CrunchedCredit : Capital Markets Finance and Real Estate Attorneys

The one-day program was eye-opening and fascinating. The speakers, present company excepted, were extraordinary. The keynote was delivered by Chris Flowers, one of the savviest investors on the planet. Speakers included Jim Lockhart, who’s Vice Chairman of WL Roth & Co. and currently running what’s left of the UK bank previously known as Northern Rock, our partner Tom Vartanian who is a genius on structuring private equity to save open but damaged banks, John Moran, the Secretary General of the Department of Finance of Ireland, Nils Melngailis and Steve Franck, Co-Head and Senior Director respectively of the Financial Industry Advisors team at Alvarez, Mike Krimminger, the General Counsel for the FDIC (who has certainly seen this movie before), Sophie Bertin-Hadjiveltcheva, the Head of State Aid for Financial Services of the European Union, Andrew Gracie, the Head of the Special Resolutions Unit at the Bank of England, Piers Haben the Director of Oversight for the European Banking Authority, and a host of others.  A financial glitterati prepared to slog into the detritus of a bruised, if not broken, bank system.

A lot of great take-aways: 

• Every bank on the continent is engaged in the naval gazing exercise of dividing risk assets into core and non-core. In some significant measure, and because of politics, “non-core” is code word for the financial NIMBY: “Loans not made to my citizens.”
• When folks like Chris Flowers and Jim Lockhart of WL Ross & Co. think it’s worth hanging around the European bank rim, it’s worth hanging around the European bank rim.
• The European Commission has provided in excess of €5 trillion in aid to the European financial service sector. €5 trillion. There’s an attention grabber!
• The recent massive infusion of liquidity into the sector by the ECB will, on balance, make it slightly easier and more likely the European banks will dispose of non-core assets. The notion that this liquidity means assets will not be sold is wrong-headed.
• There’s something like $2 trillion in commercial real estate assets on the balance sheets of the European banking community as a whole. Largely, it’s marked at par. Largely, it’s worth 80 cents on the dollar. That’s a $400 billion hole in the collective balance sheets of the banks. Because of Basel III, the ECB is requiring that the banking community provide something in the range of $300 billion of additional capital before summer. Is that really $700 billion?   
• The ECB defines capital needs as a ratio of capital to risk assets. Adding liquidity doesn’t fix that ratio. Raising equity or selling assets does. The bet is assets will get sold before capital will get raised. John Moran, the Irish finance minister, pointed out the Irish government is way out ahead of largely everyone else with a creative and aggressive assault on bank solvency with a comprehensive bad bank, good bank, government assisted scheme. The herd is not following the Irish bell cow here. 
• Major EU banks are enormous. Many of these institutions have assets exceeding the gross domestic product of their host countries. Note that Lehman at its height had assets amounting to about 4% of US GDP. How does the mouse hoist the elephant?
• The European banks are also woefully at risk because of their reliance on wholesale funding. US deposits as a percent of bank liabilities are almost 60%. In the Euro area, just over 30%. Yikes. 
• To maximize the opportunities for buying European bank assets, we need a Goldilocks moment. If the banks’ capital is too low, kicking the can becomes the only strategy and they simply cannot sell assets to improve capital ratios. This compels a strategy of comprehensively fibbing about capital and hoping cheap liquidity will somehow fix the problem. If they are lavishly recapitalized by their respective host governments (see above; not likely in most cases), then they can afford to kick the disposition can down the road. Bet is we’re getting Goldilocks. The EC and host countries are doing everything they can to prop up these banks. It’s likely to be just enough to allow the banks to sell non-core assets but not so much that they can ride out the storm and just hope for a tsunami of appreciation.
• Assisted deal to fix open and at least notionally solvent banks is the best way to fix the European bank problem. There are, regrettably, massive headwinds in the way of this getting done. The bank regulatory structure of Europe is vast, diffuse, overlapping, confusing and highly politicized. One thing the regulatory community agrees on though, is that Anglo-Saxon private equity is pretty much evil. If you cannot invite in private capital, assisted with a modicum of state aid, and you cannot face the dilutive consequences of selling vast quantities of common stock, you better sell assets. 

From where I sat on the podium, all of this seemed to be a validation of our view here at Dechert that the disintermediation of the European banks is a trend that will continue to provide real opportunities to entertain the US players for the next couple of years. I love validation. Next time, practical pointers on how to buy and sell pools of bank assets.

By: Rick Jones

Dexia has now unloaded nearly half of its exposure to troubled sovereign debt and reduced its risk-weighted assets through the sale of its units in France, Belgium and Turkey to find additional Tier I capital.

