The challenges in the market for bonds backed by commercial mortgages continue to grow.

Delinquencies are hitting new highs, and refinancing of maturing loans is tough in a sluggish economy, in which hotels face growing vacancies as business and leisure travelers cut back, and retailers struggle to attract consumers. No new CMBS deals have surfaced in more than a year, though some are said to be in the pipeline. Headlines about defaults on loans are scaring wary investors.

For sure, the situation isn't as dire as in the market for bonds backed by home loans, which stood at the heart of the credit crisis. This market - which is for mortgages that don't meet the standards set by the mortgage funding giants Fannie Mae and Freddie Mac - collapsed as falling home prices triggered a rush of downgrades and has yet to show signs of life.

Still, the CMBS market is far from healthy, prompting the Federal Reserve and the Treasury Department to extend into next year a support program that gives investors in CMBS access to cheap loans. Thursday is the deadline for the third round of loan applications under the Term Asset-Backed Securities Loan Facility, or TALF. Investors can get cheap funds to buy both existing and new CMBS. For existing bonds, the program will run until March 31, 2010, and for new bonds until June 30, 2010. The program was initially set to expire at the end of the year.

Fed support is helping stabilize prices of existing CMBS, but it can't do much about "the losses due to aggressive underwriting, overleverage and weak fundamentals," said Aaron Bryson, CMBS strategist at Barclays Capital in New York.

Delinquencies on loans due for 30 days or more have crossed the 4% mark, having doubled since March. This is the highest the rate has ever been in the CMBS market, Bryson said, noting this is still "the early stages."

By December, the rate could touch 7%, according to Richard Parkus, head of CMBS research at Deutsche Bank Securities.

Due to the long lease structure, commercial loans are lagging, he said. Delinquencies typically rise for 12 months after employment begins to stabilize, so the earliest improvement would come in 2011.

That, however, is the worst-case outlook, say those who believe the economy could improve, leading to better performances of these mortgages.

A "surprising" number of borrowers would pay their mortgages "quickly" if the outlook improves, said Darrell Wheeler, head of securitization research at Citigroup.

Another positive sign he points to is that about 80% of loans due for refinancing in the first quarter were able to get deals done, albeit at higher rates. That's to be expected, he said, given the tighter credit conditions.

Yet refinancings could become a bigger problem, even if rates continue to move higher, as banks - the largest lenders in this sector - continue to limit their exposure.

Already, the market for refinancing is "highly dislocated" for loans larger than $35 million, Parkus said, noting that regional and community banks can handle only small loans.

For recently issued larger and not-so-well performing loans, "the doors are shut unless you are a REIT with a property that fits into an insurance company's portfolio with a 10-year exposure," Parkus said, referring to real estate investment trusts, which are active in the CMBS market this year.

Also, the size of the loans that need to be refinanced in the coming years will grow substantially: about $40 billion is due in 2010, $70 billion in 2011 and $80 billion in 2012, according to Barclays.

"The number goes up, and the quality comes down," Bryson said.

-By Anusha Shrivastava, Dow Jones Newswires; 212-416-2227; anusha.shrivastava@dowjones.com