Deutsche Bank Securities Inc. has received 
fees equal to approximately 1.5 percent of gross proceeds ($16.6M). 
This is a haircut to the typical average secondary equity offering fees 
of 3.5 to 4.5 percent.
    \548\ Warrant Disposition Report, supra note 537. It is generally 
accepted that, compared to discriminating price auctions in which a 
bidder pays what he bids, uniform price auctions increase how 
aggressively participants bid in an auction, thus increasing the amount 
of proceeds from the auction. This occurs because uniform price 
auctions decrease the so called ``winner's curse,'' which is a bidder's 
fear that an auction win means he overpaid. A uniform price auction is 
the same type of auction used to sell Treasury debt.
---------------------------------------------------------------------------
    By comparison, the Panel's warrant valuation methodology 
employs a Black-Scholes model modified to account for the 
warrants' dilutive effects on common stock and the dividend 
yield of the stock. A Black-Scholes model and binomial model 
share similar underlying assumptions but differ in the 
variability of those assumptions. In its use of Black-Scholes, 
the Panel assumed that the risk-free rate, the dividend yield, 
and the stock price volatility of each financial institution 
would be constant over time.\549\ The binomial model, on the 
other hand, includes inherent variability in assumptions at 
various time intervals. This model is generally more complex 
and time-intensive, whereas Black-Scholes is, by comparison, 
more transparent and reproducible.
---------------------------------------------------------------------------
    \549\ Congressional Oversight Panel, July Oversight Report: TARP 
Repayments, Including the Repurchase of Stock Warrants (July 10, 2009) 
(online at cop.senate.gov/documents/cop-071009-report.pdf).
---------------------------------------------------------------------------
    Congress has addressed the receipt and disposition of TARP 
warrants in three separate legislative actions: EESA, American 
Recovery and Reinvestment Act of 2009 (ARRA), and Helping 
Families Save Their Homes Act of 2009 (HFSA). EESA was 
authorized on October 3, 2008, and provided that, in exchange 
for the purchase or commitment to purchase a troubled asset: 
(1) in the case of a financial institution whose securities are 
traded on a national securities exchange, Treasury is to 
receive a warrant giving the right to receive nonvoting common 
stock or preferred stock, or (2) in the case of all other 
financial institutions, Treasury is to receive a warrant for 
common or preferred stock or a senior debt instrument.\550\
---------------------------------------------------------------------------
    \550\ Warrant Disposition Report, supra note 537.
---------------------------------------------------------------------------
    This legislation was followed by ARRA, enacted on February 
17, 2009, which stated that when TARP assistance is repaid by a 
financial institution, ``the Secretary of the Treasury shall 
liquidate warrants associated with such assistance at the 
current market price.'' \551\ On May 20, 2009, HFSA amended 
section 7001(g) of ARRA by striking ``shall liquidate warrants 
associated with such assistance at the current market price'' 
and inserting ``at the market price, may liquidate warrants 
associated with such assistance.'' \552\ This effectively 
reversed the limitations on the Secretary's discretion to 
dispose of TARP warrants as set forth in ARRA. Given the 
timing, the ``shall liquidate'' language may have created a 
greater sense of urgency in Treasury's initial warrant 
dispositions and may have ultimately influenced the lower bid 
prices received in those warrant repurchases.
---------------------------------------------------------------------------
    \551\ Warrant Disposition Report, supra note 537.
    \552\ Warrant Disposition Report, supra note 537.
---------------------------------------------------------------------------
    The following table includes both data previously published 
by the Panel and new data provided by Treasury in its January 
19th Warrant Disposition Report. In prior reports, the Panel 
has provided a table detailing warrant repurchases by financial 
institutions to date, repurchase/sale proceeds, the Panel's 
best estimate of warrant fair market value,\553\ and the 
internal rate of return for each institution's CPP repayment, 
which is also a Panel staff calculation.\554\ To allow for 
comparison between Panel estimates and the data Treasury has 
utilized in its disposition decisions, this table has been 
expanded to include the best estimates of warrant market value 
from Treasury's three valuation methods discussed above (noted 
in columns headed ``Market Quotes Estimate,'' ``Third-Party 
Estimate,'' and ``Treasury Model Valuation''). The ``Price/
Estimate Ratio'' column displays the number of cents on the 
dollar that Treasury has received for warrant dispositions 
compared to the Panel's best estimate of warrant value.
---------------------------------------------------------------------------
    \553\ The Panel's modified Black-Scholes model produces a low 
estimate, high estimate, and ``best'' estimate of warrant value.
    \554\ The Internal Rate of Return (IRR) is effectively the interest 
rate received for an investment (i.e., Treasury's TARP CPP investment) 
consisting of payment(s) (i.e., Treasury's initial investment in the 
financial institution) and income (i.e., dividends, TARP CPP preferred 
repayment, warrant redemption) at discrete points in time. For 
Treasury's TARP investments in a financial institution, the IRR is 
calculated from the initial capital investment and subsequent dividends 
and warrant repayments/sale proceeds over time.

                                                         FIGURE 47: WARRANT DISPOSITIONS FOR FINANCIAL INSTITUTIONS WHICH HAVE FULLY REPAID CPP FUNDS AS OF FEBRUARY 2, 2010 555
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                                                                              Panel's Best
                                                                   Investment                      Warrant       Market Quotes       Third Party       Treasury Model        Warrant           Valuation         Price/    IRR (Percent)
                          Institution                                 Date            QEO        Repurchase         Estimate           Estimate          Valuation       Repurchase/Sale      Estimate at       Estimate
                                                                                                    Date                                                                      Amount        Repurchase Date      Ratio
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Old National Bancorp...........................................      12/12/2008            No        5/8/2009         $1,353,000         $3,054,000         $1,326,000         $1,200,000         $2,150,000       0.5581          9.30
Iberiabank Corporation.........................................       12/5/2008           Yes       5/20/2009          1,566,000          2,334,000          1,421,000          1,200,000          2,010,000       0.5970          9.40
Firstmerit Corporation.........................................        1/9/2009            No       5/27/2009          4,918,000          6,485,000          5,400,000          5,025,000          4,260,000       1.1796         20.30
Sun Bancorp, Inc...............................................        1/9/2009            No       5/27/2009          2,096,000          4,028,000          2,252,000          2,100,000          5,580,000       0.3763         15.30
Independent Bank Corp..........................................        1/9/2009            No       5/27/2009          2,104,000          2,885,000          2,345,000          2,200,000          3,870,000       0.5685         15.60
Alliance Financial Corporation.................................      12/19/2008            No       6/17/2009            762,000            990,000            818,000            900,000          1,580,000       0.5696         13.80
First Niagara Financial Group..................................      11/21/2008           Yes       6/24/2009          1,646,000          4,221,000          2,807,000          2,700,000          3,050,000       0.8852          8.00
Berkshire Hills Bancorp, Inc...................................      12/19/2008            No       6/24/2009            611,000          1,494,000            971,000          1,040,000          1,620,000       0.6420         11.30
Somerset Hills Bancorp.........................................       1/16/2009            No       6/24/2009            266,000            447,000            276,000            275,000            580,000       0.4741         16.60
SCBT Financial Corporation.....................................       1/16/2009            No       6/24/2009          1,159,000          2,888,000          1,281,000          1,400,000          2,290,000       0.6114         11.70
HF Financial Corp..............................................      11/21/2008            No       6/30/2009            424,000            753,000            563,000            650,000          1,240,000       0.5242         10.10
State Street...................................................      10/28/2008           Yes        7/8/2009         33,000,000         55,000,000         57,000,000         60,000,000         54,200,000       1.1070          9.90
U.S. Bancorp...................................................      11/14/2008            No       7/15/2009        127,000,000        144,000,000        140,000,000        139,000,000        135,100,000       1.0289          8.70
The Goldman Sachs Group, Inc...................................      10/28/2008            No       7/22/2009        826,000,000        993,000,000        902,000,000      1,100,000,000      1,128,400,000       0.9748         22.80
BB&T Corp......................................................      11/14/2008            No       7/22/2009         36,000,000         62,000,000         67,000,000         67,010,402         68,200,000       0.9826          8.70
American Express Company.......................................        1/9/2009            No       7/29/2009        219,000,000        309,000,000        285,000,000        340,000,000        391,200,000       0.8691         29.50
Bank of New York Mellon Corp...................................      10/28/2008            No        8/5/2009         94,000,000        136,000,000        135,000,000        136,000,000        155,700,000       0.8735         12.30
Morgan Stanley.................................................      10/28/2008            No       8/12/2009        731,000,000        900,000,000        855,000,000        950,000,000      1,039,800,000       0.9136         20.20
Northern Trust Corporation.....................................      11/14/2008            No       8/26/2009         69,000,000         86,000,000         84,000,000         87,000,000         89,800,000       0.9688         14.50
Old Line Bancshares Inc........................................       12/5/2008            No        9/2/2009            102,000            254,000            214,000            225,000            500,000       0.4500         10.40
Bancorp Rhode Island, Inc......................................      11/21/2008            No       9/30/2009          1,166,000          1,476,000          1,423,000          1,400,000          1,400,000       1.0000         12.60
CVB Financial Corp.............................................       12/5/2008           Yes      10/28/2009            917,000          1,110,000          1,349,000          1,307,000          1,230,279       1.0624        -26.30
Centerstate Banks of Florida Inc...............................      11/21/2008            No      10/28/2009            125,000            236,000            206,000            212,000            220,000       0.9636          5.90
Manhattan Bancorp..............................................       12/5/2008            No      10/14/2009             34,000             50,000             56,000             63,364            140,000       0.4526          9.80
Bank of the Ozarks.............................................      12/12/2008            No      11/24/2009          2,210,000          2,480,000          2,509,000          2,650,000          3,500,000       0.7571          9.00
Capital One Financial..........................................      11/14/2008            No       12/3/2009         30,000,000        124,000,000        108,000,000        148,731,030        232,000,000       0.6411         12.00
JP Morgan Chase & Co...........................................      10/28/2008            No      12/10/2009        658,000,000      1,063,000,000        998,000,000        950,318,243      1,006,587,697       0.9441         10.90
TCF Financial Corp.............................................       1/16/2009            No      12/16/2009         15,900,000         16,200,000         14,300,000          9,599,964         11,825,830       0.8118         11.00
LSB Corporation................................................      12/12/2008            No      12/16/2009            446,000            605,000            569,000            560,000            535,202       1.0463          9.00
Wainwright Bank & Trust Company................................      12/19/2008            No      12/16/2009            532,000            632,000            541,000            568,700          1,071,494       0.5308          7.80
Wesbanco Bank, Inc.............................................       12/5/2008            No      12/23/2009            577,000            643,000            851,000            950,000          2,387,617       0.3979          6.70
Union Bankshares Corporation...................................      12/19/2008           Yes      12/23/2009            448,000            424,000            410,000            450,000          1,130,418       0.3981          5.80
Trustmark Corporation..........................................      11/21/2008            No      12/30/2009          7,601,000          9,014,000          9,704,000         10,000,000         11,573,699       0.8640          9.40
Flushing Financial Corporation.................................      12/19/2008           Yes      12/30/2009            742,000          1,007,000            850,000            900,000          2,861,919       0.3145          6.50
                                                                                                              --------------------------------------------------------------------------------------------------------------------------
    Total......................................................  ..............  ............  ..............     $2,870,705,000     $3,935,710,000     $3,683,442,000     $4,025,635,703     $4,367,594,154       0.9217         14.40
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
555 ``Market Quotes Estimate,'' ``Third party Estimate,'' and ``Treasury Model Valuation'' are from the OFS Warrant Disposition Report. ``Panel's Best Valuation Estimate at Repurchase Date'' is from the Panel's internal valuation
  model.

