Where was the CMBS crash?
The total volume of outstanding U.K. Commercial Real Estate (CRE) debt reached £247bn at the end of 2007, comprising outstanding debt on bank balance sheets and the value of outstanding commercial mortgage-backed securitisations (CMBS). The total disclosed problem loan portfolios of Lloyds (NYSE:LYG) and RBS (NYSE:RBS) that were provisionally designated from the Treasury’s Asset Protection Scheme were £300bn.
Since 2007, CRE lenders were said to have had an increasing number of non-performing or defaulted loans in their portfolio against office, retail and leisure property assets in the U.K. and Europe. And without wonder. The collapse of the global credit market in September 2008 has caused a weakening of the covenants of both borrowers and tenants and a fall in the value of property assets as investment yields have widened and as trading assets have seen margins squeezed.
As a result of the write downs that many banks were forced to take in 2008 and 2009, regulatory capital was impaired as financial institutions had to provision for the losses by setting capital aside – also reducing balance sheet capacity for new lending. Governments swooned and the banks received billions in what has to be one of the greatest debt for equity swaps of all time. We believed that none of this debt could be ‘refinanced’, and that there would be a flood of defaulted assets rushed into the market by banks such as RBS desperate to clean up their books....and yet, far from their slogan of ‘Make it Happen’, it ‘Didn’t Happen’.
Well, given the scale of the distress, the widespread lack of experience in managing distressed or defaulted loans within the banks and above all the cushion of receiving billions in bailout money, banks are under no incentive or government pressure to dispose of distressed assets or loans. This is absolutely right. In fact, they are being encouraged by central government to lend more than they were and have been provided with the liquidity to refinance the loans internally.
Specifically, banks are holding onto troubled loans and refinancing them for several reasons:
They believe that the market would not offer them anything more than a significantly discounted price for the assets. This is following a cascade of private investor interest in ‘bidding’ banks below market value. Perhaps it was Philip Green who best demonstrated this by hopping on a plane to Iceland after their widespread default in 2008 and offered ‘peanuts’ for several large Icelandic-owned companies. He was shown the door.
The belief that, over time, markets will recover and they will be able to exit at face value or less of a discount to fire selling today. Economic growth and market recovery will see them through.
Banks have learnt from the mistakes of the last recession (1990/3) when many, most notably Barclays (NYSE:BCS), panicked and defaulted borrowers. This left the banks with thousands of real estate assets that continued to fall in value because of under-management and fire-selling.
- They have no incentive to sell the assets or loans.
- Low cost financing allows them to refinance loans cheaply, central banks are more than happy to provide sufficient liquidity.
‘Extend & Pretend’
There is a widespread practice within the banks to ‘extend and pretend’ whereby they ‘roll-over’ maturing loans with new covenants and pretend that the loan is performing. This is made all the more allowable because in the U.K. we have ‘upward-only’ rents. This means that although the rental market has declined in some parts of the U.K. by up to 30%, tenants continue to pay the same rent they agreed at the last review. This sustains the continuation of rent from which the interest on the loan is paid. The loan may well be worth less than the asset, since asset price yields have widened, but the interest is being serviced.
In the U.K., far less of the loans advanced by banks against real estate assets were securitised compared to other countries such as the U.S. Commercial Mortgage Backed Securities (CMBS) are bonds created after splitting the risk of a whole into many pieces, before being sold to investors who took the risk the loan may default for the price of the interest they received from the underlying loan. As a result, when a default on a loan occurs, far more of the loans in the U.K. are still held on the books of the bank, rather than with bond holders who bought the CMBS. This allows the bank to ‘extend and pretend’ as above. In the case of defaulting CMBS, it is more difficult to resolve the default because there may be 1,000 holders of the CMBS who need to somehow get together and enforce their security over the asset.
In conclusion, the commercial mortgage bailout saga has left a market confused, bemused and humbled.
The great crash that we all expected, the fears over the un-refinanceable debt mountain of banks such as RBS, the flood of cheap, distressed assets into the market, didn’t happen. Real estate asset values have rebounded from the lows of Q1 2009 according to the Investment Property Databank and the market seems to be looking to growth once again. It seems as if the view of the banks to hold onto their loan assets, wait until the market recovery and then redeem the full value is paying off. This way, they eventually realize a profit on the difference between the written down value of the assets and the redeemed value as a profit which they will keep, given that their tax losses were so big in 2008 and 2009.
Whilst the environment is of course still uncertain and it is probably far too soon to say, my guess is that the Treasury will see a solid profit on its investment in the banks for the taxpayer, and a super one at that. In short, it seems as if RBS did ‘Make it Happen’ after all.
Disclosure: No positions