The global economic contraction began with sub-prime residential mortgages souring. There will be a series of “next shoes to drop”. Staying with residential mortgages, we are seeing defaults rise on the higher quality loans: Alt-A mortgages and prime mortgages. The market for Alt-A mortgages + prime mortgages is several times larger than sub-prime. Hopefully, the economy will stabilize before a second tsunami is caused by the core residential mortgage market melting down.

Putting residential mortgages aside (and that is very big), there will be approx $600B in US commercial mortgages coming up for renewal in 2009-2010. Many of these property owners are going to have a hard time securing new terms on loans because banks are reducing their own risk by demanding roughly double the equity that was previously required by the property owners. This is happening at the same time as commercial properties have fallen in value by 35% – effectively wiping out all the equity the property owners had – and then some.  In fact, 2008 saw write-offs for banks on their commercial property rise 7 X what it was in 2007. Imagine how this is going to be in 2009-2010.

What does this mean? It means default rates on commercial mortgages are going to sky-rocket in 2009-2010. There are a couple asset classes that come to mind that I would avoid like the H1N1 flu.