    In sum, warrant repurchases and auction sales have 
generated proceeds of $2.9 billion and $1.1 billion, 
respectively. Treasury notes that these warrant dispositions 
have produced an absolute return--the ratio of actual proceeds 
to the CPP preferred investment amount--of 3.1 percent from 
dividends and 5.7 percent from sale of warrants for total 
absolute return of 8.8 percent.\556\ The Panel agrees with this 
simple calculation but prefers to use an internal rate of 
return (IRR) calculation, which is an annualized measure and 
therefore allows for comparison with other investment 
alternatives in the economy. The Panel's latest IRR for the 
TARP CPP, based on all warrant sales and repurchases to date, 
is 14.4 percent.\557\
---------------------------------------------------------------------------
    \556\ Warrant Disposition Report, supra note 537.
    \557\ Warrant Disposition Report, supra note 537. The ``QEO'' 
column in the table above notes whether a financial institution 
completed a qualified equity offering before December 31, 2009, in 
which case, according to the terms of CPP contracts, the institution 
was allowed to reduce by half the number of warrants owned by Treasury 
and available for its disposition. A QEO is an offering of securities 
that qualifies as Tier 1 capital.
---------------------------------------------------------------------------
    The proceeds from warrant sales/repurchases of larger 
financial institutions were from 86 to over 100 percent of the 
Panel's best estimate, with the only significant outlier being 
Capital One Financial, whose auction results reflected only 64 
percent of the Panel's best estimate. This result may have been 
due to several factors, including: (1) market uncertainty 
surrounding Treasury's warrant auctions, as Capital One's 
warrants were the first to go to auction; (2) the significant 
portion of Capital One's earnings derived from its credit card 
business, which given recent regulatory changes may be viewed 
as a less desirable investment option; and (3) the decline in 
implied volatility of Capital One's stock price in the months 
preceding the auction (a higher volatility suggests the 
potential for greater returns in the future, leading to higher 
valuations of the associated stock's warrants).
    For smaller institutions, the ratio of actual proceeds 
received to the Panel's best estimates tended to be lower than 
that for larger institutions, possibly reflecting the fact that 
the market for trading of the underlying stock of these smaller 
institutions is less liquid.
    Some trends in estimates versus actual sales prices emerge 
when reviewing the pattern of warrant repurchases over time. 
The first five repurchase bids came in below Treasury's 
internal model ``best estimate'' and well below the third-party 
valuation ``best estimate.'' Treasury attributed this to the 
warrant liquidation language in ARRA, as discussed above, and 
to the fact that Treasury initially relied on financial 
modeling consultants for third-party input as opposed to 
external asset managers.\558\ The remaining accepted warrant 
repurchase bids came in above or just below Treasury's internal 
model ``best estimate,'' well above most of the market quote 
valuations, and close to the third-party valuations. Overall, 
the gross proceeds of $2.9 billion from warrant repurchases to 
date--although only 94 percent of the Panel's best estimated 
value for these warrants of $3.1 billion--were greater than 
Treasury's internal model valuation of these warrants of $2.6 
billion.
---------------------------------------------------------------------------
    \558\ Warrant Disposition Report, supra note 537.

                       FIGURE 48: VALUATION OF OUTSTANDING WARRANTS AS OF FEBRUARY 2, 2010
                                              [Dollars in millions]
----------------------------------------------------------------------------------------------------------------
                                                                                 Warrant Valuation
  Stress Test Financial Institutions with Warrants Outstanding   -----------------------------------------------
                                                                   Low  Estimate  High  Estimate  Best  Estimate
----------------------------------------------------------------------------------------------------------------
Wells Fargo.....................................................         $354.41       $1,836.20         $817.62
Bank of America Corporation.....................................          578.94        2,581.34          965.46
Citigroup, Inc..................................................           10.04          921.63          175.81
The PNC Financial Services Group Inc............................           99.66          540.64          251.21
SunTrust Banks, Inc.............................................           14.85          238.42          110.90
Regions Financial Corporation...................................            7.36          185.20           90.87
Fifth Third Bancorp.............................................           87.22          359.91          201.68
Hartford Financial Services Group, Inc..........................          510.11          863.18          619.91
KeyCorp.........................................................           16.77          151.28           78.41
All Other Banks.................................................          751.70        2,890.27        1,921.43
                                                                 -----------------------------------------------
    Total.......................................................       $2,431.06      $10,568.07       $5,233.30
----------------------------------------------------------------------------------------------------------------

    As the above table shows, the Panel's best estimate of 
Treasury's outstanding warrants is $5.2 billion, with a minimum 
valuation estimate of $2.4 billion and a maximum estimate of 
$10.6 billion. Bank of America and Wells Fargo, both of whom 
repaid their CPP investment in December 2009, will likely be 
the next high-valued warrants to be auctioned.\559\ Combining 
the best estimate of warrants outstanding with the warrant 
redemption receipts received so far shows that the Panel's best 
estimate of the total amount Treasury will receive from the 
sale of TARP warrants now stands at $9.3 billion.
---------------------------------------------------------------------------
    \559\ Treasury Transaction Report, supra note 450.
                    SECTION THREE: ADDITIONAL VIEWS


                A. J. Mark McWatters and Paul S. Atkins

    We concur with the issuance of the February report and 
offer the additional observations below. We appreciate the 
spirit with which the Panel and the staff approached this 
complex issue and incorporated suggestions offered during the 
drafting process.
    There is little doubt that much uncertainty exists within 
the present commercial real estate, or CRE, market. Broad based 
recognition of CRE related losses has yet to occur, and 
significant problems are expected within the next two years. 
The bottom line is that CRE losses need to be recognized--
hiding losses on balance sheets is not good for financial 
institutions, for investors, or for the economy. Just as in the 
residential real estate market, the CRE market needs freedom to 
engage in price discovery in order for investors to have 
confidence and transparency to resume investing risk capital in 
CRE.
    In order to suggest any ``solution'' to the challenges 
currently facing the CRE market, it is critical that market 
participants and policymakers thoughtfully identify the sources 
of the underlying difficulties. Without a proper diagnosis, it 
is likely that an inappropriately targeted remedy with adverse 
unintended consequences will result.
    Broadly speaking, it appears that today's CRE industry is 
faced with both an oversupply of CRE facilities and an 
undersupply of prospective tenants and purchasers. In addition 
to the excess CRE inventory created during the 2005-2007 bubble 
period, it appears that there has been an unprecedented 
collapse in demand for CRE property. Many potential tenants and 
purchasers have withdrawn from the CRE market not simply 
because rental rates or purchase prices are too high, but 
because their business operations do not presently require 
additional CRE facilities. Over the past few years while CRE 
developers have constructed a surplus of new office buildings, 
hotels, multi-family housing, retail and shopping centers, and 
manufacturing and industrial parks, a significant number of end 
users of such facilities have suffered the worst economic 
downturn in several generations. Any posited solution to the 
CRE problem that focuses only on the oversupply of CRE 
facilities to the exclusion of the economic difficulties facing 
the end users of such facilities appears unlikely to succeed. 
The challenges confronting the CRE market are not unique to 
that industry, but, instead, are generally indicative of the 
systemic uncertainties manifest throughout the larger economy.
    In order to address the oversupply of CRE facilities, 
developers and their creditors are currently struggling to 
restructure and refinance their CRE portfolio loans. In some 
instances creditors with sufficient regulatory capital are 
acknowledging economic reality and writing their loans down to 
market value with, perhaps, the retention of an equity 
participation right. In other cases lenders are merely 
``kicking the can down the road'' by refinancing problematic 
credits on favorable terms at or near par so as to avoid the 
recognition of book losses and the attendant reductions in 
regulatory capital. With respect to the most problematic 
credits, lenders are foreclosing on their CRE collateral 
interests and are either attempting to manage the properties in 
a depressed market or disposing of the facilities at 
significant discounts. While these approaches may offer 
assistance in specifically tailored instances, none directly 
addresses the challenge of too few tenants and purchasers of 
CRE facilities.
    Until small and large businesses regain the confidence to 
hire new employees and expand their business operations, it 
remains doubtful that the CRE market will sustain a meaningful 
recovery. As long as businesses are faced with the multiple 
challenges of rising taxes, increasing regulatory burdens, and 
enhanced political risk associated with unpredictable 
governmental interventions in the private sector (including 
government actions that will affect health care and energy 
costs), it is unlikely that they will enthusiastically assume 
the entrepreneurial risk necessary for protracted business 
expansion at the microeconomic level and thus a recovery of the 
CRE market at the macroeconomic level. It is fundamental to 
acknowledge that the American economy grows one job and one 
consumer purchase at a time, and that the CRE market will 
recover one lease, one sale, and one financing at a time. With 
the ever-expanding array of less-than-friendly rules, 
regulations and taxes facing businesses and consumers, we 
should not be surprised if businesses remain reluctant to hire 
new employees, consumers remain cautious about spending, and 
the CRE market continues to struggle.
    It is indeed ironic that while Treasury is contemplating a 
plan to fund another round of TARP-sourced allocations for 
``small'' financial institutions (including targeting funds to 
certain favored groups, including CDFIs), the Administration is 
also developing a plan to raise the taxes and increase the 
regulatory burden of many financial institutions and other CRE 
market participants. The Administration seems reluctant to 
acknowledge that such actions may raise the cost of capital to 
such financial institutions and decrease their ability to 
extend credit to qualified CRE and other borrowers. More 
significantly, the Administration appears indifferent to the 
dramatic level of uncertainty that such actions have injected 
into an already unsettled marketplace.
    It is also troublesome that Treasury would contemplate 
another round of bailouts to rescue financial institutions that 
placed risky bets on the CRE market. Over the years many of 
these institutions have profited handsomely by extending credit 
to CRE developers, and it is disconcerting that these same 
institutions and their CRE borrowers would approach the 
taxpayers for a bailout. We should also note that during the 
bubble era, these institutions and the CRE developers were 
almost assuredly managed by financial and real estate experts 
and advised by competent counsel and other professionals who 
were thoroughly versed in the risks associated with CRE lending 
and development.\560\
---------------------------------------------------------------------------
    \560\ Sophisticated securities products, including CDSs, also were 
developed to provide for hedging and risk management for CRE and CMBS 
exposure, among other things. Some have mistakenly likened these 
products to ``insurance,'' because some market participants viewed them 
in that sort of role. It is a facile comparison, because they differ in 
significant ways from ``insurance.'' Thus, they properly are not 
treated as such.
---------------------------------------------------------------------------
    Although some financial institutions may struggle or even 
fail as a result of their ill-advised underwriting decisions 
and the resulting overdevelopment of the CRE market, any 
taxpayer-funded bailouts of these institutions will inject 
unwarranted moral hazard risk into the market and all but 
establish the United States government as the implicit 
guarantor of any future losses arising from distressed CRE 
loans.\561\ Such actions will also encourage private sector 
participants to engage in less-than-prudent economic behavior, 
confident in the expectation--if not an emerging sense of 
entitlement--that the taxpayers will yet again offer a bailout 
if their CRE portfolios materially underperform. Since CRE 
market participants reaped the benefits from the run-up to the 
CRE bubble, they should equally shoulder the burdens from the 
bursting of the bubble. The Administration--through TARP, a 
program similar to the Resolution Trust Corporation (RTC),\562\ 
or otherwise--should not force the taxpayers to subsidize these 
losses and underwrite the poor management decisions and 
analysis of such CRE lenders and developers. A market economy 
by necessity must cull or marginalize the products and services 
of the weakest participants so that those who have developed 
innovative and competitive ideas may prosper on a level playing 
field. Any attempt by the Administration to prop up the 
financial institutions and developers who contributed to the 
oversupply of CRE property is not in the best interests of the 
more prescient and creative market participants or the 
taxpayers. The opportunity for entrepreneurs to succeed or fail 
based upon their own acumen and judgment must survive the 
current recession and the implementation of the TARP program.
---------------------------------------------------------------------------
    \561\ The results of any additional ``stress tests'' conducted by 
the applicable banking supervisors should not be used by Treasury as an 
excuse for the allocation of additional TARP funds to capital-deficient 
financial institutions. Instead, such financial institutions should 
seek capital from the private markets or be liquidated or sold through 
the typical FDIC resolution process.
    \562\ The RTC responded to the failure of a significant number of 
financial institutions within specific geographic areas. Without the 
RTC, some have argued that the affected areas would have been 
``materially under-banked.'' It is not apparent that the same situation 
manifests itself today as a result of distressed CRE loans or 
otherwise. Some banks will fail (and will be liquidated or sold through 
the typical FDIC resolution process), but a substantial majority should 
survive and will be better off by not having to compete with their 
mismanaged former peers. Because these banks are not systemically 
significant financial institutions, the failure of which might 
materially impair the U.S. economy, Treasury's potential use of the 
TARP program to recapitalize them stretches the intent of EESA and 
would create risks of moral hazard and implicit government guarantees. 
In addition, an RTC-type approach raises the potential for unintended 
enrichment of some participants at the taxpayer's expense.
---------------------------------------------------------------------------
    In addition, as the Report notes, Treasury has realized 
that financial institutions increasingly consider TARP to be a 
stigma of weakness. This perception is inevitable after almost 
a year and a half of TARP and is a healthy development. In 
fact, banks that accept TARP funds at this point of the 
economic cycle should be branded as weaker institutions. A 
question for policymakers is whether they should be allowed to 
fail rather than be propped up further at taxpayer expense.
    Finally, as Treasury considers its actions in using TARP 
funds in the context of CRE or other areas, it must be mindful 
not only of political realities, but also funding realities. As 
the Report indicates, there are substantial ``uncommitted'' 
funds available to Treasury under the TARP. Some of these funds 
have never been allocated out of Congress's original 
authorization of $700 billion under EESA. However, if Treasury 
exceeds the original $700 billion in total allocations under 
the TARP, it then would rely on its interpretation that EESA 
allows ``recycling'' of TARP funds; that is, amounts returned 
to the Treasury create more ``headroom'' for Treasury to use 
TARP funds up to a maximum outstanding at any time of $700 
billion. We find Treasury's legal analysis regarding this 
interpretation of EESA unconvincing and disagree with 
Treasury's assertion that these returned amounts become 
``uncommitted'' funds again, which may be re-committed.
           SECTION FOUR: CORRESPONDENCE WITH TREASURY UPDATE

