Treasury Works on 'Plan C' To Fend Off Lingering Threats
Troubling Issues in Lending Could Still Disrupt Economy

By David Cho and Binyamin Appelbaum
Washington Post Staff Writers
Wednesday, July 8, 2009

As the financial system tries to right itself after its near-collapse last fall, the Treasury Department has assembled a team to examine what could yet bring it down and has identified several trouble spots that could threaten the still-fragile lending industry.

Informally known as Plan C, the internal project is focused on vexing problems such as the distressed commercial real estate markets, the high rate of delinquencies among homeowners, and the struggles of community and regional banks, said government sources familiar with the effort.

Part of the mission is assessing which firms are the most vulnerable and trying to decipher what assets these companies hold and whether they pose a danger to the wider financial system. Plan C is a small-scale, relatively informal approach to a problem the administration hopes to address in the long term by empowering the Federal Reserve to oversee systemic risk.

The team is also responsible for considering potential government responses, but top officials within the Obama administration are wary of rolling out initiatives that would commit massive amounts of federal resources, said other sources in close contact with the administration. The sources spoke on condition of anonymity because the discussions are private. Instead, the administration thinks some ailing sectors of the credit markets should work out problems on their own, the sources said.

The creation of Plan C is a sign that the government has moved into a new phase of its response, acting preemptively rather than reacting to emerging crises, officials said.

"We are continually examining different scenarios going forward; that's just prudent planning," Treasury spokesman Andrew Williams said.

The officials in charge of Plan C -- named to allude to a last line of defense -- face a particular challenge in addressing the breakdown of commercial real estate lending.

Banks and other firms that provided such loans in the past have sharply curtailed lending.

That has left many developers and construction companies out in the cold. Over the next few years, these groups face a tidal wave of commercial real estate debt -- some estimates peg the total at more than $3 trillion -- that they will need to refinance. These loans were issued during this decade's construction boom with the mistaken expectation that they would be refinanced on the same generous terms after a few years.

The credit crisis changed all of that. Now few developers can find anyone to refinance their debt, endangering healthy and distressed properties.

General Growth Properties, which owns the Tysons Galleria mall in Northern Virginia, one of the most profitable shopping centers in the nation, filed for bankruptcy this spring after it could not roll over its loans. The John Hancock Tower in Boston, one of the city's most famous landmarks, was auctioned off after its owner defaulted on its debt.

"There's going to be a lot of these stories where people relied very heavily on this high-leverage cheap availability of debt," said Kevin Smith of Blackwell Advisors, a financial consultancy.

Kim Diamond, a managing director at Standard & Poor's, said the trend is expected to accelerate over the next few years, further depressing prices on some of the nation's most valuable properties.

"It's not a degree to which people are willing to lend," she said. "The question is whether a loan can be made at all."

The problem affects not just the recipients of the loans but also the institutions that lend, many of them small community banks and regional firms.

Thousands of these institutions wrote billions of dollars in mortgages on strip malls, doctors offices and drive-through restaurants. These commercial loans required a lot of scrutiny and a leap of faith, and, for much of the decade, the smaller banks that leapt were rewarded with outsize profits.

In doing so, many took on bigger and bigger risks. By the beginning of the recession in December 2007, the median midsize bank held commercial real estate loans worth 3.55 times its capital cushion -- its reserve against unexpected losses -- according to the Federal Deposit Insurance Corp.

Borrower defaults increasingly are draining capital from many of those banks, forcing some to close. Financial analysts said losses on commercial real estate loans are now the single largest cause of bank failures.

The federal government has set up bailout programs to provide relief to the commercial real estate market, but none of these efforts is big enough to address the size of the problem, industry analysts said.

One Fed program to revive lending took aim at the problem. But this effort faltered in June, failing to attract much interest in the issuance of new commercial real estate loans. The central bank said yesterday that the program sparked only $5.4 billion in new loans of any kind last month, less than half the previous month's total.

Another government effort to buy mortgages, including commercial loans, off the books of banks has been shelved because of a lack of interest from industry. A companion plan to buy toxic bank assets, some of which back commercial loans, is being downsized for similar reasons.

Another issue identified by the Plan C team is homeowner delinquencies, which continue to rise as large numbers of people lose their jobs and miss monthly payments.

The backlog of seriously delinquent mortgages, which so far affects about 1 million borrowers, masks the full extent of the housing crisis. The trend foreshadows even more financial losses to come for lenders as many of these homeowners are expected to continue to miss payments and eventually fall into foreclosure.

The Obama administration announced last week that it would loosen the eligibility requirements for a program aimed at helping borrowers with no equity to refinance into cheaper mortgages.

Acknowledging that falling housing prices have made it increasingly difficult for borrowers to qualify, officials said the program would now be open to those whose mortgage debt is up to 125 percent of their home value. The program, launched in February, was initially open only to those borrowers who owed no more than 105 percent of their home value.

Staff writer Renae Merle contributed to this report.

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