We’ve been writing a lot recently about the likelihood that European banks and, to a lesser extent, U.S. banks would be strongly incented to sell assets to improve capital ratios. We had a client briefing in New York on the Eurobank crisis a few weeks ago. We brought together our North American and European regulatory and transactional counsel to cover a wide range of issues from the sale of assets to rescue capital. We had a lively conversation on the panel and with the audience about asset sales. It was pretty clear to one and all that if assets are not disintermediated, bankers will be defenestrated. Given the choice, we are pretty sure the banks will sell assets.
De-risking of banks’ balance sheets might be less than terrific macroeconomic policy at a time when economic activity is weak and could be very bad if it touches off a powerful credit contraction and a descent into a continent full of zombie banks. That’s bad. But, always look on the bright side of life, in a Life of Brian sort of way. In the short to medium run, the velocity of transactional activity around financial assets will go up. Indeed, we have been very busy since mid-year buying, selling or financing pools of loans bereft of the love of the bank who made ‘em.
Of course, banks can meet capital targets by either selling assets or raising new capital. Our European friends seem to have a strong predilection for meeting necessary capital ratio targets by trimming the numerator as opposed to growing the denominator. Commerzbank is a good example. The Wall Street Journal reported recently that Commerzbank is back on the regulatory griddle after actually raising significant new equity. But the bank used that equity to pay off governmental investments and avoid dilution as opposed to simply deepening the capital cushion. That seems emblematic of a continental mind set. We think it will be a while before the European banks and their regulators will broadly embrace all that new capital that is just awaiting the invitation to shore up those balance sheets and impatiently sitting in the coffers of those nefarious Anglo-Saxon private equity shops. And, by the way, this is a capital problem, not a liquidity problem. A few weeks back, the ECB deposited over half a trillion dollars into European banks, which of course they gobbled up and neatly re-deposited back in the ECB. While the markets got giddy for a day, it didn’t fix the capital problem. Liquidity is not the problem. Solvency is.
So, shedding alligator tears at the woes of the European bank market, U.S. transactional players are quite excited about the opportunities in 2012 and beyond as the slow motion train wreck that is the Eurobank crisis continues and continues and continues. And the even better news for us transaction junkies is that these assets are moving from hold-to-maturity players to folks with a much more dynamic approach to the management of financial assets. So as assets are sold by the European banks, they will enter a high velocity environment here Stateside where they will be re-financed, re-structured, re-packaged and re-sold.
The pattern we’ve seen, which we think will continue, is that the healthy U.S. banks will be the strong bid for high-quality performing loans. These institutions continue to struggle to grow their loan book and buying pools moves the needle. The more transitional, or dodgier, assets will be snapped up by the high-yield community using leverage from those self-same major banks. There is a robust bid to finance successful buyers. Most of this financing is repo based, but has proved to be very flexible structurally to accommodate the business realities of a dynamic pool of loans. What I expect to see during the year is some of this bank financing replaced on a long-term, durationally-matched basis by CMBS or CDO type structures which will be very effective stable leverage for players in the space. Lonestar’s L-Star transaction in mid-2011 is the poster child for this trade. We will see many more.
Before getting too giddy over the opportunities flowing from the European banks, remember that every rose has its thorn.
Whether buying or financing, these trades can be difficult. First, many of the banks are turning to established auction shops like Eastdil and HFF to sell pools of assets. While the optionality and transparency of the bid process may be compellingly attractive to the sell side, it creates material barriers to entry on the buy side. The pattern of recent transactions has been a due diligence period followed by a brief contract period and a brief period to closing. The ante is an incredible amount of diligence work prior to making the bid. This has and will continue to limit the number of bidders and it’s conceivable we’ll see more transactions occurring on a private, negotiated basis as bidder fatigue shrinks the pool of willing buyers.
Second, these loans are seasoned and were originated for portfolios as opposed to the secondary market. That means the documentation is all over the lot and the quality of the data captured at origination and through servicing is, in some cases, woeful.
Third, interest rate calculations and payment terms in the underlying loans are, in many cases, downright weird. It’s fascinating how bankers left to their own devices will find new and heretofore unimagined mechanics around setting the interest rate, the interest accrual period and the pay dates. Cutting through this hodge-podge of payment terms is complex to say the least. And if temporary bridge financing is to be taken out by a capital markets execution, it just gets very much worse.
Fourth, for reasons which may be somewhat cultural, the loans coming from the European banks often have restrictions on transfers in either the loan document or in the attendant hedges that makes transferring these loans to new ownership difficult. One can certainly call the borrowers and say, “May I please have a waiver, but I don’t want to pay for it”. But where that doesn’t work, the fixes are complex and typically involve workaround structures such as participations, back-to-back and total return swaps.
Finally, sellers in this market seem to be more than usually allergic to reps. Where data is not good and real, comprehensive representations can’t be had, pricing or taking on more risk become the only fixes. The rep problem is made more serious when there are questions about the long-term viability of the sellers and, in some cases, about the potential impact of sovereign immunity upon residual claims. Nothing’s easy.
So, in summary, European banks will sell assets, U.S. banks and funds will buy assets, U.S. banks will initially finance assets, long-term financing will ultimately be provided directly by capital markets execution, bankers who buy these assets will work them hard to restructure, sell, buy-down, DPO or foreclose these assets to lock in yield. We’ll be there every step of the way. Isn’t that a beautiful thing?
By Rick Jones.
