Commercial mortgage-backed securities might get all the headlines, but when it comes to commercial real estate’s unfolding horror show, old-fashioned bank debt is the real star. It’s banks, not CMBS, on the hook for souring construction loans. It’s banks, not CMBS bondholders, holding the bulk of underwater commercial debt. And it’s banks that will suffer the most as a painful deleveraging unfolds over the next few years.

“Bank debt is so much more of the overall market,” said Hans Nordby, chief strategist at Boston-based Property & Portfolio Research (PPR). “CMBS was more poorly underwritten, and that’s blowing up now, but it was done with longer terms, and to the extent that the property can meet the debt service, the owner can keep holding on. The bank universe was better underwritten, but it’s so much larger. There’s no comparison.”

PPR data shows although CMBS debt is performing worse than banks, banks own the bulk of shaky commercial debt.

According to PPR, nearly 50 percent of CMBS debt from 2006 is underwater, compared to 30 percent of banks’ commercial debt. For 2007-vintage debt, 70 percent of CMBS loans are underwater, compared to 50 percent of bank loans.

Not So Fast

Still, in the 2006 vintage, banks own $60 billion more shaky debt than CMBS bondholders. For commercial debt issued in 2007, banks own $110 billion more in underwater loans. In that class, a staggering $270 billion in bank-held commercial debt is underwater, compared to $160 billion in CMBS debt.

Much noise has been made about the threat expiring CMBS loans pose to the commercial universe, as no mechanism exists for rolling those loans over. Nationally, CMBS issuances topped $230 billion in 2007, but ground to a halt halfway through 2008.

“There’s a rollover crisis, no question about it,” said University of Wisconsin economist Timothy Riddiough, speaking at a recent industry roundtable in Boston. However, he added, “CMBS rollover really won’t hit until 2015.”

Riddiough said banks are facing a rollover shortfall that’s between five and 10 times bigger than that posed by CMBS.

“CMBS is not going to be at the leading edge of the problem, or the solution. In the short term, it’s a small-bank and medium-bank problem. A lot of them are going to fail,” Riddiough said.

William Wheaton, a professor of economics at MIT, said he expects bank problems to be the worst in California, Florida, Arizona and Nevada, but added that no region should be immune.

“It’s pretty widespread,” he said.

Michael Gatlin, a real estate attorney in Framingham, said so far the lenders he works with haven’t seen many souring development loans.

“It’s the individual borrowers, as opposed to large tracts of development,” he said.

Approximately $550 billion in commercial debt needs to roll over every year from 2009 to 2012. In each year, bank-held commercial mortgages account for approximately $200 billion. Moreover, in that period, banks hold an additional $200 billion-$220 billion of maturing construction debt.

“That’s what’s driving a lot of the underwater loans,” Nordby said. “It’s stranded. You can’t get rid of it.”

The construction loans, in particular, have ballooned out of control, Nordby said. A typical loan on a residential or condominium development made at a loan-to-value ratio of 60 may have swelled to an LTV of 130, thanks to rapidly falling values and rising cap rates.

Exploding loan-to-value ratios mean many problem loans cannot be realistically refinanced. Regulators have been cautious about protecting banks’ capital levels, so they haven’t forced lenders to mark commercial loans to market. That has created a situation in which bad loans sit on lenders’ books, and troubled properties drift, rudderless. Douglas Linde, president of Boston Properties, recently characterized these owners as “zombie landlords,” because they have no capital left in their assets.

“Properties are overleveraged,” Linde said at the recent CREW Network convention. “Values have come down. There is simply not enough capital to ever pay off the debt based upon where the leverage is today. At some point, there will have to be a day of reckoning with these assets. There will have to be a sale of the asset, a reduction in the value, a new capital structure, and it’s not happening yet.”

No Rush To Sell … For Now

At that conference, Thomas Deane of Wachovia said banks will have to begin liquidating nonperforming assets. Still, he said his division is not engaging in bulks sales because the gap between buyers and sellers remains too wide.

“If the seller is not forced to sell, we will not see those transactions,” he said. “If you’re not the FDIC, or if you’re not trying to cleanse your balance sheet by quarter’s end, you are not forced to sell.”

Susan Winston Leff, a senior vice president at Wells Fargo Bank in Boston, added that at Wells and other large banks, there is no rush to dispose of assets.

“That’s frustrating for the acquisition [side],” she said. “There’s a feeling in the ether that you can buy OREO [properties] or notes at a steep discount. We’re not in that position.”

“We’re getting all these calls from folks who want a deal,” said Lea Land, an executive at Wachovia Securities. “Banks can’t give you a deal. We have to maximize the price.” Land said her department is hanging on to some assets until next year to see whether freer financing will help inflate prices.

“As banks show profit, they will be able to take them back,” Nordby predicted. “The regulators will say, ‘I’m going to make you honest now, and make you make healthy loans.’” Still, he said, that process will take a good amount of time. In the meantime, Nordby is hearing about loans getting kicked down the road by as many as five years.

“Banks are watching a slow motion train-wreck, and they can’t figure out a way to jump in and stop it,” Riddiough argued. “Small and medium-sized banks see the train-wreck happening, and at the same time, they see the federal government coming in and bailing out these other sectors. They’re saying, ‘Let’s wait to see that happens.’ It’s a game of chicken. We need to experience some distress, more a dose of reality, to get buyers and sellers together.”