The need for Europe’s banks to significantly deleverage their balance sheets has been universally recognised, but the pace at which they are doing so has been less widely understood.
This approach of ”not too fast, not too slow” was neatly expressed by European Central Bank (ECB) President Mario Draghi earlier this year on 13 March in Vienna (Austria), when he noted, “Clearly, we do not want any excessively rapid deleveraging that involves disorderly fire sales of assets … ”. He went on to say, “At the same time, we do not want any excessively prolonged deleveraging, where banks reduce their loan book by curtailing new lending, while hoping that the underperforming assets they hold recover in value. Put bluntly, this would create ‘zombie’ banks that do not lend … “.
Deleveraging in the aftermath of the global financial crisis
Post global financial crisis, had regulators imposed capital rules and stress tests too harshly, banks would have faced losses from selling assets in a highly depressed market, or been forced to raise capital at prohibitively expensive levels. In most cases, regulators had little choice but to be lenient, and governments little choice other than to provide guarantees or capital injections to banks to give breathing room – five years and counting – to facilitate deleveraging.
For European banks, the deleveraging of assets initially involved sales of public securities, mainly US mortgage-backed securities (MBS) and, to a lesser extent, European asset-backed securities (ABS). Yet, the bulk of non-core/non-performing assets in Europe was, and still is, in the form of private loans. These loans are predominantly held by commercial banks, as opposed to investment banks that were more inclined to hold on to them or even to extend their maturities, rather than sell.
However, the emphasis in Europe now appears to be shifting from “not too fast” to “not too slow”. Regulators and governments alike are keen to see banks return to independence and cleanse their balance sheets. This will likely lead to a progressive multi-year deleveraging process for European banks, with a view to optimising capital and accounting impact. And while we do not expect fire sales, pressure is building, and over the last few quarters there has been some acceleration in asset sales by European banks.
Looking at Figures 1 and 2, we can see the rising face value of performing and non-performing asset sales by European banks since 2011. The volume of asset sales, Figure 1, shows acceleration in each of the last three calendar years, and again in the first half of 2014. Over this period, Commercial Real Estate (CRE) has represented approximately 20%–30% of asset sale volumes annually.
The geographic composition of asset sales varies considerably year by year, with Irish banks accounting for the biggest volume of asset sales in the first half of 2014.
CRE distress in Europe
Between 2004 and 2007, there was a boom in volumes of CRE debt origination in Europe, which was accompanied by the following:
- Increased leverage: Senior loans frequently financed 70%–75% of the market value of CRE. And with a junior tranche, a total loan-to-value (LTV) of 90% could be achieved.
- Loosening covenants: Those governing LTV or interest cover were sometimes abandoned or structured such that enforcement could not be realistically anticipated.
- Reduced margins: Debt financing representing a 90% LTV could be obtained at an average lending margin below 100 basis points.
The financial crisis initially caused CRE lending to decelerate and eventually to halt by mid-2008, with the notable exception of prime properties in major cities at modest leverage levels. Liquidity in the secondary market for commercial mortgage-backed securities (CMBS) dropped drastically, while for CRE loans it virtually disappeared. With debt financing no longer available, CRE asset values began to decline, often below the notional amount of the loans secured against them. Such distress was widespread in CRE debt, even though there were few near-term maturities to crystalise actual defaults. While many banks needed to de-risk and raise liquidity in the second half of 2008, CRE loans were not an area where they could achieve those objectives without destroying significant amounts of capital.
Once the acute phase of the financial crisis had passed, regulators increased capital charges for CMBS and CRE assets. This further inhibited – in pro-cyclical fashion – the availability of debt and contributed to the decline of European CRE asset value: approximately 30% on average, but up to 60% in some countries. The low in valuations was reached in mid-2009 in the UK, while in Spain and Italy average valuations were at new current cycle lows at the end of 2013 (see Figure 3).
The pace of asset sales
It is not a coincidence that this pattern of regional variation is also reflected in the pace at which European banks have been selling assets, since banks are typically more willing to sell into recovering markets. Other key factors that weighed, and continue to do so, on the pace of asset sales across Europe include the following:
- Resolution strategy: Banks in Ireland and Spain came to represent a significant proportion of those countries’ GDP, and as a result governments/regulators imposed a centralised deleveraging process, with write-downs imposed on banks to facilitate the transfer of assets to publicly owned non-core asset management entities (e.g., National Asset Management Agency (NAMA) in Ireland and Sociedad de Gestión de Activos procedentes de la Reestructuración Bancaria (SAREB) in Spain)
In Germany, by contrast, the affected banks were mainly regional Landesbanks; with a more relaxed deleveraging timetable, local financial support and guarantees have been sufficient to avert significant asset sales.
- Bank size: Due to their less-systemic nature, smaller banks typically warrant less government support, even though they have less access to capital markets. Larger banks have been able to recover more quickly and, due to retained profits and capital issuance, are able to write down their legacy portfolios more aggressively, making asset sales plausible.
- Internal management: Banks that changed senior executives first tended to be among the first to sell assets.
- Bank oversight: While jurisdictional differences in definitions of key metrics, such as “non-performing” or “forbearance”, remain, the Asset Quality Review (AQR) process undertaken by the ECB on the top 128 European banks should enable a more consistent treatment of stressed assets, with results due to be published in the fourth quarter of 2014.
European CRE deleveraging outlook
European bank deleveraging will continue to progress at an increased, albeit measured, pace, and be achieved via a combination of asset sales and raising fresh capital. In large part, assets sold will continue to comprise performing but non-core assets, as well as sub-performing and non-performing assets.
These asset sales are likely to take three primary forms:
1) Single asset sales: limited competition processes
2) Large portfolio sales: typically competitive auction processes
3) Partnerships and more complex structured transactions: mainly off-market processes
We expect that CRE will continue to constitute a significant proportion of European bank assets to be sold as the recovery in CRE is broadening well beyond prime markets. Further, a significant amount of capital has been raised, mainly by US-based private equity managers, but also through the advent of new real estate investment trusts (REITs), notably in Spain and Ireland. As these groups seek to deploy capital and banks increase provisions enabling disposals, the bid-offer spread has narrowed.
At PIMCO, we believe that significant investment opportunities remain, particularly in the form of single assets and complex structured transactions. Those work-outs will take many forms, which will require capital that is flexible, expertise that is local and hands-on asset management in addition to financial engineering. As with bank deleveraging, when deploying capital opportunistically in European CRE, a “not too fast, not too slow” approach is currently a good philosophy.