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As the government finalises details of its asset protection scheme (APS), real estate private equity funds are holding their breath at the prospect of snapping up distressed property loans from the UK banks, reports Dealreporter.
Despite having raised significant funds to deploy on the distressed debt, as they did in the early 90s, the funds have so far been frustrated at the UK banks’ reluctance – and incapacity - to sell, sources said. Private equity wants to buy the loans at around 40-50 pence in the pound, but so far the UK banks are not playing ball, they said
Most foreign banks have now offloaded their UK real estate exposure, including Credit Suisse, which this week announced the sale of a USD 1bn portfolio of European property loans to GE. But, saved from the brink last year, the banks cannot afford to take further write-downs on their fragile balance sheets. “The banks are under pressure to reduce balance sheets, but aren’t going to do a whole lot,” a source familiar with RBS said. “The vast majority of bank books will not be fire-sold, but worked out over time.”
However, experts warn that the banks’ attitude to the problem could come back to bite. In addition to the commercial property exposure clogging up balance sheets and impeding the restoration of lending, the drought of refinancing money means most loans are simply being extended. This removes maturity concerns for now, but could potentially snowball into a serious concern in 2011-12, sources surveyed by this news service said. This is when huge swathes of debt will mature if asset prices do not recover and liquidity is not restored to the system, the sources said.
In total, the banks are on the hook for around GBP 250bn in commercial property loans, with a further GBP 50bn outstanding in CMBS debt. The bulk of the debt is concentrated in the hands of a few, one expert said: RBS, Lloyds plus the Irish banks. RBS has lent some GBP 97bn to the sector, according to its FY08 figures, while Lloyds is exposed to a similar figure, the expert said. “It’s a humongous issue for most banks,” Barry Osilaja, head of debt and structured finance at Jones Lang Lasalle (JLL), said. Lloyds and RBS did not comment.
Over GBP 20bn of that debt is either in default or has breached covenants, according to a study by De Montfort university. A private equity manager described as “ghost ships” the increasing number of hugely distressed assets floating around the market with little sense of who controls them. But as long as banks are still collecting interest on the loans, they are reluctant to call the assets in, another fund manager said
JLL’s Osilaja said a big factor in the equation is that the banks simply cannot afford to take the write-downs that would come with marking assets to market. “If you look at the figures, technically the banks are underwater. The collateral on the loans was worth around GBP 400bn but values have collapsed by around 50%. Therefore technically most of equity is gone in most loans. Look at the numbers, if all the banks marked to market, they would be insolvent.”
Much of the debt is of the 2006-2007 “vintage,” when the property bubble was at its most inflated and lending terms at their most excessive, typically at 80-90% loan-to-value (LTV) ratios.
The trouble is that with more than half the debt maturing in the next three years, and new lending terms requiring LTV ratios of around 60%, there is not enough money in the system to refinance the loans. “You need around GBP 40bn annually,” JLL’s Osilaja said. “Even at the peak of the property market, that would be difficult to achieve.”
Therefore, the banks are rolling over the debt, pushing back maturities in return for higher margins. However, this is creating a debt snowball that will come back to bite in a few years’ time, one property lending banker at a major foreign bank said. In recent weeks, the real estate private equity community has coined a new moniker to sum up the banks’ attitude: “Pretend and Extend.”
“They’re pretending the underlying problem isn’t as great as it is and just pushing back maturities to create a bigger problem later,” the lending banker said. “There is a lot of fear about what’s going to happen in 2011-12.” Osilaja said: “It’s a case of ‘see no evil, hear no evil’.”
While a significant chunk of the loans are likely to be put in the APS, details of which are anticipated during the summer, the scheme is not a cure-all, experts said.
“The toxic assets will go off balance sheet but banks don’t get rid of the problem completely,” Mark Creamer, head of CBRE’s London-based loan and corporate recovery team said. It is expected that they will still need to work them out.”
“The APS is there to ensure banks won’t lose more than a certain amount of money,” the source familiar with RBS said. “But it will also make it restrictive in terms of what happens to certain assets. At the same time people working on specific assets won’t actually know if they’re in the APS.”
“The APS is fraught with disaster,” the asset management source said. “All it does is keep unhealthy banks in business. As long as there’s no capital to lend, they won’t lend, meaning there’s no service to the greater economy.”
The banks themselves argue it would make little sense to sell distressed assets to private equity “vultures” at hugely discounted prices. “There’s a strong incentive for the banks to wait this one out for 3-4-5-6 years,” a credit analyst said.
In RBS’ case, the majority of the bad debt will be held in the hope asset prices recover with distressed loans being worked out over time, the source familiar with the bank said. “The vulture funds want to play at distressed levels,” the source said. “They want to rip the faces off the unfortunate souls who hold the loans and assets but we won’t sell at prices that don’t make sense. There will be some deals with problem loans that need working out but not a whole lot.”
“The banks realise there’s no point in selling at bottom of the market except in extreme cases,” Creamer said. “They got their fingers burned in the 90s, selling off loans … then the market came back strongly. This is near the bottom of the market so if they hold on prices will come back.”
However, the failure of the banks to properly resolve their legacy issues from the years of debt-fuelled real estate exuberance is impeding the return to a functioning market, sources feared. Clogged up with commercial property debt, the banks are not lending. “How long they keep these non-performing loans will impact on banks’ ability to lend,” Creamer said. At a recent conference, a director from Barclays Capital’s real estate finance team said it had all but stopped lending to the sector. And recent comments from RBS chief Stephen Hester that the bank had “far too much” property debt already hardly bode well.
“No clearing means no clean-up; no clean means no trust; no trust means no return to vitality,” the asset management source said. “We’ll limp along like Tokyo did. In financial terms, it’s the death by a thousand cuts.”
The source familiar with RBS admitted that the negative effect of working out the loans over time rather than selling them off was that it stops a floor being put into the market and works against the freeing up of liquidity – just what the system needs to recover. “As long as the banks have these loans on their books, there’s no new financing available,” the manager of a distressed debt fund said.
“If banks are unwilling to get rid of their legacy problems, it makes it hard to return to a good property and lending market,” the first lending source said. “Logic follows that there can’t be an active lending market until this is cleared up – it’s a Catch 22 situation.”
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