Germany: Europe’s bad-debt Goliath
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Germany: Europe’s bad-debt Goliath

As banks in the UK, Ireland and Spain accelerate their disposals of non-core loan portfolios, one European country is conspicuous by its absence – Germany.

Bank balance sheets groaning under the weight of too many bad loans are not the preserve of Europe’s periphery – no matter how much the continued focus on Spain and previously Ireland might suggest this. In mid-October Spain’s economy ministry announced a €90 billion limit on the size of the bad bank that the country is to establish to deal with the fallout from its soured real estate boom (a total of €180 billion in bad real estate assets sits on the balance sheets of Spain’s banks). Contrast the situation with that of the country that is pivotal to Spain’s fiscal fortunes – Germany. In Germany €273 billion of assets have already been transferred to bad banks from just two lenders: WestLB and Hypo Real Estate. And there could be much more to come. When it comes to bad real estate debt in the eurozone, Germany is top of the heap.

German banks were notorious for being on the wrong end of many of the deals that soured after 2007 and some astonishingly poor decisions were made – particularly in structured credit. The lion’s share of the problem loans that the banks need to deal with are, however, in real estate. Despite this, large-scale loan sales remain few and far between. The assumption of large volumes of bad debt by two state-owned vehicles and state-backed asset guarantees for the Landesbanken have kept a lot of assets out of the market. And thanks to little pressure from regulator BaFin, activity by private-sector banks has so far been muted as well. According to PwC €4.3 billion of non-core asset sales have taken place in Germany so far this year after negligible activity in 2010 and 2011. Compare this with the UK, where there were €7.5 billion of sales in 2010, €8.8 billion in 2011 and €3.6 billion in 2012.

Analysis by PwC shows Germany topping the non-performing loan rankings in Europe from 2008 to 2011 with €196 billion outstanding, so there is growing expectation that something will have to give – both in performing and non-performing loan sales. According to global real estate adviser CBRE, over €7.5 billion of commercial real estate loan sales had been completed by European banks year to date by September 2012. But of the 14 transactions tracked, six were sales of loan portfolios where the assets were solely located in the UK and Ireland, where there has been a lot of pressure from the regulator to shed assets. CBRE estimated that over €11 billion of loans, divided into nine portfolios, were being marketed by Europe’s banks. But how many of these include German assets? Recently the European market has been rife with suggestions that a large portfolio of German assets is up for sale. When Euromoney spoke to market participants in October it became clear that at least two portfolios of German assets were being actively marketed, but by non-German banks. One is thought to be a €300 million pool of predominantly corporate loans that is being sold by an Austrian lender; the other a roughly €500 million portfolio that includes real estate assets, again from an international bank. There is certainly no shortage of investor appetite for such assets and if these deals complete successfully many in the market believe there could be more.

Ralph Winter, founder and chairman at Switzerland-based specialist private equity firm Corestate Capital
Ralph Winter, founder and chairman at Switzerland-based specialist private equity firm Corestate Capital

A recent discussion paper published by the Real Estate Management Institute and the EBS Business School calculates that €125 billion of distressed real estate assets will fall due over the next four years in Germany. "There is a lot of pressure on lenders," says Ralph Winter, founder and chairman at Switzerland-based specialist private equity firm Corestate Capital. Corestate recently published an investor survey on the back of the REMI/EBS discussion paper findings to establish appetite for distressed real estate debt in Germany. "The momentum is bad and this has a negative impact on the market, leading to a bottleneck of debt," Winter tells Euromoney. "The lending environment in non-core cities has changed over the last four to six months and things are getting worse and worse. Banks are no longer willing to finance these types of assets. And even if a portfolio is in a healthy condition today banks will no longer extend loans at maturity."

Winter expects that the situation will deteriorate unless the fundamentals in Germany improve. Of the investors Corestate spoke to, 58% estimated that distressed debt made up between 0% and 10% of their outstanding real estate loans, but that this figure was expected to rise sharply over the next two years. According to the REMI/EBS paper, 82% (€301.5 billion) of funding to Germany’s commercial real estate market comes from domestic banks, with 13% funded via CMBS, 3% from foreign banks and 2% from insurance companies. So this distress will overwhelmingly be felt in the domestic banking sector.

But even this might not be sufficient impetus to prompt the banks to sell. "The regulatory pressure and incentives for German banks to accelerate the reduction of their local portfolios remains relatively low," says Graham Martin, partner and global head of the portfolio solutions group at KPMG. "Despite this we are expecting more activity in Germany over the next 12 to 24 months which will be mainly driven by non-German banks with real estate exposure to the country."

