“A SYSTEM WHERE banks are piling up non-performing loans has a very negative impact on the economy. If you look at NPL problems around the world it always takes the banks to clear their bad debt problems for valuations in the underlying assets to pick up. Banks will not extend credit on more assets in the same asset class. Take real estate: the minute banks sell to people like us, volumes can start to rebuild, and that’s great for the German economy.”
So argues Bruno Scherrer, partner and European head of Lonestar, a Texas-based private-equity firm that has played a pivotal role in stirring up the honey pot of German lending.
Scherrer explains that NPL values in Germany are so high – anywhere between €200 billion and €350 billion, depending on which analyst you believe – that the German economy can no longer sustain them. “Once that happens, the NPL problem won’t disappear by itself unless the growth in the economy is double-digit growth,” he says.
So are Lonestar, and other predominantly US-based institutions now looking to buy up NPLs, riding to the rescue of the Germany economy? Tell that to the domestic reactionaries bemoaning the “locusts” now attempting to strip bare the country’s financial sector.
Of course the real concern for many of those voicing these complaints – often long-standing stakeholders in German companies – might be that their investments are locking in losses on assets that have underperformed for 10 years just as there are signs that the market, particularly in real estate, is picking up again.
And foreign investors are hardly in it for altruistic reasons. Investor returns vary depending upon the asset class, says Scherrer. Similar to any other asset class, a greater risk profile should equate to higher returns. Investors will require greater returns on unsecured consumer assets, which are more volatile than those that are secured. Typically, for NPLs backed by residential assets, equity investors will seek an internal rate of return of 15% to 20%.
But even the naysayers cannot dispute the fact that hopes of sustained economic growth in Germany will not be realized until problems with non-performing loans and weak real estate prices are dealt with.
The connection between Germany’s dormant domestic economy, banks’ poor performance and a 10-year decline in real estate prices is all too obvious, as it weighs on corporate and consumer confidence. Credit from domestic banks has been scarce as they struggle to cope with the weight of bad loans.
Banks bite the bullet
German banks all but ignored the real estate crisis in the 1990s. German regulator BaFin has played a large role in this, according to market observers. The regulator has a far more liberal concept of what an NPL is than most of its international peers. But of greater importance is the fact that German banks are highly relationship oriented, which has made it hard for them to admit to NPLs or even poorly performing loans.
Given their natural reluctance to write down loans, why have German banks finally bitten the bullet? Sales of NPLs are driven by the fact that banks are now focused on providing shareholders with double-digit growth.
A further impetus for change has come from the Landesbanken’s loss of state guarantees. The subsequent decline in ratings means that they urgently need to address their NPL books, especially in the light of Basle II.
Another blow for German commercial and public sector banks has been the dramatic tightening of international capital and loan markets, eating away further at their business margins. As a result, the traditional base of commercial lending by financial institutions has suffered at the expense of CMBS conduit lenders.
Foreign investors buying large portfolios of real estate and NPLs are evidence of real change in Germany’s business and banking sectors. The sheer size of the NPL market has attracted a range of foreign players with experience of NPL markets in the US, Italy and Japan.
However, in real estate there appears to be a gap between the optimism of international investors and the low confidence of the domestic sellers. There is anecdotal evidence that some sellers cannot understand why foreign investors want to buy these underperforming assets. But shrewd observers perceive that the arrival of an army of savvy foreign investors signals that prices have reached a low point and must begin to rise.
“If private-equity players and hedge funds are buying tracts of German real estate, it shows that the market is undervalued,” says a senior executive at a German bank.
The advent of these foreign buyers is far from universally popular. This summer, emotive language was used to describe private equity and hedge funds active in Europe’s largest economy, culminating in the description of these investors by Social Democrat party chairman Franz Müntefering as “a plague of locusts” that “descend on companies, chew them up and move on”. Those decrying foreign intervention suggest that this deployment of foreign capital is indeed little more than asset stripping and that it will have little positive impact on the German economy.
Fears arise from the perception that such investors have a relatively short-term time horizon. The investors themselves take an opposite view of their activities. “You need a long-term perspective to be in this business,” says David Abrams, head of the German strategic initiative and head of speciality finance investments and origination at CSFB. “We are allowing companies access to growth that would otherwise be constrained by debt.”
NPL logjam
It is worth remembering that although Germany’s export sector has performed well recently, the international outlook remains mixed. After a painful period of readjustment, German corporates are still only just returning to health. To get economic growth above current weak levels (1.6% in 2004), Germany needs all the help it can get. And the banking sector, saddled with many billions of euros-worth of bad loans, is now weak by western European standards.
For example, HypoVereinsbank has €24 billion-worth of NPLs and early this year placed a €15 billion real estate portfolio in a separate work-out division, HypoReal Estate. Aareal, a bank only active in real estate, suffers from 11% of its customer loans being NPLs, according to research by DrKW. Realizing book gains on the sale of these NPLs is essential for many of Germany’s commercial banks if they want to get tier 1 capital ratios back to adequate levels.