    Secretary of the Treasury Timothy Geithner sent a letter to 
Chair Elizabeth Warren on January 13, 2010,\563\ in response to 
a letter from the Chair regarding the assistance provided to 
CIT Group, Inc. under the Capital Purchase Program.
---------------------------------------------------------------------------
    \563\ See Appendix I of this report, infra.
              SECTION FIVE: TARP UPDATES SINCE LAST REPORT


                           A. TARP Repayments

    No additional banks have repaid their TARP investments 
under the CPP since the Panel's most recent oversight report. A 
total of 59 banks have repaid their preferred stock TARP 
investments provided under the CPP to date. Treasury has also 
liquidated the warrants it holds in 40 of these 59 banks.

                     B. CPP Monthly Lending Report

    Treasury releases a monthly lending report showing loans 
outstanding at the top 22 CPP recipient banks. The most recent 
report, issued on January 15, 2010, includes data through the 
end of November 2009. Treasury reported that the overall 
outstanding loan balance of the top CPP recipients declined by 
0.2 percent between the end of October 2009 and the end of 
November 2009. The total amount of originations at the end of 
November 2009 was five percent below what it was when EESA was 
enacted.

                   C. CPP Warrant Disposition Report

    As part of its investment in senior preferred stock of 
certain banks under the CPP, Treasury received warrants to 
purchase shares of common stock or other securities in those 
institutions. At the end of 2009, Treasury held warrants in 248 
public companies as part of the CPP. In December 2009, Treasury 
began the public sale of warrants to third parties, in addition 
to original issuers, through a standardized process that, 
according to Treasury, is designed to ensure that taxpayers 
receive fair market value whether the warrants are purchased by 
the issuer or a third party.
    On January 20, 2010, the Treasury released a report showing 
that as of December 31, 2009, the government had received $4 
billion in gross proceeds on the disposition of warrants in 34 
banks. These proceeds consisted of $2.9 billion from 
repurchases by the issuers and $1.1 billion from auctions. See 
Section Two for a detailed discussion of the report.

       D. TARP Initiative to Support Lending to Small Businesses

    On February 3, 2010, Treasury announced the final terms of 
a TARP initiative to invest capital in CDFIs that lend to small 
businesses. Under the program, eligible CDFIs will have access 
to capital at a two percent rate, compared with a five percent 
rate under the CPP. CDFIs that are already participating in 
TARP will be able to transfer those investments into this 
program. Further, CDFIs will not be required to issue warrants 
to take part in the initiative.

          E. Term Asset-Backed Securities Loan Facility (TALF)

    At the January 20, 2010 facility, investors requested $1.5 
billion in loans for legacy CMBS. Investors did not request any 
loans for new CMBS. By way of comparison, investors requested 
$1.3 billion in loans for legacy CMBS at the December facility 
and $1.4 billion at the November facility. Investors did not 
request any loans for new CMBS at the December facility but did 
request $72.2 million in loans for new CMBS at the November 
facility. These have been the only loans requested for new CMBS 
during TALF's operations.
    At the February 5, 2010 facility, investors requested $987 
million in loans to support the issuance of ABS collateralized 
by loans in the auto, credit card, equipment, floor plan, 
servicing advances, small business, and student loan sectors. 
No loans were requested in the premium financing sector. By way 
of comparison, at the January 7, 2010 facility, investors 
requested $1.1 billion in loans collateralized by the issuance 
of ABS in the credit card, floor plan, and small business 
sectors.

     F. Legacy Securities Public-Private Investment Program (PPIP)

    On January 29, 2010, Treasury released its initial 
quarterly report on PPIP for the quarter ending December 31, 
2009. The report indicates that PPIP, which Treasury intends to 
support market functioning and facilitate price discovery in 
the mortgage-backed securities markets through the purchase of 
eligible assets, has created $24 billion in purchasing power 
for public-private investment funds. As of the end of the 
quarter, these funds had drawn down $4.3 billion in total 
capital which was invested in eligible assets or cash 
equivalents pending investment.

  G. Home Affordable Modifications Program (HAMP) Updated Requirements

    On January 28, 2010, Treasury and the Department of Housing 
and Urban Development (HUD) released guidance regarding 
documentation requirements and procedures for servicers 
participating in the HAMP. Under these new terms, all 
modifications with an effective date on or after June 1, 2010, 
will require an initial standard package of three documents 
before evaluation. Treasury and HUD also clarified procedures 
by which borrowers may be converted from trial modifications to 
permanent modifications.

                               H. Metrics

    Each month, the Panel's report highlights a number of 
metrics that the Panel and others, including Treasury, the 
Government Accountability Office (GAO), Special Inspector 
General for the Troubled Asset Relief Program (SIGTARP), and 
the Financial Stability Oversight Board, consider useful in 
assessing the effectiveness of the Administration's efforts to 
restore financial stability and accomplish the goals of EESA. 
This section discusses changes that have occurred in several 
indicators since the release of the Panel's January report.
     Interest Rate Spreads. Interest rate spreads have 
continued to contract since the Panel's January report, further 
reflecting signs of economic stability. The mortgage rate 
spread, which measures the difference between the conventional 
30-year mortgage rate and 10-year Treasury bills, was 1.3 
percent at the end of January.\564\ This represents a 45 
percent decrease since the enactment of EESA.
---------------------------------------------------------------------------
    \564\ Board of Governors of the Federal Reserve System, Federal 
Reserve Statistical Release H.15: Selected Interest Rates: Historical 
Data (Instrument: Conventional Mortgages, Frequency: Weekly) (online at 
www.federalreserve.gov/releases/h15/data/Weekly_Thursday_/
H15_MORTG_NA.txt) (hereinafter ``Federal Reserve Statistical Release 
H.15: Selected Interest Rates: Historical Data'') (accessed Jan. 27, 
2010); Board of Governors of the Federal Reserve System, Federal 
Reserve Statistical Release H.15: Selected Interest Rates: Historical 
Data (Instrument: U.S. Government Securities/Treasury Constant 
Maturities/Nominal 10-Year, Frequency: Weekly) (online at 
www.federalreserve.gov/releases/h15/data/Weekly_Friday_/
H15_TCMNOM_Y10.txt) (hereinafter ``Federal Reserve Release H.15'') 
(accessed Jan. 27, 2010).

