Banks face distressed asset dilemma.

While banks continue extensions on commercial mortgages to hold off foreclosures, analysts say successful banks will need to eventually take distressed debt off their balance sheets.

"It is so extensive within the banks--not all banks, but a grand majority of the banks in terms of the nonperforming debt--that it has to be moved in order for there to be liquidity," said Bliss Morris, president and chief executive officer of First Financial Network, Oklahoma City, Oklahoma.

First Financial, one of a few loan-sale advisers working with the Federal Deposit Insurance Corporation (FDIC) to sell distressed commercial real estate loans from failed banks, established itself in 1989 during the savings-and-loan (S&L) crisis. Morris said that by the late 1990s, following the S&L crisis, banks took either a portion or all of its loan losses but, unlike the current situation, that event did not have the same capital problems.

"This crisis, we have a lot of nonperforming loans and big capital issues," Morris said. "Obviously, there would not have been $700 billion in TARP [Troubled Asset Relief Program| money doled out to banking institutions of that size and those that are much smaller. We did not see as much of the capital crisis then that we are seeing now. That was clearly a difference."

Morris said some banks are in a position to sell off loans if they have the capital provisions to cover the losses and have not already recognized losses. She said banks that used loan sales as a tool prior to the credit crunch "are clearly going to do it again" in the next three to five years. First Financial did not finish selling off nonperforming loans after the S&L crisis until the late 1990s.

William Hughes, managing director at Marcus and Millichap Capital Corporation, Encino, California, said "a huge spread" exists for banks between the cost of money and rates of real estate, personal or auto loans. He said banks cannot extend problematic loans indefinitely and will "have to deal with" them in the next two to three years. However, he said, banks have a number of workout options and currently have "patience toward transactions [that] may be having some issues now."

He added, "The profitability of banks is substantial at this point in time, and the longer that can occur--because of the low cost of funds the government is providing--is certainly going to help allow them to heal. There is this school of thought that thinks if we can keep that spread or that profit margin [for] banks high enough or long enough as we move through this challenging market, they will be able to better deal with those toxic or legacy assets they are holding on their books and it will be a self-healing measure."

With many more bank failures imminent, Morris doubled her staff at First Financial from 20 to 40 full-time employees and added contractors, which could add up to 90 personnel. Morris said she has never seen the "expansive growth in the investors participating on the sales" as they are now. Some investors include private-equity funds and stronger banks.

"Healthy banks that want to grow their portfolios and pick up some of the performing loans that are not bought by the acquiring banks--we have a lot of activity there," Morris said. "That's a perfect match for those kinds of borrowers."

Alan Pontius, managing director of the national office and industrial properties group at Marcus and Millichap, said distressed sales and foreclosures can impact cap-rate activity in the next year, but not at present. He said the better-quality assets are trading and cap rate movement for single-tenant properties has not been as severe as with multi-tenant properties.

"The-cap rate averages today are not a reflection at all of distressed activity," Pontius said. "In the next 12 months, certainly a greater volume of assets that ... have to be sold undoubtedly are going to transact in the marketplace--undoubtedly. That will potentially and probably take the cap-rate averages for the period potentially up higher than the average itself. I would argue that might become a bit of a false impression, depending on the over all quality of the asset."

Morris said that while some banks may hold onto commercial mortgages, extend them out and not take writedowns, more "savvy" bank executives will want to get out of managing nonperforming loans, because otherwise they will not be able to start lending. She said some banks holding loans for the past 18 months are getting ready to sell them into the private sector.

"It is so individual to each institution. Some institutions are not going to employ asset sales," Morris said. However, other bank executives want to figure out how "to get out of this and get back to what they do well, which is service communities," she said.

"They are in the business to lend money, help businesses be prosperous and support those businesses to run their companies in the communities they are located in," Morris said.