While financial institutions glumly watch the ongoing residential real estate crisis, a few analysts worry they might be in for a sequel – only this time, commercial mortgage defaults play the villain, and lenders such as insurance companies get pulled further into the storyline.

Commercial loan delinquencies have doubled over the past six months, hitting 1.8 percent as of March and are on track to hit 3.5 percent by the end of the year, according to Deutsche Bank AG’s recent report.

But if this sequel is indeed underway, it’s in the very early stages. The American Council of Life Insurers reported that out of 35,000 outstanding commercial real estate loans from the life insurance industry, only 33 were delinquent as of the end of 2008, said Jamie Woodwell, vice president of commercial real estate research with the Mortgage Bankers Association.

But Rosemarie Mirabella, a manager with A.M. Best, expects a jump in delinquencies: “We do expect defaults are going to rise – exactly how fast and how rapid a pace that remains to be seen.

“Potentially, it could be quite a significant risk to insurers’ balance sheets,” she added.

Bitten After Branching Out

Insurance companies’ real estate activity is usually confined to direct writing of commercial real estate loans, but some had begun to deal in riskier securitized loans as well. Across the life insurance sector, 10 percent of assets are in direct commercial loans and another 6 percent are tied up in commercial mortgage-backed securities, Mirabella said. With that kind of exposure, even single-digit default rates could hack deeply into bottom lines.

Insurance companies, many of which have drastically scaled back or stopped real estate lending altogether as of the end of 2008, have kept their eye on soon-to-mature loans instead, saying they don’t expect many borrowers to be able to pay off their debts.

Defaults are under 1 percent as of last quarter, but Mirabella said the last peak came in 1997, when default rates got as high as 13 percent for insurance company-originated loans.

And right now, real estate fundamentals don’t look good, she said: unemployment is up, businesses are going under, and vacancies are on the rise, among other things. That does not bode well.

The Deutsche Bank report indicated more lenders will see defaults on borrowers unable to pay loans as they come due – not an inability to make ongoing loan payments.

But Tim Kenny, managing director with MassMutual’s Babson Capital Management, said his company has a relatively light year for loan maturities, and that he’d guess other companies are in a similar position for 2009.

For borrowers who can’t refinance, the plan is to extend the loan but ask for a paydown from the borrower first, he said. Most of the time, that works out well, and only rarely is a borrower too far gone to be unable to pay back at least some of the principle.

And insurers’ famous conservatism has come to their aid in these troubled times, Kenny said. Many loans were not nearly as highly leveraged as CMBS lenders, so the blow is cushioned when property values drop as they have.

“It’s not like equity has evaporated from the deal, which helps out tremendously,” he said.

Credit-Starved Business

As for new loans, George Fantini of Boston-based brokerage Fantini and Gorga said he estimates the entire life insurance industry will only put up $15 billion. In a normal year, it’s usually something like $40 billion – a nasty dropoff. Plus, he said, insurers are likely to put some of that $15 billion toward refinancing for borrowers who can’t pay off their loans.

“How do I characterize it without sounding hysterical? It’s really hard to overstate how credit-starved the commercial real estate business is currently,” Fantini said.

As for maturing loans, banks and insurance companies will likely refinance because they have few other options, and they’ll have the flexibility to do so because they’re often the direct writers of those loans. But insurance companies with securitized loans will, like any CMBS lender, have a headache trying to refinance these much more complicated, splintered loans.

And it’s not just about this year – Kenny was relatively optimistic about the loans on deck for 2009, but said higher maturing loan volumes in 2010 and 2011 might prove to be the real challenge.

“2010 gets a little heavier and ’11 gets heavier still – we’re kind of at the beginning stages of this,” he said.