There are a number of reasons for this: predominantly the extent of state support that Germany’s dysfunctional banks still enjoy. The transfer of €173 billion of Hypo Real Estate group loans to state-owned FMS Wertmanagement (FMSW) in October 2010 and the assumption by bad bank Erste Abwicklungsanstalt (EAA) of €100 billion of WestLB assets removed a vast chunk of bad lending from the market.

In December last year private equity firm Apollo walked away from negotiations to buy WestLB’s Westdeutsche ImmobilienBank real estate unit for €400 million, so an additional €24 billion European property loan book was transferred to EAA in April. These winding-up agencies (they do not like to be referred to as bad banks) are tasked with running down the portfolios they have taken on over the long term and are under very little pressure to sell. "Their mantra is not to sell loans," says one Germany-based expert. "They are playing a very long game." Another banker says that discussions with the German bad banks suggest it could be a ten-year project.

They are able to do this because they fund themselves so cheaply: EAA issued a €1.75 billion five-year note at the end of August at 18 basis points over mid-swaps. For this reason the large volumes of loans that have been transferred to them are likely to stay there, or at least not be sold at a big discount. "EAA and FMS have absorbed assets and are in the process of selling them off, but their approach is very different from that which the private sector would take," says one banker. "They can finance purchases cheaply and sell them down as close to par as possible – they are not distressed sellers."

Two other German Landesbanken that are under no pressure to sell loans are HSH Nordbank and LBBW. Both have been granted temporary state guarantees for their bad debts. HSH Nordbank has a €7 billion second-loss guarantee issued by the states of Hamburg and Schleswig-Holstein for which it pays an annual fee of 3% of outstanding assets (rising to 7% in the event that losses breach an agreed cap).

LBBW was granted an asset relief guarantee of €12.7 billion from the state of Baden-Württemberg as part of its recapitalization in 2009. Assets covered by these guarantees are not risk weighted and do not need to be provisioned against – an active disincentive for any bank to sell them. At HSH Nordbank the hedging provided by the guarantee reduced loan-loss provisioning by €131 million in the first quarter of this year.

With such large volumes of assets either in state-owned bad banks or under state guarantee it is hardly surprising that Germany has been slower than the UK and Ireland to deal with balance-sheet deleveraging. The German bank that has been most active in selling down loan portfolios so far is the Bundesbank itself, which announced the sale of the €1.8 billion ex-Lehman Excalibur portfolio it inherited from the European Central Bank in January this year. The pool, which includes senior loans, mezzanine loans, corporate loans and CMBS, was sold to US private equity and distressed-debt firm Lone Star. The loans were acquired in two stages(January and April) at a discount rumoured to be in the region of 40%.

The Bundesbank is looking to sell a number of loan portfolios it inherited following the bankruptcy of Lehman and is believed to have sold other assets to Pimco. An additional €238.7 million portfolio dubbed Project Green was on the block in June this year. That deal is expected to close by the year-end.

The Bundesbank is, however, an outlier in this regard. "We will see non-German banks selling German loan assets but there will not be much activity from German banks selling German portfolios," warns Jörg Schürmann, director at Jones Lang LaSalle Corporate Finance in Frankfurt. Those sales that have been undertaken by the private banks have focused on US assets, driven by dollar funding issues experienced by many eurozone banks last year. In June, Wells Fargo bought a $6 billion portfolio of US assets from WestLB, which included short-term lending to funds and Reits. In the same month, Eurohypo (now rebranded Hypotheken Frankfurt) sold a $760 million portfolio of US loans to US Bancorp, Wells Fargo and Blackstone. Hypotheken Frankfurt has a €56 billion European real estate book that has been the subject of much speculation since it was rolled into Commerzbank’s new non-core unit this summer.

Shifting the problem Non-core asset transactions

In August, the Frankfurt-based lender spectacularly U-turned on its decision to launch a real estate and shipping finance business, which it had announced as recently as March. Instead, the bank’s existing commercial real estate exposure, together with €20 billion of shipping loans and €96 billion of public finance lending, have been placed in the new non-core unit to be wound down. Hypothekenbank Frankfurt also has a €7 billion UK commercial real estate loan book that will be run off over the next five to seven years. The crucial issue as to whether initiatives such as this lead to portfolio sales is the nature of the lending itself and the extent to which it has been marked to market. The German banking sector is notoriously exposed to eurozone stress: Germany still had outstanding loans of €323 billion to Greece, Ireland, Portugal, Spain and Italy at the end of 2011, according to the Bank for International Settlements, despite having taken big losses on such exposure already. FMSW is believed to have taken between €8 billion and €9 billion of losses on Greek exposure so far, and it was the €243.8 write-down that Westdeutsche ImmobilienBank took on Greek government bonds last year that is understood to have soured the deal with Apollo.