                    FIGURE 49: INTEREST RATE SPREADS
------------------------------------------------------------------------
                                                   Percent Change Since
          Indicator            Current  Spread    Last Report (12/31/09)
                               (as of 1/29/10)          (Percent)
------------------------------------------------------------------------
TED spread \565\ (in basis                   17                   -10.5
 points)....................
Conventional mortgage rate                 1.32                     0.76
 spread \566\...............
Corporate AAA bond spread                  1.62                     3.8
 \567\......................
Corporate BAA bond spread                  2.57                    -3.4
 \568\......................
Overnight AA asset-backed                  0.13                    -0.25
 commercial paper interest
 rate spread \569\..........
Overnight A2/P2 nonfinancial               0.13                    -0.16 
 commercial paper interest
 rate spread \570\..........
------------------------------------------------------------------------
\565\ TED Spread, SNL Financial.
\566\ Federal Reserve Release H.15, supra note 564 (accessed Jan. 27,
  2010); Federal Reserve Release H.15, supra note 564 (accessed Jan. 27,
  2010).
\567\ Board of Governors of the Federal Reserve System, Federal Reserve
  Statistical Release H.15: Selected Interest Rates: Historical Data
  (Instrument: Corporate Bonds/Moody's Seasoned AAA, Frequency: Weekly)
  (online at www.federalreserve.gov/releases/h15/data/Weekly_Friday_/
  H15_AAA_NA.txt) (accessed Jan. 27, 2010); Federal Reserve Release
  H.15, supra note 564 (accessed Jan. 27, 2010).
\568\ Board of Governors of the Federal Reserve System, Federal Reserve
  Statistical Release H.15: Selected Interest Rates: Historical Data
  (Instrument: Corporate Bonds/Moody's Seasoned BAA, Frequency: Weekly)
  (online at www.federalreserve.gov/releases/h15/data/Weekly_Friday_/
  H15_BAA_NA.txt) (accessed Jan. 27, 2010); Federal Reserve Release
  H.15, supra note 564 (accessed Jan. 27, 2010).
\569\ Board of Governors of the Federal Reserve System, Federal Reserve
  Statistical Release: Commercial Paper Rates and Outstandings: Data
  Download Program (Instrument: AA Asset-Backed Discount Rate,
  Frequency: Daily) (online at www.federalreserve.gov/DataDownload/
  Choose.aspx?rel=CP) (hereinafter ``Federal Reserve Release: Commercial
  Paper'') (accessed Jan. 27, 2009); Board of Governors of the Federal
  Reserve System, Federal Reserve Statistical Release: Commercial Paper
  Rates and Outstandings: Data Download Program (Instrument: AA
  Nonfinancial Discount Rate, Frequency: Daily) (online at
  www.federalreserve.gov/DataDownload/Choose.aspx?rel=CP) (accessed Jan.
  27, 2010). In order to provide a more complete comparison, this metric
  utilizes a five-day average of the interest rate spread for the last
  five days of the month.
\570\ Federal Reserve Release: Commercial Paper, supra note 569
  (accessed Jan. 27, 2010). In order to provide a more complete
  comparison, this metric utilizes a five day average of the interest
  rate spread for the last five days of the month.

     Commercial Paper Outstanding. Commercial paper 
outstanding, a rough measure of short-term business debt, is an 
indicator of the availability of credit for enterprises. The 
amount of asset-backed commercial paper outstanding decreased 
by 11 percent in January. Financial and non-financial 
commercial paper outstanding both increased in January by 4 and 
11 percent, respectively.\571\ Total commercial paper 
outstanding has continued to decrease since the enactment of 
EESA. Asset-backed commercial paper outstanding has declined 
nearly 40 percent and nonfinancial commercial paper outstanding 
has decreased by 43 percent since October 2008.\572\
---------------------------------------------------------------------------
    \571\ Federal Reserve Release: Commercial Paper, supra note 569 
(accessed Jan. 27, 2010).
    \572\ Federal Reserve Release: Commercial Paper, supra note 569 
(accessed Jan. 27, 2010).

                 FIGURE 50: COMMERCIAL PAPER OUTSTANDING
                          [Dollars in billions]
------------------------------------------------------------------------
                                                  Percent Change  Since
          Indicator             Current Level    Last Report  (12/31/09)
                               (as of 1/27/10)          (Percent)
------------------------------------------------------------------------
Asset-backed commercial                    $431                   -11.3
 paper outstanding
 (seasonally adjusted) \573\
Financial commercial paper                  601                     4.03
 outstanding (seasonally
 adjusted) \574\............
Nonfinancial commercial                     115                    11.2
 paper outstanding
 (seasonally adjusted) \575\
------------------------------------------------------------------------
\573\ Federal Reserve Release: Commercial Paper, supra note 569
  (accessed Jan. 27, 2010).
\574\ Federal Reserve Release: Commercial Paper, supra note 569
  (accessed Jan. 27, 2010).
\575\ Federal Reserve Release: Commercial Paper, supra note 569
  (accessed Jan. 27, 2010).

     Lending by the Largest TARP-recipient Banks. 
Treasury's Monthly Lending and Intermediation Snapshot tracks 
loan originations and average loan balances for the 22 largest 
recipients of CPP funds across a variety of categories, ranging 
from mortgage loans to commercial real estate to credit card 
lines. The data below exclude lending by two large CPP-
recipient banks, PNC Bank and Wells Fargo, because significant 
acquisitions by those banks since October 2008 make comparisons 
difficult.\576\ In November, these 20 institutions originated 
$186.5 billion in loans, a decrease of 14 percent compared to 
October 2008.\577\ The total average loan balance for these 
institutions decreased by 2.5 percent to $3.3 trillion in 
November.\578\
---------------------------------------------------------------------------
    \576\ PNC Financial and Wells Fargo purchased large banks at the 
end of 2008. PNC Financial purchased National City on October 24, 2008 
and Wells Fargo completed its merger with Wachovia Corporation on 
January 1, 2009. The assets of National City and Wachovia are included 
as part of PNC and Wells Fargo, respectively, in Treasury's January 
lending report but are not differentiated from the existing assets or 
the acquiring banks. As such, there were dramatic increases in the 
total average loan balances of PNC and Wells Fargo in January 2009. For 
example, PNC's outstanding total average loan balance increased from 
$75.3 billion in December 2008 to $177.7 billion in January 2009. The 
same effect can be seen in Wells Fargo's total average loan balance of 
$407.2 billion in December 2008 which increased to $813.8 billion in 
January 2009. The Panel excludes PNC and Wells Fargo in order to have a 
more consistent basis of comparison across all institutions and lending 
categories.
    \577\ U.S. Department of the Treasury, Treasury Department Monthly 
Lending and Intermediation Snapshot: Summary Analysis for November 2009 
(Jan. 27, 2010) (online at www.financialstability.gov/docs/surveys/
Snapshot_Data_November_2009.xls) (hereinafter ``Treasury Snapshot for 
November 2009'').
    \578\ Treasury Snapshot for November 2009, supra note 577.

           FIGURE 51: LENDING BY THE LARGEST TARP-RECIPIENT BANKS (WITHOUT PNC AND WELLS FARGO) \579\
                                              [Dollars in millions]
----------------------------------------------------------------------------------------------------------------
                                                                  Percent Change Since     Percent Change Since
              Indicator                    Most Recent Data     October 2009  (Percent)   October 2008 (Percent)
                                           (November 2009)
----------------------------------------------------------------------------------------------------------------
Total loan originations..............                 $186,556                    -0.25                    -14.5
Total mortgage originations..........                   55,227                     1.07                     24.7
Small Business Originations..........                    4,586                   -15                 \580\ -10.3
Mortgage refinancing.................                   32,519                     6.9                      73.3
HELOC originations (new lines & line                     1,954                   -12.2                     -58.9
 increases)..........................
C&I renewal of existing accounts.....                   49,614                     4.1                     -13.6
Total Equity Underwriting............                   30,600                     4.8                      58.3
Total Debt Underwriting..............                  262,719                   -13                        -27
----------------------------------------------------------------------------------------------------------------
\579\ Treasury Snapshot for November 2009, supra note 577.
\580\ Treasury only began reporting data regarding small business originations in its April Lending Survey, this
  number reflects the percent change since April 2009. Treasury Snapshot for November 2009, supra note 577.

     Housing Indicators. Foreclosure filings increased 
by fourteen percent from October to November, and are 25 
percent above the October 2008 level. Housing prices, as 
illustrated by both the S&P/Case-Shiller Composite 20 Index and 
the FHFA House Price Index, increased slightly in November.

                                          FIGURE 52: HOUSING INDICATORS
----------------------------------------------------------------------------------------------------------------
                                                                  Percent Change From
                                         Most Recent  Monthly    Data Available at Time    Percent Change Since
              Indicator                          Data               of  Last Report       October 2008 (Percent)
                                                                       (Percent)
----------------------------------------------------------------------------------------------------------------
Monthly foreclosure filings \581\....                  349,519                    14                          25
Housing prices--S&P/Case-Shiller                         145.5                     0.24                     -7.1
 Composite 20 Index \582\............
FHFA Housing Price Index \583\.......                    200.4                     0.07                    -1.3
----------------------------------------------------------------------------------------------------------------
\581\ RealtyTrac, Foreclosure Activity Press Releases (online at www.realtytrac.com//ContentManagement/
  PressRelease.aspx) (hereinafter `` Foreclosure Activity Press Releases'') (accessed Jan. 27, 2010). Most
  recent data available for December 2009.
\582\ Standard & Poor's, S&P/Case-Shiller Home Price Indices (Instrument: Seasonally Adjusted Composite 20
  Index) (online at www.standardandpoors.com/prot/servlet/BlobServer?blobheadername3=MDT-Type&blobcol
  =urldata&blobtable=MungoBlobs&blobheadervalue2=inline%3B+filename%3DSA_
  CSHomePrice_History_012659.xls&blobheadername2= Content-
  Disposition&blobheadervalue1=application%2Fexcel&blobkey =id&blobheadername1=content-
  type&blobwhere=1243643617751 &blobheadervalue3=UTF-8) (hereinafter ``S&P/Case-Shiller Home Price Indices'')
  (accessed Jan. 27, 2010). Most recent data available for November 2009.
\583\ Federal Housing Finance Agency, U.S. and Census Division Monthly Purchase Only Index (Instrument: USA,
  Seasonally Adjusted) (online at www.fhfa.gov/webfiles/15368/MonthlyIndex_ Jan1991_to_Latest.xls) (accessed
  Jan. 27, 2010). Most recent data available for November 2009.

FIGURE 53: FORECLOSURE FILINGS AS COMPARED TO THE CASE-SHILLER 20 CITY 
              HOME PRICE INDEX (AS OF NOVEMBER 2009) \584\

---------------------------------------------------------------------------
    \584\ Foreclosure Activity Press Releases, supra note 581 (accessed 
Jan. 27, 2010); S&P/Case-Shiller Home Price Indices, supra note 582 
(accessed Jan. 27, 2010). Most recent data available for November 2009. 


[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

     Small Business Lending. On February 5, 2010, 
federal and state financial agencies, including the Federal 
Reserve and FDIC, issued a statement highlighting the 
importance of prudent and productive small business lending. 
This statement urged institutions to focus their decision on a 
small business owner's business plan rather than basing the 
decision solely on economic and portfolio manager models. 
Furthermore, it stated that regulators will not adversely 
classify loans solely due to a borrower's specific industry or 
geographic location.\585\ As figure 54 illustrates, new small 
busi-
---------------------------------------------------------------------------
    \585\ Board of Governors of the Federal Reserve System, Federal 
Deposit Insurance Corporation, National Credit Union Administration, 
Office of the Comptroller of the Currency, Office of Thrift 
Supervision, Conference of State Bank Supervisors, Interagency 
Statement on Meeting the Credit Needs of Creditworthy Small Business 
Borrowers (Feb. 5, 2010) (online at www.fdic.gov/news/news/press/2010/
pr10029a.pdf) (``As a general principle, examiners will not adversely 
classify loans solely due to a decline in the collateral value below 
the loan balance, provided the borrower has the willingness and ability 
to repay the loan according to reasonable terms. In addition, examiners 
will not classify loans due solely to the borrower's association with a 
particular industry or geographic location that is experiencing 
financial difficulties'').
---------------------------------------------------------------------------
ness lending by the largest TARP participants has decreased 
more than 10 percent since Treasury began tracking this metric 
in April 2009.