Other European banks will need to raise nearly 120 billion Euros in the first half of 2012 to meet the new 9% Tier I capital requirement. Without help in recapitalizing from the ECB (not happening, per Mr. Draghi), these banks will need to unload assets or raise equity. While the US banks broadly sought new equity, the Europeans seem more comfortable embracing asset sales. If every bank does the same thing at the same time, we’ll see cascading cycles of lower prices requiring more sales, producing fewer Euros or dollars, requiring more sales, etc., etc.

The dirty secret is, of course, that no policy nostrum, no level of enhanced capital, no enhanced prudential regulatory regime will save the banking system in Europe or, indeed, anywhere around the world if faith in the value of risk assets is not restored. Gold bugs may rail against the failings of fiat currency, but all assets depend upon a level of faith that you and everybody else agrees that the assets have inherent value. If that collective belief system breaks down, nothing prevents the abyss.

But that’s not gonna happen, right? Right. It cannot and will not, but this whistling by the graveyard experience should chasten markets, and that’s probably good. Faith functions best when the suspension of reality required to maintain it is not too great.

In the meantime, there’s plenty to do. Loss of confidence coupled with regulatory intervention and uncertainty will create terrific arbitrage between the perceived value of financial assets in the hands of those who have lost faith or might, by reason of regulatory pressure, be a seller of necessity and those who can manage both the real and perceived risk and attendant liquidity issues. George Soros is the poster child of this arb, having just purchased $2 billion worth of MF Global’s sovereign portfolio. Toxic for MFG, home run for Mr.Soros.

So there is fun to be had for the brave and liquid and those of us who midwife the trades. I’m feeling good about 2012!

By Rick Jones.

The Golden Turkey for the Best All-Around Performance: Europe

I defy anyone to explain European monetary and fiscal policy. No amount of magical thinking or psychotropic drug therapy can make this make sense. The explosive dysfunctionality of common monetary and fractured fiscal policies have been baked in the cake since inception and ignored by a sheer act of will. The inevitable denouement from this toxic brew was certain; not whether but when. While perhaps a common currency made sense from the perspective of keeping German troops out of Belgium, it was a disaster in a world where the business cycle was alive and well. The profligacy of European economies, the attendant sovereign debt crisis, the European banking crisis, world banking tensions and European recession can all be laid at the feet of the profound suspension of reality that this was some sort of a good idea.

The Golden Turkey for Pouring Gasoline onto Fire: Basel III

OK, I get the notion that banks need more capital, that the socialization of risk needs to be decoupled from market rewards, and that the system really did go casters up. But…on the cusp of a recovery, we have: the SIFIs (for the blessedly uninitiated, systemically important financial institutions), the Volcker Rule, Skin in the Game and Basel 2.5, Basel 3.0, and on and on. While we are desperately trying to re-start the economy, it seems ideologically bold, to be charitable, to embark simultaneously on dozens of untested, game-changing linked policy initiatives that will, if they do nothing else, constrain capital formation. Isn’t that a bit like citing the Titanic’s kitchen’s for unsanitary brioche pans?

The Golden Turkey for the Abbot Arnaud-Amaury Lookalike Contest

The good Abbot has won notoriety through the ages for the investiture of the City of Béziers during the Albigensian heresy. For, when confronted with the fact that many of the good citizens of Béziers were non-heretical Christians, he said something along the lines of, “Kill them all, God will choose the innocent”. Our illustrious chattering class seems to have concluded, on both the red meat right and the loony left, that trashing bankers makes good copy and good politics. Sticks and stone are bad enough, but an un-relenting policy of demonization makes for fertile ground for bad policy prescriptions, opportunistic litigation, and prosecutorial grandstanding. Whack the bankers, whack them all! Whack a mole! One would not be shocked if our banking sector was left with precious little energy for the aggressive pursuit of capital formation. The fact that the banking sector is working hard to do its job and support commercial real estate with capital is a tribute to our bankers.

The Golden Turkey for Unintended Consequences: 17-g-5

This is a very crowded category. The more we try to prescriptively engineer financial and market outcomes with legislation, the more we encounter the goblin of unintended consequences. You’d think at some point we’d create an OMB for unintended consequences to make a sustained effort think through the chances for unintended consequences before our elected representatives pose behind the President to get their picture taken and cop a commemorative pen. And then we all get to regret the legislative product. And the winner is: Rule 17-g-5. This is a rule introduced earlier this year which required issuers to maintain password protected data sites accessible to all NRSROs to see all the information in connection with a structured finance product rating recorded in these sites so that other, unretained rating agencies could analyze the data, publish an unsolicited rating and, therefore, keep everyone honest. Certainly, the Hobbesian instinct behind this notion to utilize the power of raw market capitalism to achieve the goal of breaking the perceived cozy relationship between rating agencies and bankers was estimable, but it didn’t work. To my knowledge, no unsolicited rating has occurred. And it’s pretty clear why. The cost of producing a rating on a CMBS transaction is enormous. If no one’s going to pay you for it, it’s hard to understand why an agency would undertake all that work to make a point. Moreover, here’s what makes this prize so well earned: the requirement that all information made available to the retained agencies be made simultaneously available to all NRSROs has meant that banks have had to become punctilious about controlling information flow to avoid violating the shared information rule.  In consequence, the NRSROs are getting much less information as conversation has been cut off and everything has been reduced to written submission. Moody’s showed courage this year by writing a thought piece that said 17g-5 was reducing the quality of ratings. They are right.  Now that's a useful outcome, right?

