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Two months ago, to hear advocates of the Emergency Economic Stabilization Act tell it, the financial system was in impending danger of complete meltdown unless the US government stepped in to strip away toxic debt from lenders’ balance sheet, among other measures. Yesterday, Treasury Secretary Henry Paulson all but declared that this thinking had been a mistake. Purchasing illiquid mortgage-related assets, it was decided, he said, “is not the most effective way to use TARP [Troubled Asset Relief Program] funds.”

To be sure, there were many critics of TARP within the CRE industry; the criticism focused on the mechanics of how the assets would be valued and purchased as well as concerns that the funds waiting on the sidelines to pick up distressed paper and assets would be priced out of the market by taxpayer funds.

Still, though, to have the program snatched away suddenly is a blow — – both in the expectations that funding would improve as a result of the buy-back program, as well as a vague confidence that Treasury really knew what it was doing.

“By my reckoning, this is now the fourth prime objective stated since the first Paulson proposal 45 days ago,” Brian Olasov, managing director at McKenna Long & Aldridge LLP in Atlanta, tells GlobeSt.com.”First, Paulson called for purchasing troubled assets. The second was a call to stabilize regulated financial institutions through direct capitalization. The third, particularly espoused by the FDIC, focused on mitigating foreclosures. While there’s nothing inherently wrong with any of these initiatives, it looks a bit like cabinet-level ADD.”

Also it is not a foregone conclusion that the banking sector – as Paulson maintained – has stabilized. “There seems to be a general sense of disappointment with the change of plans because bank stocks are once again falling,” Frederic Ruffy, the senior options strategist at WhatsTrading.com, a New York City-based provider of options market analysis, tells GlobeSt.com. The Dow shed 411 points on Wednesday, largely in response to the news. Furthermore “the PHLX Bank Sector Index (BKX), which tracks the performance of 24 companies in the industry, is down 2.97 to 48.23 and falling below the closing lows from both October 9 and July 15.” Judging by the action in the share prices, he says, “investors seem to feel a sense of disappointment and anxiety about the outlook for banks, perhaps even more than in mid-July and mid-October.”

The Street’s discontent, though, does not change the situation. Twenty-four plus hours ago the government was going to clear toxic debt off of banks’ balance sheets. Now it won’t. The question is, how will this policy about-face impact commercial real estate lending, which has all but dried up now?

The consensus, not surprisingly, is that it will result in an even further tightening of lending to real estate projects. “Treasury’s decision to shift the focus of TARP funding away from purchasing illiquid mortgage assets from bank balance sheets is likely to prolong the credit thawing process for real estate finance,” James I. Clark, managing principle of EnTrust Realty Advisors, an affiliate of the Alter Group in Lombard, Ill., tells GlobeSt.com. “There will be little incentive to increase real estate exposure through new loans until balance sheets are cleansed.”

While a similarly dismal credit environment existed before TARP was ever formed, lenders are now going to have to shoulder the additional burden of dashed expectations among shareholders, Kenneth Miller, an attorney with Moldo Davidson Fraioli Seror & Sestanovich LLP in Los Angeles, tells GlobeSt.com.

“For example, upon learning about the denial of buyout money to commercial lenders, shareholders may sell off their shares of stock in the lender, if the lender is a publicly traded company, even if the commercial lender may not need the bailout money in the first place. The denial of money to commercial lenders could also negatively affect their bond ratings, which in turn worsens the public perception, and which again may also lead to the sell-off of shares of stock in the company.”

There are some bright spots to the situation, though. As a general holistic approach – as heretical as this view may be to the CRE industry – there is a grudging sense that using TARP to bolster consumer spending is a better plan. “With TARP government was interfering directly in the market by helping to set the price,”William Gamble, author of “Freedom: America’s Competitive Advantage in the Global Market”, tells GlobeSt.com. “There were also too many conflicts of interests, economic incentives without sufficient legal disincentives — Treasury was asking the people who created these things to value them.” Rather than trying to put a floor under the bad mortgages, Paulson is doing something much better, he continues — trying to speed up the work out process. “Faster resolution of the mortgage issues provides information about lending risk to the market, which, over time, will increase the amount of credit and help commercial real estate.”

Also at least one constituency in the commercial real estate market – opportunistic funds and investors — is likely to benefit from the shift, Adam Weissburg, partner with Cox Castle & Nicholson in Los Angeles, tells GlobeSt.com.

In its original incarnation the Emergency Economic Stabilization Act was to have created an instant market place for distressed assets, he says. One concern about this initial plan was that banks would not be motivated to sell if the Treasury was a buyer. “The thought was that investors would need to offer more than bottom dollar to encourage sellers to redirect sale efforts to the private markets,” he says. It is now clear that the Treasury believes it is more important to stabilize the banks themselves through capital infusion. “This new direction means that those opportunistic investors now have less competition.”

Indeed, forcing buyers and sellers to finally come to terms on the value of distressed assets and paper may well be the proverbial silver lining of this whole debacle, Barbara Trachtenberg, a partner in DLA Piper’s Real Estate practice in Boston and president-elect of Newire (New England Women in Real Estate), tells GlobeSt.com.

“My initial reaction to the news that the bailout will not be used to buy the illiquid assets is that it will be bad for commercial real estate. If the assets aren’t purchased, how else are they going to get off the books? In addition, what is going to happen in 1Q 2009 when the outstanding commercial real estate debt starts to mature and the underlying properties are under water?”

The news, though, bad as it is, does creates some certainty in a dismal market. “Now we know that the government is not going to provide the needed stability for commercial real estate,” Trachtenberg says. “Perhaps that certainty will encourage those holding illiquid assets to sell them now, at whatever price the market will bear, and get them off the books in 2008. Maybe that certainty will encourage lenders holding maturing commercial real estate loans to work with their borrowers or recognize the losses. We know that there is plenty of equity waiting in the wings for things to start moving again, this could be the catalyst to get the commercial real estate industry going so that equity can come in.”

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