      FIGURE 54: SMALL BUSINESS LENDING BY LARGEST TARP-RECIPIENT BANKS (WITHOUT PNC AND WELLS FARGO) \586\
                                              [Dollars in millions]
----------------------------------------------------------------------------------------------------------------
                                                                        Percent Change from
                                                      Most Recent      Data Available at Time    Percent Change
                    Indicator                         Monthly Data         of Last Report       Since April 2009
                                                    (November 2009)          (Percent)             (Percent)
----------------------------------------------------------------------------------------------------------------
Small Business Lending Origination...............             $4,586                      -15              -10.3
Small Business Lending Average Loan Balance......            179,131                     -0.4              -4.1
----------------------------------------------------------------------------------------------------------------
\586\ Treasury Snapshot for November 2009, supra note 577.

                          I. Financial Update

    Each month, the Panel summarizes the resources that the 
federal government has committed to economic stabilization. The 
following financial update provides: (1) an updated accounting 
of the TARP, including a tally of dividend income, repayments 
and warrant dispositions that the program has received as of 
February 1, 2010; and (2) an updated accounting of the full 
federal resource commitment as of December 31, 2009.

1. TARP

            a. Costs: Expenditures and Commitments
    Treasury has committed or is currently committed to spend 
$519.5 billion of TARP funds through an array of programs used 
to purchase preferred shares in financial institutions, offer 
loans to small businesses and automotive companies, and 
leverage Federal Reserve loans for facilities designed to 
restart secondary securitization markets.\587\ Of this total, 
$298.3 billion is currently outstanding under the $698.7 
billion limit for TARP expenditures set by EESA, leaving $403.3 
billion available for fulfillment of anticipated funding levels 
of existing programs and for funding new programs and 
initiatives. The $298.3 billion includes purchases of preferred 
and common shares, warrants and/or debt obligations under the 
CPP, AIGIP/SSFI Program, PPIP, and AIFP; and a $20 billion loan 
to TALF LLC, the SPV used to guarantee Federal Reserve TALF 
loans.\588\ Additionally, Treasury has allocated $36.9 billion 
to the Home Affordable Modification Program, out of a projected 
total program level of $50 billion.
---------------------------------------------------------------------------
    \587\ EESA, as amended by the Helping Families Save Their Homes Act 
of 2009, limits Treasury to $698.7 billion in purchasing authority 
outstanding at any one time as calculated by the sum of the purchase 
prices of all troubled assets held by Treasury. Pub. L. No. 110-343, 
Sec. 115(a)-(b); Helping Families Save Their Homes Act of 2009, Pub. L. 
No. 111-22, Sec. 402(f) (reducing by $1.26 billion the authority for 
the TARP originally set under EESA at $700 billion).
    \588\ Treasury Transaction Report, supra note 450.
---------------------------------------------------------------------------
            b. Income: Dividends, Interest Payments, and CPP Repayments
    As of February 1, 2009, a total of 59 institutions have 
completely repurchased their CPP preferred shares. Of these 
institutions, 37 have repurchased their warrants for common 
shares that Treasury received in conjunction with its preferred 
stock investments (including six institutions for whom warrants 
were exercised at the time of the initial Treasury investment); 
Treasury sold the warrants for common shares for three other 
institutions at auction.\589\ For further discussion of 
Treasury's disposition of these warrants, see Section Two of 
this report. In January, Treasury received partial repayments 
from two institutions, totaling $57.2 million.\590\ In 
addition, Treasury receives dividend payments on the preferred 
shares that it holds, usually five percent per annum for the 
first five years and nine percent per annum thereafter.\591\ In 
total, Treasury has received approximately $189.5 billion in 
income from repayments, warrant repurchases, dividends, 
payments for terminated guarantees, and interest payments 
deriving from TARP investments,\592\ and another $1.2 billion 
in participation fees from its Guarantee Program for Money 
Market Funds.\593\
---------------------------------------------------------------------------
    \589\ Treasury Transaction Report, supra note 450.
    \590\ Treasury Transaction Report, supra note 450.
    \591\ See, e.g., U.S. Department of the Treasury, Securities 
Purchase Agreement: Standard Terms (online at 
www.financialstability.gov/docs/CPP/spa.pdf) (accessed Jan. 4, 2010).
    \592\ See U.S. Department of the Treasury, Cumulative Dividends and 
Interest Report as of December 31, 2009 (Jan. 20, 2010) (online at 
www.financialstability.gov/docs/dividends-interest-reports/
December%202009%20Dividends%20and%20Interest%20Report.pdf) (hereinafter 
``Treasury Dividends and Interest Report''); Treasury Transaction 
Report, supra note 450.
    \593\ U.S. Department of the Treasury, Treasury Announces 
Expiration of Guarantee Program for Money Market Funds (Sept. 18, 2009) 
(online at www.treasury.gov/press/releases/tg293.htm).
---------------------------------------------------------------------------
            c. TARP Accounting

                            Figure 55: TARP ACCOUNTING (AS OF FEBRUARY 1, 2010) \594\
                                              [Dollars in billions]
----------------------------------------------------------------------------------------------------------------
                                                                          Total
                                            Anticipated     Actual     Repayments/       Funding       Funding
             TARP Initiative                  Funding      Funding       Reduced       Outstanding    Available
                                                                        Exposure
----------------------------------------------------------------------------------------------------------------
Capital Purchase Program (CPP) \595\....          $204.9     $204.9            $122           $82.9           $0
Targeted Investment Program (TIP) \596\.            40.0       40.0              40               0            0
AIG Investment Program (AIGIP)/                     69.8  \597\ 46.               0            46.9         22.9
 Systemically Significant Failing                                 9
 Institutions Program (SSFI)............
Automobile Industry Financing Program               81.3       81.3             3.2            78.1            0
 (AIFP).................................
Asset Guarantee Program (AGP) \598\.....             5.0        5.0       \599\ 5.0               0            0
Capital Assistance Program (CAP) \600\..
Term Asset-Backed Securities Lending                20.0       20.0               0            20.0            0
 Facility (TALF)........................
Public-Private Investment Partnership               30.0       30.0               0            30.0            0
 (PPIP) \601\...........................
Supplier Support Program (SSP)..........       \602\ 3.5        3.5               0             3.5            0
Unlocking SBA Lending...................            15.0          0             N/A               0         15.0
Home Affordable Modification Program                50.0  \603\ 36.               0            35.5         14.5
 (HAMP).................................                          9
Community Development Financial
 Institutions Initiative \604\..........
Total Committed.........................           519.5      468.5               -           298.3           51
Total Uncommitted.......................           179.2        N/A           170.2             N/A  \605\ 349.4
    Total...............................          $698.7     $468.5          $170.2          $298.3      $400.4
----------------------------------------------------------------------------------------------------------------
\594\ Treasury Transaction Report, supra note 450.
\595\ As of December 31, 2009, the CPP was closed. U.S. Department of the Treasury, FAQ on Capital Purchase
  Program Deadline (online at www.financialstability.gov/docs/
  FAQ%20on%20Capital%20Purchase%20Program%20Deadline.pdf).
\596\ Both Bank of America and Citigroup repaid the $20 billion in assistance each institution received under
  the TIP on December 9 and December 23, 2009, respectively. Therefore the Panel accounts for these funds as
  repaid and uncommitted. U.S. Department of the Treasury, Treasury Receives $45 Billion in Repayments from
  Wells Fargo and Citigroup (Dec. 22, 2009) (online at www.treas.gov/press/releases/20091229716198713.htm)
  (hereinafter ``Treasury Receives $45 Billion from Wells Fargo and Citigroup'').
\597\ In information provided by Treasury in response to a Panel request, AIG has completely utilized the $40
  billion made available on November 25, 2008 and drawn down $5.3 billion of the $29.8 billion made available on
  April 17, 2009. This figure also reflects $1.6 billion in accumulated but unpaid dividends owed by AIG to
  Treasury due to the restructuring of Treasury's investment from cumulative preferred shares to non-cumulative
  shares. Treasury Transaction Report, supra note 450.
\598\ Treasury, the Federal Reserve, and the Federal Deposit Insurance Company terminated the asset guarantee
  with Citigroup on December 23, 2009. The agreement was terminated with no losses to Treasury's $5 billion
  second-loss portion of the guarantee. Citigroup did not repay any funds directly, but instead terminated
  Treasury's outstanding exposure on its $5 billion second-loss position. As a result, the $5 billion is now
  accounted for as available. Treasury Receives $45 Billion from Wells Fargo and Citigroup, supra note 596.
\599\ Although this $5 billion is no longer exposed as part of the AGP and is accounted for as available,
  Treasury did not receive a repayment in the same sense as with other investments.
\600\ On November 9, 2009, Treasury announced the closing of this program and that only one institution, GMAC,
  was in need of further capital from Treasury. GMAC received an additional $3.8 billion in capital through the
  AIFP on December 30, 2009. U.S. Department of the Treasury, Treasury Announcement Regarding the Capital
  Assistance Program (Nov. 9, 2009) (online at www.financialstability.gov/latest/tg_11092009.html); Treasury
  Transaction Report, supra note 450.
\601\ On January 29, 2010, Treasury released its first quarterly report on the Legacy Securities Public-Private
  Investment Program. As of that date, the total value of assets held by the PPIP managers was $3.4 billion. Of
  this total, 87 percent as non-agency Residential Mortgage-Backed Securities and the remaining 13 percent was
  Commercial Mortgage-Backed Securities. U.S. Department of the Treasury, Legacy Securities Public-Private
  Investment Program (Jan. 29, 2010) (online at www.financialstability.gov/docs/External%20Report%20-%2012-
  09%20FINAL.pdf).
\602\ On July 8, 2009, Treasury lowered the total commitment amount for the program from $5 billion to $3.5
  billion. This action reduced GM's portion from $3.5 billion to $2.5 billion and Chrysler's portion from $1.5
  billion to $1 billion. On November 11, 2009, there was a partial repayment of $140 million made by GM Supplier
  Receivables LLC, the special purpose vehicle created to administer this program for GM suppliers. This was a
  partial repayment of funds that were drawn down and did not lessen Treasury's $3.5 billion in total exposure
  to the ASSP. Treasury Transaction Report, supra note 450.
\603\ This figure reflects the total of all the caps set on payments to each mortgage servicer and not the
  disbursed amount of funds for successful modifications. In response to a Panel inquiry, Treasury disclosed
  that, as of Jan 10, 2010, $32 million in funds had been disbursed under the HAMP. Treasury Transaction Report,
  supra note 450.
\604\ On February 3, 2010, the Administration announced a new initiative under TARP to provide low-cost
  financing for Community Development Financial Institutions (CDFIs). Under this program, CDFIs are eligible for
  capital investments at a 2 percent dividend rate as compared to the 5 percent dividend rate under the CPP.
  Currently, the total amount of funds Treasury plans on investing has not been announced.
\605\ This figure is the sum of the uncommitted funds remaining under the $698.7 billion cap ($179.2 billion)
  and the repayments ($170.2 billion).


