Although I would expect financials to lead the final phase of this bear rally, given the very supportive market conditions engineered by the Fed and other central banks to boost operating earnings, the medium term risks of a wave of new defaults hitting bank balance sheets are rising. As the ratings agencies belatedly find religion on default risk, S&P recently announced radical changes to its methodology for assessing the appropriate ratings for Commercial Mortgage Backed Securities (CMBS): 'It is likely that the proposed changes, which represent a significant change to the criteria for rating high investment-grade classes, will prompt a considerable amount of downgrades in recently issued (2005-2008 vintage) CMBS. Classes up through the most senior tranches of outstanding deals  are likely to be affected.' Commercial mortgages originated in 2006 and 2007 account for about 65% of the loans currently on rating agency watchlists for downgrade, comprising $47.7 billion of 2006 loans and $55.3 billion of 2007 loans.

During those years at the peak of the credit boom, lenders regularly underwrote mortgages based on collateral properties' projected property cash flows, as opposed to actual cash flows.And those projected cash flows in many, and perhaps most cases, have failed to materialize. The drop in cash flow resulted in debt service coverage ratio (the minimum ratio of cash available to the amount needed to pay interest and required principal pay-downs.) What's interesting is that a large portion of the earlier commercial mortgages did not require principal amortization.

In addition to the refinancing problem CMBS deals are facing, delinquencies in CMBS are now starting to creep up. Moody's thinks this will jump to 5-6%. Multifamily delinquencies have been on the rise for some time now because apartment rentals are heavily linked directly to the more vulnerable consumer. More recently hotel and mall (retail) properties are showing signs of stress, not surprising given the huge speculative overbuilding of retail and leisure space. much of which is only now coming on stream.

Rating agencies may have lost a lot of credibility during this crisis, but it's another example of the profound culture shift that they are now trying to catch up to "correct" the errors of the credit heyday by applying sweeping downgrades.  On top of the worries over the refinancing mountain ahead, delinquencies are creeping up. All eyes are now on TALF as the Fed is getting ready to transfer private sector risk to the taxpayer's balance sheet yet again. 

Most commercial mortgage-backed securities eligible under published guidelines for the Term Asset-Backed Securities Loan Facility will also meet other Federal Reserve criteria, the Fed told investors on Friday. That means that in many cases there is barely enough cash to cover just the interest. For many of those loans, principal payment will come from the property liquidation. Needless to say all the new deals require a full or partial principal amortization, similar to a typical residential mortgage. But the new deal flow has collapsed, and there is little primary market to take out maturing debt. There is hope that TALF may help, but nothing of significance has been refinanced yet. Meanwhile, impending downgrades would make many CMBS ineligible for the Fed's TALF program.  

Of course the TALF could always be amended in an attempt to avert a new banking solvency crisis, but that assumes banks will be responsible enough to accept the help and the restrictions attached before they hit crisis. Recent evidence suggests otherwise; in fact, so desperate are financial institutions to avoid government help except in extremis (and this is evident also in the failure of banks to participate in the PPIP toxic asset plan) that I suspect little refinancing will be done until we face a crunch next year. Unfortunately, the Treasury has little leverage over recalcitrant bankers whose irresponsibility threatens a new systemic crisis, this time led by soaring defaults in commercial lending. I'd expect this issue to become significant toward end 2009/early 2010, particularly if the economic recovery proves anaemic as I'd expect, and it makes financials no more than a tactical trade this Summer ahead of further volatility for the sector and the market as a whole.