Germany 2005 - Waiting for the real deal
The arrival in Germany of foreign capital seeking treasure among the debris of the domestic banking system has created potential for a large secured bond market. Meanwhile, the new pfandbrief law means that borrowers must lift the lid on their once opaque cover pools. Joti Mangat and William Thornhill investigate signs of a restructured German debt market.
The economic tribulations of Germany are notably apparent in the banking sector, where domestic banks are estimated to be creaking under up to €350bn of non-performing or sub-performing assets. The political sensitivity of this problem has resulted in a culture of denial that domestic lenders are only just beginning to confront.
One man's implosion is another's opportunity, however, and equity and debt financiers are lining up to take positions. Furthermore, while many Germans have lost their appetite for real estate risk, the same international investors have filled this vacuum, creating a potentially vast market for securitised term refinancings.
Against this background, what will become of the hallowed reputation of the public sector pfandbrief as a bullet-proof, top-quality bond product?
The Landesbanks’ traditional guarantees expire this July, after which public sector pfandbriefe issuers will be required to value their mortgage assets under the stricter guidelines that have pertained in the private sector for sometime.
Louis Hagen, director of the German mortgage banks’ association (VDH), believes that the public sector will be immune from any significant rise in NPLs as a consequence of the new law.
First, public sector banks can simply close the existing cover pools for mortgage pfandbriefe that still benefit from the state guarantees. New cover pools, by contrast, will have to fully comply with the law that stipulates clear valuation guidelines.
Secondly, banks can opt to take a 50% haircut on the value of mortgage loans and then apply a 60% LTV on the basis of the new valuation principles within a year. If there are loans in the pool where the collateral is not of a sufficient value, they cannot be used, or the banks must reduce the value of the pool.
It is possible to have NPLs within the collateral pool because there is a sufficient cushion in the LTV. “Just because a property is defined as an NPL, does not mean that it is bad. It’s the security of the collateral not the capacity of the borrower to pay his loan that is the key,” Hagen argued.
Notwithstanding the cushion that the conservative LTV and stricter valuation guidelines provide, complications can still arise. “There is now a market for NPLs, which is good, but banks can only sell if the price paid covers the value of the loan. If a bank sells below the book price, then the loss can perhaps be offset but in a fragile earnings environment every loss counts very heavily,” Hagen said.
Process in motion
Banks that cannot take a write-down are forced to keep loans on their books and work them out as best they can. But for banks that have decided to part with their distressed assets, dual uncertainty, arising from the lack of a stable definition and a transparent enforcement regime, is the major obstacle to a smooth exit via a bond issue.
“The definition issue originates from German bank secrecy laws and is, in essence, about the point in time that a bank is without doubt allowed to disclose information,” said Jens Rinze, partner at legal firm Lovells. “It is [defined as] an NPL if the loan is in default and terminated,
but this is a conservative definition. Another definition is where a loan is in default but not terminated, but a right to terminate exists.”
The multiplicity of meanings reflects lender banks' differing assessments of what they need to dispose of.
The practical implications are a unique blend of performing, sub and non-performing loans in any given book. These can be split, with either portions or just the sub-performing portion refinanced depending on the price and the quality of the book.
“There is an investor for every product,” said Toni Moss, servicing specialist at Eurocatalyst, an organisation that services the European mortgage industry. “The problem for these sellers is that they don't know what they’ve got in the first place because their servicing is not as good as it should be."
A major bone of contention between present owners and potential buyers is the German industry's reluctance to acknowledge the lessons of workout scenarios during the Savings and Loan crisis in the USA and the Japanese banking crisis of the 1990s.
“The only difference between a German and a Japanese bank is that a German bank thinks there is one,” joked one senior German banker.
The ABS market has been holding its breath in anticipation of the securitised refinancing of these assets for almost a year. Despite the announcement of a couple of transactions, it is unlikely, given how nebulous the definition of these assets appear to be, that structured finance technology will be the shock treatment that the German banking system so urgently needs.
For example, JP Morgan and Lone Star jointly acquired a €490m NPL portfolio in November 2003. In summer 2004 the ABS mandate was announced, but as of mid-March 2005, the deal had yet to surface.
“The first buyers to get into this market all anticipated much quicker execution than has actually been achieved,” said Charles Roberts, partner with legal firm Cadwalader, Wickersham & Taft’s securitisation practice. “Those who got in early without a tangible plan for exit put speed before value, and I think those who waited a bit longer will be better off in the long term.”
Delays in coming to market reflect the lack of reporting transparency compared to ABS market standards, the lack of a servicer ratings and the absence of historical data based on international standards as required by the rating agencies.
“The majority of asset buyers in Germany see a securitised bond exit as the best route. Securitisation technology is well suited to this risk transfer; the German servicing industry isn't,” said Roberts. Servicing sources say that they are 12–18 months away from meeting international standards
“The servicer is the bank within the bank. It is the servicers who are really managing the data and the first to come across missed payments and loan performance issues long before they become serious problems.”
The very nature of securitisation and the unbundling of the value chain into specialised sectors is what will most dramatically improve the efficiencies of the European mortgage lending sector.
“But crucial to that process are the servicers to act as the data bank and follow up on the higher risk loans,” said Eurocatalyst’s Moss.
“The S&L experience shows that after six months servicing an NPL it could well become a sub-performing loan, and after 12 months it could be repaying at par. This is the cycle that needs to develop,” Moss continued.