                                                          FIGURE 56: TARP REPAYMENTS AND INCOME
                                                                  [Dollars in billions]
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                   Repayments/                                                       Other
                                                                     Reduced     Dividends \606\  Interest \607\      Warrant       Proceeds
                        TARP Initiative                           Exposure (as    (as of 12/31/    (as of 12/31/    Repurchases   (as of 2/1/    Total
                                                                   of 2/1/10)          09)              09)       (as of 2/1/10)      10)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total..........................................................          $170.1            $12.5           $0.38           $4.03        $2.51     $189.5
CPP............................................................           121.9              8.3            0.02            4.03           --      134.3
TIP............................................................              40                3             N/A               0           --         43
AIFP...........................................................             3.2             0.94            0.34             N/A           --       4.48
ASSP...........................................................             N/A              N/A            0.01             N/A           --       0.01
AGP............................................................         \608\ 5             0.28             N/A               0   \609\ 2.23        7.5
PPIP...........................................................             N/A              N/A            .002             N/A           --      0.002
Bank of America Guarantee......................................              --               --              --              --   \610\ 0.28       .28
--------------------------------------------------------------------------------------------------------------------------------------------------------
\606\ Treasury Dividends and Interest Report, supra note 592.
\607\ Treasury Dividends and Interest Report, supra note 592.
\608\ Although Treasury, the Federal Reserve, the FDIC, and Citigroup have terminated the AGP, and although Treasury's $5 billion second-loss position
  no longer counts against the $698.7 TARP ceiling, Treasury did not receive any repayment income.
\609\ As a fee for taking a second-loss position up to $5 billion on a $301 billion pool of ring-fenced Citigroup assets as part of the AGP, Treasury
  received $4.03 billion in Citigroup preferred stock and warrants; Treasury exchanged these preferred stocks and warrants for trust preferred
  securities in June 2009. Following the early termination of the guarantee, Treasury cancelled $1.8 billion of the trust preferred securities, leaving
  Treasury with a $2.23 billion investment in Citigroup trust preferred securities in exchange for the guarantee. Treasury Transaction Report, supra
  note 450.
\610\ Although Treasury, the Federal Reserve, and the FDIC negotiated with Bank of America regarding a similar guarantee, the parties never reached an
  agreement. In September 2009, Bank of America agreed to pay each of the prospective guarantors a fee as though the guarantee had been in place during
  the negotiations. This agreement resulted in payments of $276 million to Treasury, $57 million to the Federal Reserve, and $92 million to the FDIC.
  U.S. Department of the Treasury, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and Bank of America
  Corporation, Termination Agreement, at 1-2 (Sept. 21, 2009) (online at www.financialstability.gov/docs/AGP/BofA%20-%20Termination%20Agreement%20-
  %20executed.pdf).

2. Other Financial Stability Efforts

            a. Federal Reserve, FDIC, and Other Programs
    In addition to the direct expenditures Treasury has 
undertaken through TARP, the federal government has engaged in 
a much broader program directed at stabilizing the U.S. 
financial system. Many of these initiatives explicitly augment 
funds allocated by Treasury under specific TARP initiatives, 
such as FDIC and Federal Reserve asset guarantees for 
Citigroup, or operate in tandem with Treasury programs, such as 
the interaction between PPIP and TALF. Other programs, like the 
Federal Reserve's extension of credit through its section 13(3) 
facilities and SPVs and the FDIC's Temporary Liquidity 
Guarantee Program, operate independently of TARP.
    Figure 57 below reflects the changing mix of Federal 
Reserve investments. On February 1, 2010, four temporary 
Federal Reserve programs aimed at increasing liquidity in the 
financial system expired: the Primary Dealer Credit Facility 
(PDCF), the Term Securities Lending Facility (TSLF), the Asset-
Backed Commercial Paper Money Market Mutual Fund Liquidity 
Facility (AMLF), and the Commercial Paper Funding Facility 
(CPFF). As the liquidity facilities established to face the 
crisis have been wound down, the Federal Reserve has expanded 
its facilities for purchasing mortgage-related securities. The 
Federal Reserve announced that it intends to purchase $175 
billion of federal agency debt securities and $1.25 trillion of 
agency mortgage-backed securities.\611\ As of January 28, 2010, 
$162 billion of federal agency (government-sponsored 
enterprise) debt securities and $973 billion of agency 
mortgage-backed securities have been purchased. The Federal 
Reserve has announced that these purchases will be completed by 
April 2010.\612\
---------------------------------------------------------------------------
    \611\ Board of Governors of the Federal Reserve System, Minutes of 
the Federal Open Market Committee, at 10 (Dec. 15-16, 2009) (online at 
www.federalreserve.gov/newsevents/press/monetary/
fomcminutes20091216.pdf) (``[T]he Federal Reserve is in the process of 
purchasing $1.25 trillion of agency mortgage-backed securities and 
about $175 billion of agency debt'').
    \612\ Board of Governors of the Federal Reserve System, FOMC 
Statement (Dec. 16, 2009) (online at www.federalreserve.gov/newsevents/
press/monetary/20091216a.htm) (``In order to promote a smooth 
transition in markets, the Committee is gradually slowing the pace of 
these purchases, and it anticipates that these transactions will be 
executed by the end of the first quarter of 2010''); Board of Governors 
of the Federal Reserve System, Factors Affecting Reserve Balances (Feb. 
4, 2010) (online at www.federalreserve.gov/Releases/H41/Current/).
---------------------------------------------------------------------------

 FIGURE 57: FEDERAL RESERVE AND FDIC FINANCIAL STABILITY EFFORTS \613\

---------------------------------------------------------------------------
    \613\ Federal Reserve Liquidity Facilities include: Primary credit, 
Secondary credit, Central Bank Liquidity Swaps, Primary dealer and 
other broker-dealer credit, Asset-Backed Commercial Paper Money Market 
Mutual Fund Liquidity Facility, Net portfolio holdings of Commercial 
Paper Funding Facility LLC, Seasonal credit, Term auction credit, Term 
Asset-Backed Securities Loan Facility. Federal Reserve Mortgage Related 
Facilities Include: Federal agency debt securities and Mortgage-backed 
securities held by the Federal Reserve. Institution Specific Facilities 
include: Credit extended to American International Group, Inc., and the 
net portfolio holdings of Maiden Lanes I, II, and III. Board of 
Governors of the Federal Reserve System, Factors Affecting Reserve 
Balances (H.4.1) (online at www.federalreserve.gov/datadownload/
Choose.aspx?rel=H41) (accessed Feb. 4, 2010). For related presentations 
of Federal Reserve data, see Board of Governors of the Federal Reserve 
System, Credit and Liquidity Programs and the Balance Sheet, at 2 (Nov. 
2009) (online at www.federalreserve.gov/monetarypolicy/files/
monthlyclbsreport200911.pdf). The TLGP figure reflects the monthly 
amount of debt outstanding under the program. Federal Deposit Insurance 
Corporation, Monthly Reports on Debt Issuance Under the Temporary 
Liquidity Guarantee Program (Dec. 2008-Dec. 2009) (online at 
www.fdic.gov/regulations/resources/TLGP/reports.html). 

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

3. Total Financial Stability Resources (as of December 31, 2009)

    Beginning in its April report, the Panel broadly classified 
the resources that the federal government has devoted to 
stabilizing the economy through myriad new programs and 
initiatives as outlays, loans, or guarantees. Although the 
Panel calculates the total value of these resources at nearly 
$3 trillion, this would translate into the ultimate ``cost'' of 
the stabilization effort only if: (1) assets do not appreciate; 
(2) no dividends are received, no warrants are exercised, and 
no TARP funds are repaid; (3) all loans default and are written 
off; and (4) all guarantees are exercised and subsequently 
written off.
    With respect to the FDIC and Federal Reserve programs, the 
risk of loss varies significantly across the programs 
considered here, as do the mechanisms providing protection for 
the taxpayer against such risk. As discussed in the Panel's 
November report, the FDIC assesses a premium of up to 100 basis 
points on TLGP debt
guarantees.\614\ In contrast, the Federal Reserve's liquidity 
programs are generally available only to borrowers with good 
credit, and the loans are over-collateralized and with recourse 
to other assets of the borrower. If the assets securing a 
Federal Reserve loan realize a decline in value greater than 
the ``haircut,'' the Federal Reserve is able to demand more 
collateral from the borrower. Similarly, should a borrower 
default on a recourse loan, the Federal Reserve can turn to the 
borrower's other assets to make the Federal Reserve whole. In 
this way, the risk to the taxpayer on recourse loans only 
materializes if the borrower enters bankruptcy. The only loan 
currently ``underwater''--where the outstanding principal 
amount exceeds the current market value of the collateral--is 
the loan to Maiden Lane LLC, which was formed to purchase 
certain Bear Stearns assets.
---------------------------------------------------------------------------
    \614\ Congressional Oversight Panel, Guarantees and Contingent 
Payments in TARP and Related Programs, at 36 (Nov. 11, 2009) (online at 
cop.senate.gov/documents/cop-110609-report.pdf).

