What do the Fed’s recently concluded “stress tests” have to do with commercial real estate? Everything. The stress test results convey the illusion that America’s largest banks possess adequate capital. But that’s not true. And since America’s largest banks possess inadequate capital, they will be reducing their exposure to commercial real estate loans. REIT-holders beware!

Forecasting loan losses at banks is an inexact science. In fact, it’s not a science at all. It’s more like a game of chance, like craps or roulette. Even if you know the odds, you still have no idea about the outcome. Forecasting future cash flow from existing loans is also a game of chance. Both of these unknowable forecasts lie at the core of last week’s stress test.

The market’s reaction to the stress test — in the form of soaring bank stocks — tells me that the consensus is treating this stress test as if it has the ability to magically predict yearend 2010 capital levels with pinpoint accuracy.

Most of us do not have magic predictive powers — only the ability to make judgments based on knowledge and experience. In my judgment, the stress test was not stressful enough. For instance, it is not really accounting for borrower behavior in a scenario where they are underwater on their mortgage and under- or unemployed.

For example, the stress test’s estimated losses on second-lien mortgages in particular seem very low. In foreclosure, these are often total losses. With another big wave of Alt-A resets and foreclosures in the pipeline, the performance data on second lien mortgages should worsen. Several state-imposed and bank-imposed foreclosure moratoriums are ending.

The bulk of housing activity right now consists in foreclosure auctions and short sales. How much are second mortgage liens worth under this scenario? Not much.

Most big banks already have low levels of tangible capital relative to towering trillions in risky assets. The cash flow from their existing and new loans must exceed their loan losses in order to simply maintain existing capital levels (let alone increase capital).

Think of this situation as a bathtub. Bank capital is the amount of water in the bathtub, and the faucet pours new water into it (that’s cash flow from existing, paying loans and securities, plus new capital infusions) and the drain sucks it out (these are the loan losses). Pessimists claim that the drain of losses is sucking water out so fast that it will empty the bathtub within a year or two, depending on the bank. They tend to ignore or downplay the new water coming in. Optimists claim that if regulators prevent the water from falling to a very low level during this crisis (regulatory forbearance), in time, the water level will eventually rise back to normal levels. There’s a risk that if the optimists are wrong about the amount of new water coming in, we’ll be stuck with a Japanese-style “zombie bank” situation.

After last week, I think the risk of the zombie bank scenario is much higher. We’ll probably see this manifested in continued tight credit conditions. The banks under the most intense scrutiny will tend to reinvest cash flows into less risky assets like Treasuries and agency mortgage-back securities (another form of government guaranteed debt) — rather than write new commercial or consumer loans.

The big banks certainly will not be underwriting many commercial real estate loans (this is central to my thesis on buying the UltraShort Real Estate ETF (NYSE: SRS). Any commercial real estate lending that’s done will incorporate much lower loan-to-value ratios and higher interest rates. With property prices down 50%, the equity in levered deals done at the peak of the bubble has mostly vanished. REITs are a form of equity in leveraged commercial properties.

As you can see in the term sheet of the latest iteration of TALF lending for CMBS, the Fed is in no position to lower its lending standards (see link here). It is not willing to lend against commercial mortgage collateral that’s below investment grade or was created before July 2008 (“All mortgage loans must have been originated on or after July 1, 2008.”). These terms exclude virtually the entire pool of distressed commercial real estate assets. So even if the Fed lowers its collateral standards further, REIT equity will still not avoid massive dilution or elimination. Underwater commercial property owners (including REITs) are finding it nearly impossible to refinance maturing loans.

Certainly, the Federal Reserve will continue trying to cushion the deleveraging process underway in commercial real estate. The market’s expectation of Fed intervention in this sector has fueled much of the recent rally in REITs. But I think the market has it wrong here. The Fed may be able to slow the destruction of wealth in this sector, but it cannot preserve the equity value of overleveraged REITs, any more than the Fed’s 2007 lending programs could preserve equity value for Citigroup (NYSE:C) shareholders.

Source: Commercial Real Estate…The Crisis Begins