The Golden Turkey for the Best Idea Ever, that doesn’t Work: Covered Bonds

In the past few weeks, the companion bill to the U.S. Covered Bond Bill 2011 has been introduced into the Senate. The Senate bill tinkers with the version re-introduced by Congressman Garrett into the House earlier this year and, in some respect, improves the enabling legislation. We’ve been introducing covered bond bills and talking about covered bonds for years. Not much has happened. No one has actually made a compelling case that there are major financial institutions in the United States of America that want to use covered bonds. No one has ever made a compelling argument that this is accretive to the cost of capital without an offsetting negative impact on the market. Finally, there is no evidence that anyone in our dysfunctional bicameral legislature actually thinks a bill will pass anytime soon. Now don’t get me wrong, we at Dechert love the covered bond, and hope one day to be retained by serious players with serious budgets to make one of these transactions really work. But frankly, and to misquote Winston Churchill, “Never has so much been said by so many about so little”.

The Golden Turkey Send off: Here’s to you Mr. Politician

Whether you are a Keynesian economist (like many politicians pretend not to be) or a follower of F. A. Hayek (like all of the Republican potential nominees proclaim to be), one thing is for certain, we can all agree that the markets are volatile and 2011 is not the year to be an incumbent politician. So, with Thanksgiving right around the corner and the end of the year drawing closer, we at Crunched Credit would like to give a friendly send-off to those politicians who have done much to keep the news entertaining but little to calm the markets. To all of “them” (we all know who they are, even if they don’t) and to the rest of “them” still standing, “It’s the Economy, Stupid”!!!

By the Crunched Credit Team.

The Golden Turkey Award for the Idea Which Launched a Thousand Ships: Risk Retention

Yes, we have to make mention of the 2010’s fiscal cure-all - risk retention. Risk retention has earned a place of just south of gravity and just north of evolution (with some notable exceptions) as received wisdom in this country. It is at the core of a vast amount of regulatory change which will sweep financial markets when turbo charged by FASB's views on consolidation of securitization vehicles literally changing the fundamental rules of the securitization game in a way to diminish capital formation at a time when capital formation is critical to the recovery of our economy. A base for received wisdom? Pretty dodgy. Lehman, Bear, Merrill, AIG, et. al. didn't fail because it laid off the risk of ownership of financial assets. It was because they retained it. The worst performing sector of the entire commercial real estate debt capital markets was the land loan and construction lending sectors. Sectors notably bereft of the ability to sell off the risk. While reasonable people might differ on the behavioral impact of retaining a 5% strip of a financial asset, the data simply do not support the religious fervor with which this notion has been embraced. Hockey stick, anyone?

The Golden Turkey Award for the Most Opaque Regulation: 17g-5

This was a highly competitive category this year – but the winner is Rule 17g-5!

Rule 17g-5 provides that rating agencies must require a party retaining a rating agency to rate an asset backed security (including CMBS), to establish and maintain a password-protected website for all other rating agencies. The website must contain all information provided to the rating agency in connection with the rating. Both written and oral information must be loaded into the website simultaneous with its delivery to the retained rating agency. While the idea behind Rule 17g-5, the simultaneous sharing of information is good – the end result has been murky at best.

Bankers legitimately concerned with liability are insisting that there be only one conduit of information from the issuer’s side to the rating agency. No one is quite sure how to deliver oral communication to all the rating agencies simultaneously through the web-based delivery system. Credit rating agencies are likely to make mistakes due to the fact that they no longer have access to as much information. Accordingly, we find the revisions to Rule 17g-5 thoroughly deserving of a Golden Turkey.

The Golden Turkey Award for the Scapegoat of the Moment: MERS

In an upset, Mortgage Electronic Systems unseats Wall Street Fats Cats, winner of this category since 2007.

Until recently, Mortgage Electronic Systems (“MERS”)  was ubiquitous but relatively unknown. MERS has two roles. First, it acts as record title holder of the mortgage (as nominee for the noteholder) and keeps track of the owner of the beneficial interests in the note. Second, in states where it is permitted, MERS will appear in court to execute the foreclosure process.