               FIGURE 58: FEDERAL GOVERNMENT FINANCIAL STABILITY EFFORT (AS OF DECEMBER 31, 2009)
                                              [Dollars in billions]
----------------------------------------------------------------------------------------------------------------
                                                     Treasury         Federal
                     Program                          (TARP)          Reserve          FDIC            Total
----------------------------------------------------------------------------------------------------------------
Total...........................................          $698.7        $1,518.6          $646.4        $2,863.7
    Outlays \i\.................................           286.8         1,136.1            69.4         1,492.3
    Loans.......................................            42.7           382.6               0           425.3
    Guarantees ii...............................              20               0             577             597
    Uncommitted TARP Funds......................           349.2               0               0           349.2
AIG.............................................            69.8            68.2               0           138.5
    Outlays.....................................      \iii\ 69.8               0               0            69.8
    Loans.......................................               0         iv 68.2               0            68.7
    Guarantees..................................               0               0               0               0
Bank of America.................................               0               0               0               0
    Outlays.....................................             v 0               0               0               0
    Loans.......................................               0               0               0               0
    Guarantees..................................               0               0               0               0
Citigroup.......................................              25               0               0              25
    Outlays.....................................           vi 25               0               0              25
    Loans.......................................               0               0               0               0
    Guarantees..................................               0               0               0               0
Capital Purchase Program (Other)................              58               0               0              58
    Outlays.....................................          vii 58               0               0              58
    Loans.......................................               0               0               0               0
    Guarantees..................................               0               0               0               0
Capital Assistance Program......................             N/A               0               0        viii N/A
TALF............................................              20             180               0             200
    Outlays.....................................               0               0               0               0
    Loans.......................................               0           x 180               0             180
    Guarantees..................................           ix 20               0               0              20
PPIP (Loans) xi.................................               0               0               0               0
    Outlays.....................................               0               0               0               0
    Loans.......................................               0               0               0               0
    Guarantees..................................               0               0               0               0
PPIP (Securities)...............................          xii 30               0               0              30
    Outlays.....................................              10               0               0              10
    Loans.......................................              20               0               0              20
    Guarantees..................................               0               0               0               0
Home Affordable Modification Program............              50               0               0          xiv 50
    Outlays.....................................          xiii50               0               0              50
    Loans.......................................               0               0               0               0
    Guarantees..................................               0               0               0               0
Automotive Industry Financing Program...........          xv78.2               0               0            78.2
    Outlays.....................................              59               0               0              59
    Loans.......................................            19.2               0               0            19.2
    Guarantees..................................               0               0               0               0
Auto Supplier Support Program...................             3.5               0               0             3.5
    Outlays.....................................               0               0               0               0
    Loans.......................................          xvi3.5               0               0             3.5
    Guarantees..................................               0               0               0               0
Unlocking SBA Lending...........................         xvii 15               0               0              15
    Outlays.....................................              15               0               0              15
    Loans.......................................               0               0               0               0
    Guarantees..................................               0               0               0               0
Temporary Liquidity Guarantee Program...........               0               0             577             577
    Outlays.....................................               0               0               0               0
    Loans.......................................               0               0               0               0
    Guarantees..................................               0               0       xviii 577             577
Deposit Insurance Fund..........................               0               0            69.4            69.4
    Outlays.....................................               0               0        xix 69.4            69.4
    Loans.......................................               0               0               0               0
    Guarantees..................................               0               0               0               0
Other Federal Reserve Credit Expansion..........               0         1,270.4               0         1,270.4
    Outlays.....................................               0        xx 1,136               0         1,136.1
    Loans.......................................               0       xxi 134.4               0           134.4
    Guarantees..................................               0               0               0               0
Uncommitted TARP Funds..........................           349.2               0               0           349.2
----------------------------------------------------------------------------------------------------------------
\i\ The term ``outlays'' is used here to describe the use of Treasury funds under the TARP, which are broadly
  classifiable as purchases of debt or equity securities (e.g., debentures, preferred stock, exercised warrants,
  etc.). The outlays figures are based on: (1) Treasury's actual reported expenditures; and (2) Treasury's
  anticipated funding levels as estimated by a variety of sources, including Treasury pronouncements and GAO
  estimates. Anticipated funding levels are set at Treasury's discretion, have changed from initial
  announcements, and are subject to further change. Outlays used here represent investment and asset purchases
  and commitments to make investments and asset purchases and are not the same as budget outlays, which under
  section 123 of EESA are recorded on a ``credit reform'' basis.
\ii\ Although many of the guarantees may never be exercised or exercised only partially, the guarantee figures
  included here represent the federal government's greatest possible financial exposure.
\iii\ This number includes investments under the AIGIP/SSFI Program: a $40 billion investment made on November
  25, 2008, and a $30 billion investment committed on April 17, 2009 (less a reduction of $165 million
  representing bonuses paid to AIG Financial Products employees). As of January 5, 2010, AIG had utilized $45.3
  billion of the available $69.8 billion under the AIGIP/SSFI and owed $1.6 billion in unpaid dividends. This
  information was provided by Treasury in response to a Panel inquiry.
\iv\ This number represents the full $35 billion that is available to AIG through its revolving credit facility
  with the Federal Reserve ($24.4 billion had been drawn down as of January 28, 2010) and the outstanding
  principal of the loans extended to the Maiden Lane II and III SPVs to buy AIG assets (as of December 31, 2009,
  $15.5 billion and $17.7 billion respectively). Income from the purchased assets is used to pay down the loans
  to the SPVs, reducing the taxpayers' exposure to losses over time. Board of Governors of the Federal Reserve
  System, Federal Reserve System Monthly Report on Credit and Liquidity Programs and the Balance Sheet, at 17
  (Oct. 2009) (online at www.federalreserve.gov/monetarypolicy/files/monthlyclbsreport200910.pdf). On December
  1, 2009, AIG entered into an agreement with FRBNY to reduce the debt AIG owes the FRBNY by $25 billion. In
  exchange, FRBNY received preferred equity interests in two AIG subsidiaries. This also reduced the debt
  ceiling on the loan facility from $60 billion to $35 billion. American International Group, AIG Closes Two
  Transactions That Reduce Debt AIG Owes Federal Reserve Bank of New York by $25 billion (Dec. 1, 2009) (online
  at phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9MjE4OD18Q2hpbGRJRD0tMXxUeXB1PTM=&t=1).
\v\ Bank of America repaid the $45 billion in assistance it had received through TARP programs on December 9,
  2009. U.S. Department of the Treasury, Troubled Asset Relief Program Transaction Report for Period Ending
  February 1, 2010 (Feb. 2, 2010) (online at www.financialstability.gov/docs/transaction-reports/2-3-
  10%20Transactions%20Report%20as%20of%202-1-10.pdf).
\vi\ As of February 4, 2009, the U.S. Treasury held $25 billion of Citigroup common stock. U.S. Department of
  the Treasury, Troubled Asset Relief Program Transaction Report for Period Ending February 1, 2010 (Feb. 2,
  2010) (online at www.financialstability.gov/docs/transaction-reports/2-3-
  10%20Transactions%20Report%20as%20of%202-1-10.pdf).
\vii\ This figure represents the $204.9 billion Treasury has disbursed under the CPP, minus the $25 billion
  investment in Citigroup ($25 billion) identified above, and the $121.9 billion in repayments that are
  reflected as available TARP funds. This figure does not account for future repayments of CPP investments, nor
  does it account for dividend payments from CPP investments. U.S. Department of the Treasury, Troubled Asset
  Relief Program Transaction Report for Period Ending February 1, 2010 (Feb. 2, 2010) (online at
  www.financialstability.gov/docs/transaction-reports/2-3-10%20Transactions%20Report%20as%20of%202-1-10.pdf).
\viii\ On November 9, 2009, Treasury announced the closing of the CAP and that only one institution, GMAC, was
  in need of further capital from Treasury. GMAC, however, received further funding through the AIFP, therefore
  the Panel considers CAP unused and closed. U.S. Department of the Treasury, Treasury Announcement Regarding
  the Capital Assistance Program (Nov. 9, 2009) (online at www.financialstability.gov/latest/tg_11092009.html).
\ix\ This figure represents a $20 billion allocation to the TALF SPV on March 3, 2009. However, as of January
  28, 2010, TALF LLC had drawn only $103 million of the available $20 billion. Board of Governors of the Federal
  Reserve System, Factors Affecting Reserve Balances (H.4.1) (Jan. 28, 2010) (online at www.federalreserve.gov/
  Releases/H41/Current/); U.S. Department of the Treasury, Troubled Asset Relief Program Transaction Report for
  Period Ending February 1, 2010 (Feb. 2, 2010) (online at www.financialstability.gov/docs/transaction-reports/2-
  3-10%20Transactions%20Report%20as%20of%202-1-10.pdf). As of January 28, 2010, investors had requested a total
  of $65.7 billion in TALF loans ($10.7 billion in CMBS and $55 billion in non-CMBS) and $64 billion in TALF
  loans had been settled ($10 billion in CMBS and $54 billion in non-CMBS). Federal Reserve Bank of New York,
  Term Asset-Backed Securities Loan Facility: CMBS (accessed Feb. 4, 2010) (online at www.newyorkfed.org/markets/
  CMBS_recent_operations.html); Federal Reserve Bank of New York, Term Asset-Backed Securities Loan Facility:
  non-CMBS (accessed Feb. 4, 2010) (online at www.newyorkfed.org/markets/talf_operations.html).
\x\ This number is derived from the unofficial 1:10 ratio of the value of Treasury loan guarantees to the value
  of Federal Reserve loans under the TALF. U.S. Department of the Treasury, Fact Sheet: Financial Stability Plan
  (Feb.10, 2009) (online at www.financialstability.gov/docs/fact-sheet.pdf) (describing the initial $20 billion
  Treasury contribution tied to $200 billion in Federal Reserve loans and announcing potential expansion to a
  $100 billion Treasury contribution tied to $1 trillion in Federal Reserve loans). Because Treasury is
  responsible for reimbursing the Federal Reserve Board for $20 billion of losses on its $200 billion in loans,
  the Federal Reserve Board's maximum potential exposure under the TALF is $180 billion.
\xi\ It is unlikely that resources will be expended under the PPIP Legacy Loans Program in its original design
  as a joint Treasury-FDIC program to purchase troubled assets from solvent banks. See also Federal Deposit
  Insurance Corporation, FDIC Statement on the Status of the Legacy Loans Program (June 3, 2009) (online at
  www.fdic.gov/news/news/press/2009/pr09084.html) and Federal Deposit Insurance Corporation, Legacy Loans
  Program--Test of Funding Mechanism (July 31, 2009) (online at www.fdic.gov/news/news/press/2009/pr09131.html).
  The sales described in these statements do not involve any Treasury participation, and FDIC activity is
  accounted for here as a component of the FDIC's Deposit Insurance Fund outlays.
\xii\ As of February 4, 2010, Treasury reported commitments of $19.9 billion in loans and $9.9 billion in
  membership interest associated with the program. U.S. Department of the Treasury, Troubled Asset Relief
  Program Transaction Report for Period Ending February 1, 2010 (Feb. 2, 2010) (online at
  www.financialstability.gov/docs/transaction-reports/2-3-10%20Transactions%20Report%20as%20of%202-1-10.pdf).
\xiii\ U.S. Government Accountability Office, Troubled Asset Relief Program: June 2009 Status of Efforts to
  Address Transparency and Accountability Issues, at 2 (June 17, 2009) (GAO09/658) (online at www.gao.gov/
  new.items/d09658.pdf). Of the $50 billion in announced TARP funding for this program, $36.9 billion has been
  allocated as of February 4, 2010. However, as of January 10, 2010, only $32 million in non-GSE payments have
  been disbursed under HAMP. Disbursement information provided in response to Panel inquiry on February 4, 2010;
  U.S. Department of the Treasury, Troubled Asset Relief Program Transaction Report for Period Ending February
  1, 2010 (Feb. 2, 2010) (online at www.financialstability.gov/docs/transaction-reports/2-3-
  10%20Transactions%20Report%20as%20of%202-1-10.pdf).
\xiv\ Fannie Mae and Freddie Mac, government-sponsored entities (GSEs) that were placed in conservatorship of
  the Federal Housing Finance Agency on September 7, 2009, will also contribute up to $25 billion to the Making
  Home Affordable Program, of which the HAMP is a key component. U.S. Department of the Treasury, Making Home
  Affordable: Updated Detailed Program Description (Mar. 4, 2009) (online at www.treas.gov/press/releases/
  reports/housing_fact_sheet.pdf).
\xv\ See U.S. Department of the Treasury, Troubled Asset Relief Program Transaction Report for Period Ending
  February 1, 2010 (Feb. 2, 2010) (online at www.financialstability.gov/docs/transaction-reports/2-3-
  10%20Transactions%20Report%20as%20of%202-1-10.pdf). A substantial portion of the total $81 billion in loans
  extended under the AIFP have since been converted to common equity and preferred shares in restructured
  companies. $19.2 billion has been retained as first lien debt (with $6.7 billion committed to GM, $12.5
  billion to Chrysler). This figure ($78.2 billion) represents Treasury's current obligation under the AIFP
  after repayments.
\xvi\ See U.S. Department of the Treasury, Troubled Asset Relief Program Transaction Report for Period Ending
  February 1, 2010 (Feb. 2, 2010) (online at www.financialstability.gov/docs/transaction-reports/2-3-
  10%20Transactions%20Report%20as%20of%202-1-10.pdf).
\xvii\ U.S. Department of the Treasury, Fact Sheet: Unlocking Credit for Small Businesses (Oct. 19, 2009)
  (online at www.financialstability.gov/roadtostability/unlockingCreditforSmallBusinesses.html) (``Jumpstart
  Credit Markets For Small Businesses By Purchasing Up to $15 Billion in Securities'').
\xviii\ This figure represents the current maximum aggregate debt guarantees that could be made under the
  program, which, in turn, is a function of the number and size of individual financial institutions
  participating. $309 billion of debt subject to the guarantee has been issued to date, which represents about
  54 percent of the current cap. Federal Deposit Insurance Corporation, Monthly Reports on Debt Issuance Under
  the Temporary Liquidity Guarantee Program: Debt Issuance Under Guarantee Program (Dec. 31, 2009) (online at
  www.fdic.gov/regulations/resources/tlgp/total_issuance12-09.html) (updated Feb. 4, 2010). The FDIC has
  collected $10.5 billion in fees and surcharges from this program since its inception in the fourth quarter of
  2008. Federal Deposit Insurance Corporation, Monthly Reports on Debt Issuance Under the Temporary Liquidity
  Guarantee Program (Nov. 30, 2009) (online at www.fdic.gov/regulations/resources/TLGP/fees.html) (updated Feb.
  4, 2010).
\xix\ This figure represents the FDIC's provision for losses to its deposit insurance fund attributable to bank
  failures in the third and fourth quarters of 2008 and the first, second and third quarters of 2009. Federal
  Deposit Insurance Corporation, Chief Financial Officer's (CFO) Report to the Board: DIF Income Statement
  (Fourth Quarter 2008) (online at www.fdic.gov/about/strategic/corporate/cfo_report_4qtr_08/income.html);
  Federal Deposit Insurance Corporation, Chief Financial Officer's (CFO) Report to the Board: DIF Income
  Statement (Third Quarter 2008) (online at www.fdic.gov/about/strategic/corporate/cfo_report_3rdqtr_08/
  income.html); Federal Deposit Insurance Corporation, Chief Financial Officer's (CFO) Report to the Board: DIF
  Income Statement (First Quarter 2009) (online at www.fdic.gov/about/strategic/corporate/cfo_report_1stqtr_09/
  income.html); Federal Deposit Insurance Corporation, Chief Financial Officer's (CFO) Report to the Board: DIF
  Income Statement (Second Quarter 2009) (online at www.fdic.gov/about/strategic/corporate/cfo_report_2ndqtr_09/
  income.html); Federal Deposit Insurance Corporation, Chief Financial Officer's (CFO) Report to the Board: DIF
  Income Statement (Third Quarter 2009) (online at www.fdic.gov/about/strategic/corporate/cfo_report_3rdqtr_09/
  income.html). This figure includes the FDIC's estimates of its future losses under loss-sharing agreements
  that it has entered into with banks acquiring assets of insolvent banks during these four quarters. Under a
  loss-sharing agreement, as a condition of an acquiring bank's agreement to purchase the assets of an insolvent
  bank, the FDIC typically agrees to cover 80 percent of an acquiring bank's future losses on an initial portion
  of these assets and 95 percent of losses of another portion of assets. See, for example Federal Deposit
  Insurance Corporation, Purchase and Assumption Agreement Among FDIC, Receiver of Guaranty Bank, Austin, Texas,
  FDIC and Compass Bank at 65-66 (Aug. 21, 2009) (online at www.fdic.gov/bank/individual/failed/guaranty-
  tx_p_and_a_w_addendum.pdf). In information provided to Panel staff, the FDIC disclosed that there were
  approximately $132 billion in assets covered under loss-sharing agreements as of December 18, 2009.
  Furthermore, the FDIC estimates the total cost of a payout under these agreements to be $59.3 billion. Since
  there is a published loss estimate for these agreements, the Panel continues to reflect them as outlays rather
  than as guarantees.
\xx\ Outlays are comprised of the Federal Reserve Mortgage Related Facilities. The Federal Reserve balance sheet
  accounts for these facilities under Federal agency debt securities and mortgage-backed securities held by the
  Federal Reserve. Board of Governors of the Federal Reserve System, Factors Affecting Reserve Balances (H.4.1)
  (online at www.federalreserve.gov/datadownload/Choose.aspx?rel=H41) (accessed Feb. 4, 2010). Although the
  Federal Reserve does not employ the outlays, loans and guarantees classification, its accounting clearly
  separates its mortgage-related purchasing programs from its liquidity programs. See Board of Governors of the
  Federal Reserve, Credit and Liquidity Programs and the Balance Sheet November 2009, at 2 (online at
  www.federalreserve.gov/monetarypolicy/files/monthlyclbsreport200911.pdf) (accessed Dec. 7, 2009).
\xxi\ Federal Reserve Liquidity Facilities classified in this table as loans include: Primary credit, Secondary
  credit, Central bank liquidity swaps, Primary dealer and other broker-dealer credit, Asset-Backed Commercial
  Paper Money Market Mutual Fund Liquidity Facility, Net portfolio holdings of Commercial Paper Funding Facility
  LLC, Seasonal credit, Term auction credit, Term Asset-Backed Securities Loan Facility, and loans outstanding
  to Bear Stearns (Maiden Lane I LLC). Board of Governors of the Federal Reserve System, Factors Affecting
  Reserve Balances (H.4.1) (online at www.federalreserve.gov/datadownload/Choose.aspx?rel=H41) (accessed Feb. 4,
  2010); see id.