Citigroup established its servicing platform ahead of any NPL ABS, following the purchase of 14,000 NPLs for €2.4bn from Eurohypo in a joint venture with GMAC. The three counterparties set up Opus Advisors, a new business for the acquisition and servicing of NPLs and the further pursuit of new NPL business. Crucially, Opus will be staffed by 140 experienced Eurohypo NPL professional.
“Opus is concerned with best practice and how to adapt this into the local environment and culture,” said an official. “Every German region has a different culture, law and availability of information, so you must adapt best practice locally. We are working with a very experienced party [Eurohypo] who formed the core of the loan office. Our accounting and reporting standards are of an international standard. Equally, we attract interest from funds and other banks to take their servicing.”
Inefficient market opportunity
The same problem loans that are weighing down German balance sheets have indirectly created further investment opportunities for foreign capital (see the Restructuring feature in this report).
Balance sheet realignment has precluded the leading domestic market players from taking a proactive approach to the commercial property sector. “The average real estate loan is between €4m and €100m, financed at around 110% LTV at about Euribor plus 100bp. German banks just don't have the balance sheet to make these loans,” said a CMBS specialist at a recent conference on European CMBS.
“Germany is currently an inefficient market. The restructuring of the financial markets has seen a massive shift in the last three or four years. With so much change taking place, there are real opportunities to acquire some very attractive assets. Securitisation provides an ideal vehicle to take advantage of market opportunities; real estate lenders are spending in Germany,” said Arvind Bajaj, managing director and head of European CMBS origination and distribution at CSFB.
International real estate advisor DTZ recently revealed that the European commercial real estate market is worth approximately €6trn, with Germany accounting for 21% of that figure. However, Germany accounts for just 4%–5% of European CMBS issued, with most of that in synthetic format.
“The mismatch between the size of the underlying market and the volume of CMBS transactions actually closed shows the extent of the opportunity for a German CMBS market,” said Bajaj.
Real estate lending in Germany offers CMBS bankers the holy trinity of high yields, long-term leases and high capitalisation rates. The European CMBS market has been dominated by sterling-denominated deals backed by UK office, retail or industrial properties. Berkley Square in Mayfair, London recently sold with 3% yields, although UK yields are typically 6%–7%.
“German commercial real estate yields average between 7% and 10%. That's really exciting for a real estate lender; high-yielding assets facilitate the creation of a good CMBS market,” said Bajaj.
To date, deal completion has been slow, but the blueprint is established. July 2004 saw Citigroup deliver exposure to German office properties with the Marlin EMC-II sale and leaseback pan-European CMBS of a single secured loan to Blackstone Real Estate Fund secured by multiple properties. Of the collateral pool, 79% is located in Germany, with Duesseldorf (19%), Munich (13%) and Berlin (9%) being the main cities.
CSFB is the first and so far the only investment bank to make commercial real estate loans directly into Germany and securitise them with a true sale, cash transaction. Titan Europe II, which printed Triple As at Euribor plus 19bp in December 2004, securitises two German loans, giving the collateral pool 37% German assets.
“Conduit lenders are currently very active in Germany. The tight spread environment is very good for the conduits which are beating the balance sheet lenders on their own turf,” said Roberts. The number of deals backed by German loans will certainly increase this year. As of mid March, Hypo Real Estate was in the market with a €200m CMBS of purely German collateral.
Another thread of the German MBS story is the multi-family residential portfolio. A break-through trade structured and distributed by Barclays Capital gives indebted corporates another tool to exit real estate positions which are no longer desirable. Hallam Finance’s €265m multi-family MBS for FSG Immobilien, an entity of real estate corporate Vitterra, overcame significant legal and commercial barriers that had previously been thought insurmountable, or not worth tackling.
“With this deal, Hallam's weighted average cost of funds is Euribor plus 43bp. A bank loan secured against this type of asset would cost north of plus 100bp. From now on we know that these portfolios can be securitised and sold into the bond market at spreads inside bank levels without inconvenience to the issuer,” said Robert Palache, head of real estate, corporate securitisation and infrastructure finance at Barclays, at the time of pricing.
Viterra remains in the headlines as the object of attention for a host of foreign investment funds backed by investment bank debt financing consortiums. This time the entire Viterra portfolio of 150,000 residential units is up for sale, in order to bring parent E.ON into line with regulatory prescriptions.
“It is unclear at present whether the loan market or the structured finance market would provide a suitable exit scenario for any long-term refinancing for this Viterra portfolio,” said a source close to the bidding process. “There has been one small deal. But the securitisation market has developed rapidly and spreads have tightened attractively. There is quite a reasonable chance that this portfolio will be securitised.”
But when? “The large residential portfolios are being bought at a 3%–4% net yield, financed at 90% leverage at around 150bp over margin,” said one European real estate lender. “"I think we will see originators leave these loans on balance sheet to delever before securitising them.”
The Hallam paradigm could be tested even sooner. As part of a general restructuring and deleveraging exercise, German technology group Thyssenkrup sold a portfolio of 68,000 residential housing units to a MSREF/ Citigroup consortium for €1.85bn. Citigroup says that it will refinance the acquisition with an international offering of mortgage-backed securities in the second quarter.
TK has since been upgraded by Fitch Ratings (BBB+ from BBB) and returned to investment grade by S&P (BBB– from BB+), and has placed a €500m 10-year Eurobond via ABN AMRO, Commerzbank and West LB.