The volume of commercial mortgages at risk of default has quintupled since the beginning of 2008 as a deteriorating economy has made it increasingly difficult for shops and businesses to keep up with their payments.

Special servicers, companies that collect payments from borrowers in distress on behalf of mortgage bond investors, reported $23.7bn of mortgages under their care at the end of the first quarter, according to Fitch Ratings.

That was five times higher than the $4.6bn of mortgages needing special servicing at the end of 2007. Servicers experienced an almost 50 per cent increase in the volume of distressed commercial mortgages in the first quarter alone.

Mortgages for multi-family residential properties suffering from the housing downturn represented the largest share of the troubled loans at 31 per cent, said Fitch. However, mortgages for shops and businesses were catching up, with retail loans at 28 per cent of the distressed pools.

“Retail properties were the first property type to see the effects of declining economic conditions and consumer spending,” said Stephanie Petosa, analyst at Fitch. “[We have] observed an increase in defaults of retail loans and expect them to eventually surpass multi-family as the highest property type concentration.”

Fitch says it expects commercial mortgage defaults to continue to increase this year. At the end of the first quarter, defaults and payments more than 60 days late were at 1.53 per cent of outstanding mortgages. Fitch said they could reach 4 per cent by the end of 2010.

Good luck to banks holding onto junk commercial real estate loans… They better hope the government has deep pockets to cover the coming wipe out.

I’m happy to report that it wasn’t an oversight: The reality is that Fifth Third – with $120 billion in assets – didn’t quite make the cut, since it’s actually not one of the Top 12 U.S. banks. But given the high level of reader interest in our report (which ran Wednesday), I thought it was worth a look.

Alas, while it isn’t one of the Top 12 banks, Fifth Third is another “Zombie,” lurking in the undergrowth, seeking new victims (investors).

A regional bank based in Cincinnati, Fifth Third has operations in the Midwest, most notably in Ohio and Michigan. It also has some operations in Florida. At first glance, it looks like SunTrust Banks Inc. (STI) or Regions Financial Corp. (RF), both of which I classified as “Walking Wounded,” one of the four ratings I created to classify the banks’ health, and the rating that’s a notch higher than the dreaded “zombie” label, which was affixed to the worst banks in the group (is the worst of the group.

(The ratings, from worst to first, are: Zombie, Walking Wounded, Risky but Proud, and Hidden Gems.)

However, while the pattern of Fifth Third’s 2008 operations was similar to SunTrust and Regions, the Ohio bank’s results were significantly worse. Both Regions and Fifth Third reported losses for 2008 ($5.6 billion and $2.2 billion, respectively) after substantial goodwill write-offs. But Fifth Third also notched a $1.2 billion loss for 2008 – before goodwill write-offs, while Regions Financial made a $300 million profit. Fifth Third has slashed its quarterly dividend to a nominal 1 cent per share.

Though there are some positive aspects to note. For instance, much of Fifth Third’s fourth-quarter loss was due to its transferring $1.3 billion of troubled loans to “held-for-sale” status, causing an immediate write-off that worsened published results, compared to its peers.

On balance, however, Fifth Third’s situation is worse enough than Regions’ – its closest Big-12 analogue – that I concluded it belonged in the “Zombie” category, as opposed to the “Walking Wounded.”

Having said that, however, let me say that I have considerable sympathy for the bank and its management team. Citigroup Inc.’s (C) zombification came from unintelligent aggression over a period of 30 years, inventing many of the current financial crisis’ most-toxic products (such as auction rate preferred stock). And Bank of America Corp.’s (BAC) zombification came from – not one, but two – catastrophically foolish acquisitions within a year: Countrywide Financial Corp. and Merrill Lynch & Co. Inc.

In Fifth Third’s case, there was no malice – Fifth Third did not invent any of the unsound idiocies that have caused global financial markets to collapse, nor did it go on an aggressive acquisition binge. Fifth Third was simply concentrated in two of the most economically troubled states – Ohio and Michigan.

In early 2008, Ohio had the highest rate of mortgage defaults in the United States – not because of its speculative frenzy in 2005-06, but because it had an exceptionally high proportion of borrowers whose ability to afford a mortgage was marginal.

U.S. President Barack Obama’s stimulus plan, targeted towards lower-income households and hard-hit areas, may help Fifth Third’s business more than it will help other banks, in which case Fifth Third could edge back towards recovery.

But as it stands now, the bank has one foot in the grave, qualifying it for “Zombie” status

Source: Fifth Third (FITB), a Medium-Sized “Zombie” Bank