                   SECTION SIX: OVERSIGHT ACTIVITIES

    The Congressional Oversight Panel was established as part 
of EESA and formed on November 26, 2008. Since then, the Panel 
has produced 14 oversight reports, as well as a special report 
on regulatory reform, issued on January 29, 2009, and a special 
report on farm credit, issued on July 21, 2009. Since the 
release of the Panel's January oversight report, which assessed 
Treasury's exit strategy for the TARP, the following 
developments pertaining to the Panel's oversight of the TARP 
took place:
     The Panel held a field hearing in Atlanta, Georgia 
on January 27, 2010, discussing the state of commercial real 
estate lending, the potential effect of commercial real estate 
problems on the banking system, and the role and impact of the 
TARP in addressing that effect. The Panel heard testimony from 
regulators at the FDIC and the Federal Reserve as well as from 
a number of participants in the commercial real estate 
industry. An audio recording of the hearing, the written 
testimony from the hearing witnesses, and Panel members' 
opening statements all can be found online at http://
cop.senate.gov/hearings.

Upcoming Reports and Hearings

    The Panel will release its next oversight report in March. 
The report will address the assistance provided to GMAC under a 
wide array of TARP initiatives as well as the approach taken by 
GMAC's new management to return the company to profitability 
and, ultimately, return the taxpayers' investment.
    The Panel is planning a hearing in Washington on February 
25, 2010 to discuss the topic of the March report. The Panel is 
hoping to ask Treasury officials to explain their approach to 
and reasons for providing assistance to GMAC and to hear 
details from GMAC executives about their plans for the future 
of the company.
         SECTION SEVEN: ABOUT THE CONGRESSIONAL OVERSIGHT PANEL

    In response to the escalating financial crisis, on October 
3, 2008, Congress provided Treasury with the authority to spend 
$700 billion to stabilize the U.S. economy, preserve home 
ownership, and promote economic growth. Congress created the 
Office of Financial Stability (OFS) within Treasury to 
implement the Troubled Asset Relief Program. At the same time, 
Congress created the Congressional Oversight Panel to ``review 
the current state of financial markets and the regulatory 
system.'' The Panel is empowered to hold hearings, review 
official data, and write reports on actions taken by Treasury 
and financial institutions and their effect on the economy. 
Through regular reports, the Panel must oversee Treasury's 
actions, assess the impact of spending to stabilize the 
economy, evaluate market transparency, ensure effective 
foreclosure mitigation efforts, and guarantee that Treasury's 
actions are in the best interests of the American people. In 
addition, Congress instructed the Panel to produce a special 
report on regulatory reform that analyzes ``the current state 
of the regulatory system and its effectiveness at overseeing 
the participants in the financial system and protecting 
consumers.'' The Panel issued this report in January 2009. 
Congress subsequently expanded the Panel's mandate by directing 
it to produce a special report on the availability of credit in 
the agricultural sector. The report was issued on July 21, 
2009.
    On November 14, 2008, Senate Majority Leader Harry Reid and 
the Speaker of the House Nancy Pelosi appointed Richard H. 
Neiman, Superintendent of Banks for the State of New York, 
Damon Silvers, Director of Policy and Special Counsel of the 
American Federation of Labor and Congress of Industrial 
Organizations (AFL-CIO), and Elizabeth Warren, Leo Gottlieb 
Professor of Law at Harvard Law School, to the Panel. With the 
appointment on November 19, 2008, of Congressman Jeb Hensarling 
to the Panel by House Minority Leader John Boehner, the Panel 
had a quorum and met for the first time on November 26, 2008, 
electing Professor Warren as its chair. On December 16, 2008, 
Senate Minority Leader Mitch McConnell named Senator John E. 
Sununu to the Panel. Effective August 10, 2009, Senator Sununu 
resigned from the Panel, and on August 20, 2009, Senator 
McConnell announced the appointment of Paul Atkins, former 
Commissioner of the U.S. Securities and Exchange Commission, to 
fill the vacant seat. Effective December 9, 2009, Congressman 
Jeb Hensarling resigned from the Panel and House Minority 
Leader John Boehner announced the appointment of J. Mark 
McWatters to fill the vacant seat.

                            ACKNOWLEDGEMENTS

    The Panel wishes to acknowledge Richard Parkus, head of 
Commercial Real Estate Debt Research, and Harris Trifon, 
analyst, Deutsche Bank; Gail Lee, managing director at Credit 
Suisse; Matthew Anderson, partner, Foresight Analytics LLC; 
Nick Levidy, managing director, Moody's Investor Services; 
Robert White, president, Real Capital Analytics, Inc.; Jeffrey 
DeBoer, president and chief executive officer, The Real Estate 
Roundtable; and David Geltner, director of research, 
Massachusetts Institute of Technology Center for Real Estate 
for the contributions each has made to this report.
APPENDIX I: LETTER FROM SECRETARY TIMOTHY GEITHNER TO CHAIR ELIZABETH 
        WARREN, RE: PANEL QUESTIONS FOR CIT GROUP UNDER CPP, DATED 
        JANUARY 13, 2010

        [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
        