According to the Bundesbank, the average minimum core tier 1 capital ratio of the 12 German banks stressed by the European Banking Authority was 10.7% by June 2012. Of the 13 banks (including WestLB) that took part in the EBA exercise in September 2011, six failed. The country still has 2,000 banks – 460 of which tapped the ECB’s three-year long-term refinancing operation facility last February. Many of these might not be in the best shape to start crystallizing losses.

The US loans that Eurohypo sold to US Bancorp, Wells Fargo and Blackstone were of high quality and are likely to have been sold at close to par. Selling other assets at any discount would be a hit to equity that its parent is in no position to take. "The likelihood is that Commerzbank will sell some assets from the non-core unit but the decision will not be taken quickly," says a debt specialist. Managing directors Ulrich Sieber and Jochen Klosges have joint responsibility for running the new unit at the bank.

Given the sheer number of banks in the country it is of little surprise that German finance minister Wolfgang Schauble opposes a pan-European bank regulator having jurisdiction over the entire banking sector as this might attract unwanted attention to some lenders’ capitalization levels. But even at the large, systemically important German banks there is little political stomach for accelerating balance-sheet clear-outs. "All large German banks employ large teams of people in their workout divisions and there is very little political will to see these people laid off," says a Frankfurt-based banker. "The government wants to protect German jobs."

There certainly seems to be a healthy degree of scepticism on the ground about some analysts’ predictions that asset sales in Germany will flourish. "There is a difference between asking people what they expect to see and analysing the banks and what they are doing," says Schürmann. "There is a real question over the extent to which loans on the private sector banks’ books have been sufficiently written down to their market price." Any shortfall will therefore incentivize them to hold out as long as they possibly can before selling at a loss.

Away from the large banks, however, deal flow in Germany has been more encouraging. "There is a steady flow of mid-sized deals," says Gifford West, managing director, international operations and business development, at debt specialist DebtX in Boston. "These tend to be open auctions and the occasional bilateral." In September 2011, DebtX managed a sale of $160 million of performing and non-performing loans from Deutsche Postbank, the latest in a series of sales by the Deutsche Bank-owned lender.

The rising distress such private equity firms as Corestate expect is likely to be felt at the regional and smaller end of the German banking sector. Eighty percent of real estate lending in the country is in non-core cities and these are the loans that banks are no longer prepared to extend. There could be high levels of distressed selling in this segment if previous activity is anything to go by. Los Angeles-based private equity firm Colony Capital has been active in Germany for some time and made investments for its two distressed funds at big discounts. Having bought a €61 million portfolio from Bankaktiengesellschaft AG (BAG), the bad bank repository for a network of German cooperative banks, in December 2009 at an 84% discount (€10 million) it bought a €106 million non-performing portfolio from IKB Bank in July 2010 for €36.6 million (a 64% discount). In August 2011, it bought a €370 million portfolio from four banks including Eurohypo at 18% of the unpaid principal balance.

These types of discounts might, however, be a thing of the past as – unlike in some other eurozone countries – asset quality in Germany seems to have stabilized. But the potential has not escaped the attention of the many international credit opportunity funds that have set their sights on the country. "There is strong interest in German real estate, corporate and residential mortgage loans from a number of different sources including investment banks and private equity funds as well as local specialized buyers," says Martin. "This is clearly due to the strong economic fundamentals of the country,which allow buyers to have more confidence in buying loan portfolios in Germany rather than certain other eurozone countries."

Generous state support and widespread use of cheap LTRO money from the ECB have certainly delayed the day of reckoning for many German banks. And the contrast between the loan portfolio sale market in Germany and that of other high-NPL jurisdictions such as the UK, Ireland and Spain is striking. However, federal largesse is not infinite and sales must come.

A rich source of such sales next year might be the CMBS market. JPMorgan expects €27 billion of CMBS-driven asset sales across Europe in the next five years, and €10.76 billion-worth of German CMBS loans fall due in the second half of 2013 alone. In June this year, Capital & Regional defaulted on a €158 million loan backed by German real estate. The loan is part of the Talisman 6 CMBS deal.

"Things will pick up but I am not sure that we will see the volumes that everyone is predicting," says Schürmann. Martin at KPMG expects to see slightly more activity from regional lenders but not at distressed levels. "Regional German banks are also now looking at their sub-performing loan and non-performing loan portfolios with a view to reduce risk weighted assets but they generally sell on an asset-by-asset basis and only at or above their book values," he says. The large German lenders are likely to take the same view, holding fire on any portfolio selling for as long as they can.

But with Basle III looming there is only so long that they can hold their fingers in the dyke. "If a large German lender was to undertake a large sale it would be in order to send a clear message to the regulators that they are moving on cleaning up their balance sheets rather than to maximize proceeds," says West at DebtX.

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