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UPDATE 3-Economy, TARP hits US commercial property debt, stocks

(Adds CEO comment, commercial property index, updates prices)

NEW YORK, Nov 19 (Reuters) - The prices of bonds and stocks with exposure to commercial real estate plunged on Wednesday on fears the weakening U.S. economy could lead to a wave of defaults on loans for office buildings, retail stores, and hotels.

The value of commercial mortgage-backed securities (CMBS) has tumbled this year amid fears that poor underwriting standards and slower economic growth will boost defaults from historically low rates.

Yield spreads on the CMBX-5 index of “AAA” CMBS surged more than 100 basis points for a second day to 714 basis points over the benchmark of interest rate swaps, dealers said. Spreads, which measure perceptions of risk, on the derivative index are up from 200 basis points in October.

Top-quality CMBS spreads are near 1,100 basis points, for junk bond-like yields of 15 percent or higher. Those spreads were around only 30 basis points before the global credit crisis began last year.

“There is a growing concern that (commercial real estate) is going to be another tripping point in the economy,” said William Larkin, portfolio manager with Cabot Money Management in Salem, Massachusetts. “No one wants to touch anything to do with real estate.”

Selling of CMBS accelerated last week after U.S. Treasury Secretary Henry Paulson said a $700 billion rescue plan would be geared toward providing banks with fresh capital, rather than used as a fund to take illiquid mortgage assets -- such as CMBS -- off bank balance sheets. Paulson reiterated that stance this week.

Commercial mortgage holdings contributed to the downfall of Lehman Brothers Holdings Inc. in September.

Big real estate companies were hardest hit in Wednesday’s U.S. stock market trading.

Shares of Simon Property Group SPG.N, the No. 1 U.S. mall operator, slid 13 percent to $41.07, and Boston Properties Inc BXP.N, which owns skyscrapers and other office buildings in key U.S. markets, dropped 12.1 pct to $43.60. The benchmark MSCI U.S. REIT index .RMZ declined 13.4 percent, compared with a 6.1 percent drop in the S&P 500 .SPX.

"The mall operators are really, really in trouble," said Kevin Quinn, a managing director of equity trading at Stanford Group Company, mentioning Vornado Realty Trust VNO.N as a key player. "There aren't even signs on the empty stores in the malls. They've been empty for a while, barren, tumbleweeds blowing through."

Traders in the $700 billion CMBS market ramped up bearish bets this week after a Credit Suisse analyst said that two big loans in commercial mortgage bonds -- including a 2007 mortgage for two Westin hotels -- appear near default.

CMBS spreads also widened as investors sold debt financed with borrowed money to improve balance sheets for year-end. As yield spreads overshoot expectations, some investors may be now selling real estate investment trusts as a hedge.

"I've been hearing people are shorting REIT stocks to cover their losses on CMBS," Constance Moore, president and chief executive officer of BRE Properties Inc BRE.N told Reuters at the National Association of Real Estate Investment Trusts annual meeting in San Diego, California.

Default rates on loans in CMBS are below 1.0 percent but rising, as compared with levels above 20 percent for risky home loans. In general, analysts do not expect commercial real estate to fall in value to the same extent as residential property, in part because the overbuilding of the 1990s has been avoided.

Commercial property prices rose in September from August, though fell 7.9 percent from a year earlier, according to Moody’s Investors Service. Overall, prices may drop as much as 30 percent from their peaks, according to a JPMorgan forecast.

The outlook for commercial property is darkening though as U.S. economic reports point to disappointing retail sales, rising unemployment and mortgage foreclosures.

Forecasts for a mild recession are now “off the table,” in favor of an average or severe downturn, said Jay Mueller, a portfolio manager at Wells Capital Management in Menomonee Falls, Wisconsin.

Soft CMBS markets until recently have been mostly blamed on tight credit conditions, which have choked off new funding and eliminated refinancing opportunities. Loans are increasingly being transferred to “special servicers,” which can negotiate to extend loans or demand more equity to avoid default.

“I don’t expect any improvement,” said Chris Sullivan, chief investment officer at the United Nations Federal Credit Union in New York. “Most of the deterioration to this point has been technical (including deleveraging), but now worsening macroeconomic fundamentals, along with large deal-specific delinquencies, are beginning to weigh.” (Additional reporting by Ilaina Jonas and John Parry)

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