MERS was born of necessity, created to address the inability of local recorders to keep pace with the number of assignments, providing a more modern approach to tracking the ownership of mortgage loan. As we mentioned before, ubiquitous, but relatively unknown until recently. However, in early October, a judge in Oregon stopped a foreclosure of a securitized sub-prime residential mortgage loan on the grounds that the assignment of a mortgage to MERS was ineffective because MERS didn’t hold the note – leading the judge to find that MERS lacked a cognizable interest in the property. Did MERS cause foreclosures, or even contribute to the current mortgage crisis – no. Yet, we anticipate that this will be an issue we are sure to hear more about in the future.

The Golden Turkey Award for the Worst Sequel : Basel III

Basel III wins the award for worst sequel.  Basel III is the most recent effort by the Basel Committee on Banking Supervision to fix the worldwide financial system. To provide some background, Basel II was never fully implemented, certainly not in the United States. While Basel II generally resulted in a significant relaxation of capital requirements for most lending activities, it stipulated that many types of commercial real estate loans warranted uniquely higher capital changes. These loans, called High Volatility Commercial Real Estate or HVCRE, include acquisition and development loans, construction loans and loans to sectors deemed by the applicable regulators to have higher risks of default and greater loss expectancy.

Unfortunately, now everyone agrees that something must be done, and that something is to jack up capital. Additionally, politics suggest that whatever comes out of Basel III will, this time, be implemented in the United States. Some have estimated that Basel III will require banks to raise as much as a trillion dollars in equity and obtain over $5 trillion in committed facilities to meet new capital and liquidity requirements.

We’ve heard suggestions that, under Basel III, in order for commercial real estate to be a competitive asset class for the banks, the risk spread would have to increase over 200 basis points. This may simply drive commercial real estate out of the banks. That’s why we call it the worst sequel.

The Golden Turkey “Ironman Award”: Our Readers

This is our recognition of you, the commercial real estate industry and your continued, determined efforts to right the ship during the past 12 months. There can be no doubt that 2010, with properties trading, loans being made and securitizations being printed, was a significant improvement over 2009 (which, in turn, was better than its particularly ugly predecessor). Of the many lessons that may be gleaned from the credit crisis, one is that, in boom times and bust, the CRE market lies in a state of constant innovation and requires professionals with unending creativity and unceasing motivation. We stand at a critical point in the real estate cycle as you – the architects of the future of this industry - lay the foundation for CMBS 2.0.

By the Crunched Credit Team.
 

Now, with the horses well and thoroughly out of the barn, we’re gonna jack up capital. Unfortunately, when everyone agrees “something must be done,” the rush to judgment often results in rules that can do as much harm as good. If implementation chokes off lending, we’ll end up with very well capitalized banks clipping U.S. Treasuries and the economy will remain moribund.

Basel was on everyone’s screen half a decade ago and I, frankly, haven’t paid a great deal of attention to it in the intervening years. But now that G20 is insisting that Basel Committee produce new and improved guidance by December, this has got to get back on everyone’s screen. The politics suggest that whatever comes out of Basel will, this time, be implemented in the United States.  The instincts of our internationalist leaning administration, coupled with a driving need to do something and a naive conviction (to give all concerned the benefit of the doubt) that more capital is an unalloyed good, is almost certain to result in a commitment to rapid implementation. I’ve spoken to many of the CRE organizations and urged them to open initiatives on Basel tout suite. We need to get into the conversation.

While Basel III is not intended to be implemented before the end of 2012, if supported by the Obama administration, it will begin influencing U.S. bank behavior immediately.  Some have estimated that Basel III will require banks to raise as much as a trillion dollars in equity and obtain over $5 trillion in committed facilities to meet new capital and liquidity requirements.  Moreover, the gnomes of Basel continue to think that commercial real estate is worthy of special attention and, particularly HVCRE. The problem is an awful lot of the market is in that HVCRE bucket.  I’ve heard suggestions that, under Basel III, in order for commercial real estate to be a competitive asset class for the banks, the risk spread would have to increase over 200 basis points.  This may simply drive commercial real estate out of the banks.  That’s what’s called, Not Good.

Certainly the whole notion of more robust capital, pro cyclicality breaks and the like are good and meritorious.  Our job as an industry is to try, and keep trying, to manage the regulatory process by-blow of unintended consequences.  We need to ensure the Basel constituencies and our U.S. representative organizations at the Basel party, are fully aware of how CRE markets function, what can be helpful and what can be unnecessarily burdensome or damaging.  Reportedly, following the recent July 15th meeting, there will be new guidance published soon on what the Committee is thinking.  Standby for this.

Yes, I know that the regulators roll their eyes every time we say unintended consequences, but it doesn’t make them right.  Good regulation should fully account for benefits and burdens of things they do.  Our job is to help them get there.